Friday, November 30, 2007

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 for the heads-up on this one.


Jmwilson22 said...

Im absolutely thrilled about your post, I have been telling fellow students why Southwest is such a leader in its industry, I have been flying this airline for 6 years, and I'm still amazed at the fact the other airlines haven't "wised up" and followed.

Unknown said...

jm I too, am an avid flyer on SWA and if they continue "outsmarting" the industry in this way, I'm looking forward to enjoying the most affordable means of travel available

Anonymous said...

if you think about it, hedging is all about trying to eliminate some form of risk, but in the case of Southwest they were riskier than the competition by entering into longer term contracts than their competitors. In this case, the gamble has definitely worked out for them due to the increasing cost of oil. Imagine what would happene if the price of oil switches from the dollar standard to the euro as has been speculated? Then companies would be facing exchange rate risk, which with the current appreciation rate of the euro vs. the dollar would again result in Southwest beating the competition

The Wild Gunman said...

I liked that paper a lot actually. I was surprised it only made it into FM. In my mind this paper was at least as interesting and provocative than Jin and Jorion's similar JF paper on the oil industry. I always felt there was so much more to be done with this. Aside from Tufano's gold paper there hasn't been much major empirical work here.