Hedging: It’s good for you and good for your company

European Airlines Review Hedging As Oil Prices Rise: "Already grappling with stiff competition and deep cost cuts following a slump in global travel, rising fuel costs are the latest blow to the beleaguered industry"



Oil prices are at all time highs (in nominal terms) on both supply (OPEC said they could not pump much more at present) and demand (higher than expected) concerns. Now I am guessing you have heard that from a zillion places. And moreover, I would wager that you probably expected oil prices to fluctuate. So is it just me who is angry every time airlines (this time it was American Airlines) complain about the price of fuel.

Why? They can easily be hedging this risk.

While hopefully their CFOs are all subscribers to the FinanceProfessor Newsletter and read all about the good aspects of hedging when we reviewed the Simkins, Carter, and Rogers paper on airline industry hedging practices. The paper is so interesting we reviewed it a twice. First in 2001 and then again this past spring-the latter review is listed below. But maybe the executives missed those issues (spam filters being what they are and all).

So if they did miss that, and are still not reading this, maybe these constantly complaining executives may happen to have heard of a firm called Southwest Airlines ;) The low cost airline from Texas recently named Gary Kelly as their new CEO. Kelly, an accountant who was formerly the CFO, is probably most famous for his hedging of jet fuel. How well did he hedge? The firm is reported to have locked in oil at $24 and $25 a barrel for much of the next two years. Remember current market price is over $44 a barrel! Gee, I bet that helped his reputation 
It is interesting to see the how other airlines (both in the US and abroad) are dealing with the high jet fuel prices. For instance, Ryanair had hedged much of their fuel only through October. When this fact was admitted, the stock price fell about 3% on volume that was twice its average. “Scandinavian airline SAS plans to announce next week it has decided to resume hedging after being left exposed since the first quarter, while Swiss International Air Lines faces more potential losses after selling hedges to boost cash reserves.”

I will concede that there is truth to the claims that hedging long term risks is more expensive for firms with high financial risks, but the added cost is not a good excuse! So get out there and hedge! You too may end up as CEO.



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Sources:

Articles on Southwest’s hedging
http://www.freep.com/money/business/irep16e_20040716.htm
http://www.ctnow.com/business/hc-southwestair.artaug04,1,6498775.story?coll=hc-headlines-business

Article on other airlines hedging
http://news.airwise.com/stories/2004/08/1091563644.html —VERY GOOD!

For complaints on high jet fuel prices:
From Reuters on July 31, 2004:
http://news.moneycentral.msn.com/breaking/breakingnewsarticle.asp?feed=OBR&Date=20040731&ID=3877152
“``Record-high fuel prices and an intensely competitive domestic revenue environment have made the need for further cost-cutting all the more clear,'' Gerard Arpey, chief executive of American parent AMR Corp. (AMR), said earlier this month.
Continental Airlines (CAL) has said in recent months that fuel prices would add an extra $700 million in operating expenses this year, and it might have to lay off workers as a result.
``The current revenue and fuel environment have overwhelmed our efforts to return to profitability, and we now must achieve significant additional cost reductions,'' Continental CEO Gordon Bethune said when the airline released its quarterly earning in July.


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From the January 13, 2004 FinanceProfessor newsletter:

My chairman Jeff Peterson complained recently that academic publications travel at "glacial speed". The paper is by Simkins, Carter, and Rogers and looks at hedging in the US Airline industry is one such paper. It really is one of my favorites. I saw it presented a few years ago and I thought it was close to publication then, but I guess the glacier has not yet completed its journey as the paper was presented at this year's AFAs. Their findings? Hedging does create value. Using regression analysis, they report that hedging increases firm value by over 10%! How? One hypothesis is that hedgers can better afford to maintain capital spending when jet fuel prices climb. This view is supported by their finding that there is a "positive relation between hedging and…increases in capital investment."
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=325402

Airline Hedging

You probably have noticed that oil prices have dropped significantly over the past month. However, the Washington Post points out that many airlines are still paying the higher price because they locked in when prices were high.

A look in:

"Like insurance policies, hedging contracts protect against risk, allowing companies to manage damaging price swings....If the market price for oil is above a price limit arranged in a hedging contract, the airline gets the difference, which offsets higher jet fuel costs -- the biggest expense for most airlines.

Of course as this suggests that at times when prices are falling the airlines pay more (unless options are used):

"If the price of oil is below a preset price floor, the airline ends up paying more than the market price...."

"That's the risk you take with hedging," said AMR spokesman Tim Wagner, who would not comment on whether the airline was losing money on its third-quarter hedge. "When it was at $78 dollars per barrel, it looked like you had great deals."

But this "loss" comes when the overall firm is in a better position to handle it, which is exactly what a hedge is designed to do:

"...the airline greatly prefers falling oil prices even if it means some of its fuel hedges are rendered useless, he said...Despite the risk of paying up on some hedges, falling oil prices are a big boost to airlines and eases concerns about slowing demand."

BTW I will use this as an opportunity to mention my favorite airline hedging paper as well. It is by Carter, Rogers, and Simkins. Super short version: hedging is good for you.

Hedging jet fuel prices at airlines

Airline hedging has been a topic of discussion on the FinanceProfessorblog since its inception. With volatile energy prices, it is now a hot topic within the airlines as well. Here is a look at the discussion from FlightGlobal.

Hedge your bets:

"A large part of deciding whether or not to hedge comes down to the way in which ­airlines view hedging. Those that see it as an insurance policy which enables them to ­foresee exactly what they will be paying for fuel, therefore avoiding any nasty shocks, are the most likely to implement long-term fuel hedging strategies.

'Airlines should look at hedging as a ­strategic device that keeps them on an even keel and avoids extremes,' says Leo Drollas, deputy executive director and chief ­economist at the London-based Centre for Global Energy Studies. But he adds that there is a tendency for airlines to hedge tactically rather than ­strategically, meaning they are 'either too heavily hedged or too light on hedging, so they lurch from one situation to another'."

The article also gives some real world examples. For instance from Lufthansa (who I recently flew to Barcelona)

"One airline that follows a strategic approach to fuel hedging and has done so since 1990 is Lufthansa. "Our hedging programme is designed to shield the airline from the adverse impact of the market," says Lufthansa vice-president corporate fuel management Helmut Fredrich. "Our strategy is that we are not ­speculating if there is a low [fuel] price environment. The aim is to mitigate the effects of changing oil prices to give Lufthansa time to adjust to different levels. We start 24 months out, building up our hedges by 5% a month so that after 18 months up to 85-90% of demand is hedged." This means 90% of Lufthansa's fuel is hedged for the coming six months, while 54% is so far hedged for 2009."

Good stuff. Well worth the read (it is fast).

In Hedging you win some and you lose some.

Southwest's infatuation with fuel hedges backfires - MarketWatch:

"Given oil's relentless ascent, investors have been dumbfounded that Southwest's hedging program wasn't universally used by other airlines, who unfailingly blame their weak financial performance in part on rising fuel costs.
Then came the crash. Oil is now trading at half the price it fetched just three months ago. Suddenly, Southwest's aggressive bet on the market went bad"

No it did not go "bad". Almost by definition hedges will lose money when the risk the firm is hedging moves in their favor. So airlines worry about jet fuel prices. Holding other things constant, airlines drop in value as teh fuel prices rise and vice versa. So, their hedges are designed to "lose" money when the firm can better handle the losses and make money when operations would otherwise be hurting. In doing so they allow the firm (Southwest in this case) to focus on what they do well (run an airline) and not worry about what is outside of their control (price of fuel). The hedges are not designed to make money 100% of the time.

The AP had some more details and did come a bit closer to the story:

"The fuel-hedging deals at the core of Southwest's numbers include options to buy fuel in the future at below-market prices. They succeeded again in saving the airline money on its largest single expense.

Southwest's fuel spending jumped 52 percent, to $1 billion, but the airline paid less per gallon than did other major U.S. airlines.

And while Southwest took a charge to write down the value of its hedges, it also recognized cash settlement gains of $448 million from fuel contracts, and included that money in its net income."

So if I am reading this correctly, the loss was an accounting write-down, while the savings are cash saved.
A good deal in my book! But even if I am not reading it correctly, hedging (as opposed to speculating) is still the way to go in my opinion!

An Airline Shrugs at Oil Prices - New York Times

An Airline Shrugs at Oil Prices - New York Times:

"Southwest owns long-term contracts to buy most of its fuel through 2009 for what it would cost if oil were $51 a barrel. The value of those hedges soared as oil raced above $90 a barrel, and they are now worth more than $2 billion. Those gains will mostly be realized over the next two years. Other major airlines passed on buying all but the shortest-term insurance against high fuel prices..."

That other airlines were not hedging (or at least not hedging long-term) has been one of my pet peeves going back as far as the newsletter days. Sure it costs money to hedge, and sure is not without some risks (see for instance this story on what happened when oil prices fell), but hedging makes too much sense not to do.

How does hedging work? Why? The best explanation I have ever seen comes from an old Corporate text book I once used by Rao (do not think it is still in print and I can not find my copy). In it he described how hedging allows management to worry about what they do well and can control (service, pricing, safety etc) and not what they can not control (oil prices in this case).

An other view (the two views are definitely NOT mutually exclusive) is that hedgers have both better access to capital markets and less need to go when the asset (oil) moves in teh 'wrong' direction. My favorite paper in this area has long been Carter, Rogers, and Simkins.

Of course that said, all of the good I can say about hedging goes out the window if firms use the same derivatives to speculate.



Thanks to Felix over at Conde Nast's Porfolio.com for the heads-up on this one.

Airlines Return to Hedging - WSJ.com

According to the WSJ, airlines are making a switch from futures to options for their hedging programs.

Airlines Return to Hedging - WSJ.com:

"..oil prices are starting to rebound, creating a quandary for the industry. If the airlines dive back into hedging, they could end up overpaying once again should oil prices fall back. Remaining unhedged would leave airlines exposed should the recent rally extend into a price spike.

The answer, some airlines say, is to hedge their bets on how to hedge. Carriers are relying increasingly on instruments that reduce the burden of rising oil prices, but leave open the option of purchasing fuel at market rates should costs fall back. These derivatives have greater upfront costs, but airlines are unlikely to see a repeat of the massive charges they reported in their fourth quarters from hedging programs gone wrong."

and later

" The airline is using a mechanism known as a call option, which grants it the right to buy oil futures at $60 a barrel, even if their value has risen above that level. The options are pricier than other hedging instruments, but still allow an airline to take advantage of cheaper fuel when oil prices fall.

Excusing the article appears it was written for an introductory finance class, it is interesting to see the switch to options. It is surprising that futures were used as much as they were when they create an obligation to lose if prices move against your hedge. Or as you learn in any finance class: options hedge the moves against you while allowing you to participate in moves that are in your favor. The disadvantage is that they often are not as liquid and have higher transaction costs.

Southwest Hedging

Virtually every semester a focus of attention is hedging in the airline industry and no firm is studied more than Southwest, so it was surprising when I heard new numbers in this piece.  Staggering numbers in fact:

"While its point to point service and low-cost, low-fare contributed to the company’s past success, its intensive fuel hedging programs is also largely responsible for these past profits. In fact hedging alone saved Southwest Airlines over $3.5 billion and made up almost 83% of the company’s total profits between 1998-2008. ^{[1] [2]} "

Related articles

• Spike in fuel prices erasing airline profits (seattlepi.com)
• Is Alaska Air the Perfect Stock? (fool.com)

Airline CFO: Hedging Saved Us $400 Million - CNBC

Airline CFO: Hedging Saved Us $400 Million - CNBC:


"Alaska Air begins to hedge about three years in advance. Each quarter, the company adds an incremental amount to that position (usually an extra 5 to 7 percent of its future consumption) until it hits 50 percent. It’s a strategy that is constant, regardless of volatility in the energy market.

“Our program is really designed to be price agnostic. We go into the market and buy at current prices and what it is, is what it is,” Pedersen explained.

Since it uses caps only, the company says it remains insulated from major hedging losses if prices suddenly drop—like they did in 2008 when crude oil plummeted more than 70 percent in less than 6 months."

Airlines and hedging back in the news from AVIATION WEEK

The good people over at Aviation Week seemingly still don't quite get it. Hedging is not supposed to be a money making operation. It is supposed to eliminate (or at least lessen) one form of risk. In this case, those airlines that locked in the price of Jet Fuel need not worry about it. True they are paying more than the spot price, but that always happens. When they made their decision, prices could have gone to $200 and then they would be writing what a great move it was to hedge.

Airlines Made Bad Bets in Fuel Hedging | AVIATION WEEK:

"With oil prices rising to levels near $150 per barrel and then unexpectedly falling by more than 60%, airlines had plenty of opportunity to make wrong bets on fuel. And many did. Ryanair, for instance, locked in fuel prices during the run-up that now mean the carrier has to pay far more than the spot rate. Air France-KLM, too, has been hurt. At current oil prices, the carrier's hedge book means it will pay more than at spot rates for the rest of the financial year, as well as in the next two. The airline in the past quarter took a €373- million ($466-million) financial charge related to hedges.

Note to class, this is a time when the airlines REALLY wish they had purchased call options and not futures. Why? (yeah that will likely be a test question.)

An important point to ponder, given the apparent correlation of fuel prices and the economy really makes the fuel prices the best thing to be hedging (ie. what is the real exposure?).

Southwest Airlines and hedging from WSJ

Article - WSJ.com:

"Southwest Airlines Corp. (LUV), the airline industry's most aggressive fuel hedger, remains committed to hedging to lock in future fuel prices, Laura Wright, chief financial officer, told Dow Jones Newswires.

Amid today's volatile oil prices, Southwest has placed new hedges this year using only call options. 'That's our favorite way to hedge,' she said, because it offers protection against rising prices, but allows the company to pay market rates if prices remain low.

'We used call options a lot in the late 1990s, but then they got too expensive' as oil prices rose, Wright said. 'In the last two years, we used a lot more collars,' which combine options contracts, providing protection from falling prices but less upside protection if prices rise. 'We've always used simple methods of hedging, a combination of options, collars and swaps,' she said."

Just this past week a group in my MBA class did a case on Southwest's hedging, so for all of you in class, this should be nothing but review!