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Fuel-hedging And Southwest...explain?  
User currently offlineChrisNH From United States of America, joined Jun 1999, 4133 posts, RR: 2
Posted (8 years 11 months 2 weeks 6 days 2 hours ago) and read 3442 times:

I understand the gist of this but not much else: Southwest bet that fuel prices would go up and locked in lower prices to protect themselves from the rises that did occur. Do I have that much right?

OK...next question is this: There is obviously a line in the sand at which point Cinderella's carriage turns back into a pumpkin. So when that happens, will Southwest need to come out with massively increased air fares?

What is the implication of fuel hedging AFTER the expiration date? I trust that there IS an expiration date to the magic that Southwest has foisted upon itself?

Chris in NH

11 replies: All unread, jump to last
 
User currently offlineTPEcanuck From Taiwan, joined Oct 2005, 89 posts, RR: 2
Reply 1, posted (8 years 11 months 2 weeks 6 days 2 hours ago) and read 3422 times:

Hi Chris,

There is quite a bit of information on this elsewhere in the site. But I it's a forum for interaction, so here's my contribution. (not to mention any financial website!) As for specific details about Southwest's future hedges, I would imagine they are a corporate secret.

First, you are right on the basic nature of hedges. The buyer(southwest) of the hedge signed a contract that would only pay-off if the price of oil went beyond a certain price, and the seller(investment firm??) hoped the price would not increase to that point, and thus not have to buy the oil, and pocket the money paid to purchase the hedge. Basically, it works like this.

I think in 5 years, the price of oil will be $100 a barrel. You think it will be less than that. So, I buy the right to purchase oil at a price of say, $80 a barrel, 5 years into the future. You agree to this, and sell me this right at say $40 per barrel. If the price of oil does go higher than $80 during the life of this contract, I'm in the money. You would have to go into the market, buy the oil at that higher price, and sell it to me for $80. On the other hand, if the price of oil does not exceed $80, you would pocket the $40. The numbers here are just off the top of my head to illustrate the point. The actual values and time frames are carefully considered and priced.

As for a line in the sand, there may or may not be. Depends on the price of oil. If it falls below the price of the hedges, Southwest will be worse off, because they will have paid the $ for the contracts, but will not exercise them.

Morever, Southwest, or anyone else with liquid cash on hand for that matter, may continue to be purchasing hedges against the future price of oil. If the increase in prices exceeds what is predicted, again, Southwest may reap the financial rewards of this financial risk management technique. A more common strategy is to 'ladder' your hedges...structuring your hedges by price and length of the contract. This dilutes the risk (and potential benefits too..if you are exactly right like Southwest has been recently!).


User currently offlineSlider From United States of America, joined Feb 2004, 6860 posts, RR: 34
Reply 2, posted (8 years 11 months 2 weeks 6 days 2 hours ago) and read 3406 times:

Quoting TPEcanuck (Reply 1):
Morever, Southwest, or anyone else with liquid cash on hand for that matter, may continue to be purchasing hedges against the future price of oil.

Great post TPE- thanks for clarifying a lot of that. Also, there is another facet of hedging which makes it difficult for airlines to accept the risk--cash expenditures up front in order to leverage the hedge.

Airlines are not keen on additional cash outlays given concerns for liquidity, so it's another drawback on putting the hedge in place.

Also, people seem to forget that WN also had hedges in place back in the late 90s and LOST money on it. Win some, lose some. It's a calculated gamble.

They choose to take that gamble for the sake of having a predictable cost base.


User currently offlineORD From United States of America, joined Jul 1999, 1384 posts, RR: 1
Reply 3, posted (8 years 11 months 2 weeks 6 days 1 hour ago) and read 3361 times:

Here is the information on Southwest's fuel hedges:

2005: 85% hedged at $26/barrel

2006: 65% hedged at $32/barrel

2007: 45% hedged at $31/barrel

With fuel right now around $60/barrel, Southwest is clearly saving some serious money and has a huge cost advantage over competitors who are not hedged. Assuming fuel cost stays the same over the next few years, Southwest's advantage will diminish because they have less of their total fuel hedged and at a higher price.


User currently offlineLeelaw From , joined Dec 1969, posts, RR:
Reply 4, posted (8 years 11 months 2 weeks 6 days ago) and read 3313 times:

Hedging is the opposite of gambling. You hedge your bets, not bet your hedges.

User currently offlineChrisNH From United States of America, joined Jun 1999, 4133 posts, RR: 2
Reply 5, posted (8 years 11 months 2 weeks 3 days 22 hours ago) and read 3180 times:

Thanks to TPE for an excellent discussion on what this is all about! Does this mean that Southwest was on the ball while other carriers were asleep at the switch? I can imagine all sorts of 'Why didn't we think of this?' from the other carriers' CEOs.

Chris in New Hampshire


User currently offlineODwyerPW From Mexico, joined Dec 2004, 875 posts, RR: 3
Reply 6, posted (8 years 11 months 2 weeks 2 days 22 hours ago) and read 3087 times:

Or,
"I wish we had had the cash to do that?" from the other carriers' CEOs.



Quiero una vida simple en Mexico. Nada mas.
User currently offlineSupa7E7 From , joined Dec 1969, posts, RR:
Reply 7, posted (8 years 11 months 2 weeks 2 days 22 hours ago) and read 3070 times:

Quoting Leelaw (Reply 4):
Hedging is the opposite of gambling. You hedge your bets, not bet your hedges.

That's your opinion, but anything can be gambling in a sense. Southwest gambled by buying some very expensive insurance. Turned out it paid them back many times over. If it had not, their posture - "gamble" if you will, since it cost money and had uncertain returns - would have cost them money and their competitors would have had a laugh.

There is no free money lying around out there. Fuel contracts are often sensible but risky in and of themselves. The guy selling fuel hedges is also taking a sensible posture. It's not like hedging is always good; in fact the friction and markups dictate that OVERALL you save money by never hedging one bit. Your guesses are 50-50 but there is friction in the process, fees, etc.

Northwest took a different fuel-prediction posture. They flew 742s, DC-10s, DC-9s, Avros instead of buying new planes. They bet the farm that fuel prices would not rise to $60. Boy were they wrong. Now they wish they replaced all their DC-10s 5 years ago with new A330s. Would have saved a lot of money.


User currently offlineExFATboy From United States of America, joined Jul 2003, 2974 posts, RR: 9
Reply 8, posted (8 years 11 months 2 weeks 1 day 20 hours ago) and read 2962 times:

I think the best way to think of hedging in this context is as a form of insurance - the hedges insulate the buyer against at least a portion of the risk of fuel increases.

Supa7E7 is right in that in the long run, trying to hedge against 100% of all upside risk is a money-losing proposition. But a few years ago when WN bought their hedges, the geopolitical realities pointed to increasing fuel prices. Perhaps not as sharp of an inrease as we've actually seen, but an increase, so WN's position was not that big of a gamble.

NW's position of keeping their older planes was not a bet against increases in general as much as it was a bet that the increases would be much more gradual, and that in the short run the savings from not buying new planes would more than offset increased fuel expense. If fuel prices continue their recent downward trend, NW's strategy might not be that bad in the longer run.

Actually, NW's best bet would have been to both buy new aircraft and hedge, but, to paraphrase Donald Rumsfeld, "you go to war with the balance sheet you have, not the one you'd like to have."


User currently offlineAeroWesty From United States of America, joined Oct 2004, 20740 posts, RR: 62
Reply 9, posted (8 years 11 months 2 weeks 1 day 18 hours ago) and read 2925 times:

Not that anyone's on the wrong track, but just for accuracy, it is understood that there isn't a pure jet fuel hedge, right?

To hedge fuel, a series of financial transactions involving risk (aka derivatives) is setup between an airline and investment banks, based on the price of related products such as crude and heating oil.

An airline like Southwest doesn't just call up Chevron, for instance, to say "we want to pay $X in the future for your jet fuel", and Chevron says "okay".

There is more to it.



International Homo of Mystery
User currently offlineExFATboy From United States of America, joined Jul 2003, 2974 posts, RR: 9
Reply 10, posted (8 years 11 months 2 weeks 1 day 17 hours ago) and read 2872 times:

Technically correct - there is not an exchange-traded futures contract for jet fuel, at least not in the US. Here's a paper written by a Northwestern student that has a good summary of the underlying principles of a jet fuel hedge. (The figures are a little dated, though - it's from 2004. A.net isn't letting me link directly to this for some reason.):

www.kellogg.northwestern.edu/ research/fimrc/papers/jet_fuel.pdf

To simplify, I believe that an airline hedging jet fuel never actually takes delivery of product from the contract, but rather simply sells the OTC derivatve instrument (whatever form it may take), if it's "in the money", to another party who can actually use the raw material (be it crude or heating oil), and then uses the profit to offset the expense of purchasing fuel from normal jet fuel sellers. Alternatively, I guess the airline could sell the contract to another party actually capable of delivering jet fuel to the airline, but who would take delivery of the crude or heating oil, but unless that other party was able to deliver jet fuel to all the various locations where the hedging party might want it, this would be less efficient. (Also, I have no idea whether or not heating oil can be refined into jet fuel - I'm not a petrochemist. I'd presume not, though.)

As a practical matter, this doesn't matter to us, or anyone analyzing the airline's financial performance: the expense of the underlying mechanisms (including payment to the investment bank for setting up the appropriate counterparties, etc.) is simply "baked into" the final figure we see in the financials: if the underlying crude is at $25/bbl and the additional cost adds the equivalent of $1/bbl to the transaction, it's simply disclosed in the airline's financial statements as a "hedge at $26/barrel."


User currently offlineLeelaw From , joined Dec 1969, posts, RR:
Reply 11, posted (8 years 11 months 2 weeks 1 day 16 hours ago) and read 2850 times:

Quoting ExFATboy (Reply 8):
Supa7E7 is right in that in the long run, trying to hedge against 100% of all upside risk is a money-losing proposition. But a few years ago when WN bought their hedges, the geopolitical realities pointed to increasing fuel prices. Perhaps not as sharp of an inrease as we've actually seen, but an increase, so WN's position was not that big of a gamble.

No sensible hedging strategy should result in huge losses. Sensible hedging is all about transfering price risk from the hedger to the speculator at an acceptable cost. The speculator is gambling, the hedger is insuring.


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