Hedges in flight

Futures, Sep 2008 by Birkner, Christine

For airlines, hedging the cost of fuel has perhaps never been more important than it is now in the midst of a breathtaking ascent in oil prices. One of the most successful airline hedgers, Southwest, recorded a second quarter profit, while airlines that haven't hedged so aggressively are getting hit harder by fuel prices. Meanwhile, airlines have taken aim at Congress's favorite scapegoat for higher oil prices: the speculators. In early July, a coalition of airline CEOs sent a letter to airline customers urging them to contact Congress about cracking down on oil speculation. The letter said that high oil prices were due partly to "normal market forces being dangerously amplified by poorly regulated market speculation." The Air Transport Association (ATA) and the airlines also sponsor the Web site StopOilSpeculationNow.com. "The airline community believes that some $20 to $30 in today's oil price is due purely to speculation," says a spokesperson for JetBlue. An ATA spokesperson says that two weeks after the letters and Web campaign started, more than two million messages were sent to Congress about the issue.

Since the 1980s, airlines have used hedging as a way to limit their exposure to price risks in fuel. Currently, American, United, Delta, Continental, Northwest, Southwest, U.S. Airways and JetBlue all have fuel hedging programs. Dave Chatterton, vice president of RJO Financial, says that airline hedging impacts the broader market in general by creating liquidity in the marketplace. He says there has always been some degree of participation in fuel hedging across the transportation complex, including trucking, fleet operations, and the rail and marina arena, all with the same goal in mind: controlling fuel budgets. But he notes that airline hedging is often more aggressive because for the trucking and rail industry there's a surcharge pass-through mechanism in place where as fuel prices rise, they're passed along to the consumer. "[The airlines] are not able to pass fuel costs along as easily or as effectively as we find at the lower end of the transportation chain, and because of that they're particular- ly susceptible to not only the volatility of prices, but also price spikes," he says.

The more airlines are hedged, the more protected they are from price spikes. The cost of hedging has led some airlines to take their chances with the market. Chatterton notes that hedging became more aggres- sive in the 1990s, and that "9/11 and Hurricane Katrina were the two big drop-off points because cash flow, credit ratings and profitability got so bad that a lot of people dropped off because they either didn't have the credit to establish the hedges or they didn't have the cash flow and the capital to put on and maintain hedges. From that point forward, it became Southwest and a few followers like Jet Blue against everybody else. Since that time, the financial results of those who have been consistent, methodical hedgers have stood out head and shoulders above most who have not."

For third quarter 2008, Southwest is 80% hedged at an average crude oil equivalent of approximately $61 per barrel, and is 80% hedged at an average crude-equivalent price of $58 per barrel for the fourth quarter 2008 (see "Hedging their bets"). "Certainly of late, it appears that [Southwest] has been willing to cover more of their burn than any of the other airlines," Chatterton says. Southwest typically uses a mixture of purchased call options, collar structures and fixed price swap agreements for its hedge positions. A Southwest spokesperson says that its hedging positions reflect an aver- age of years of layering on hedge protection at various levels. "Historically, we have entered the year with approximately 80% hedge protection. Obviously, that may not always be the case, but we continually monitor the futures market and try to be opportunistic where we think it makes sense. We currently have approximately 40% of our fuel requirements hedged in 2010 at an average crude-equivalent price of $81 per barrel. We also have over 20% of our future fuel requirements hedged for 2011 and 2012 at an average crude-equivalent price of $77 and $76 per barrel, respectively," the spokesperson says.

A JetBlue spokesperson says its hedging program aims to be 50% hedged for the current quarter, 30% hedged one quarter out, 20% hedged two quarters out and 10% hedged three quarters out. "We hedged approximately 47% of our fuel consumption during the second quarter and recognized about $59 million in fuel hedging gains," the spokesperson says.

But hedging only goes so far and the airline coalition's letter to customers represented an intensification of the blame game against speculators. "The gist of the letter was basically 'don't blame us for mismanaging our company, blame speculators for driving up fuel prices,'" Chatterton says. The Futures Industry Association (FIA) has spoken out against Congressional efforts to limit speculation, saying the Senate's Stop Excessive Energy Speculation Act, which later failed to receive the votes necessary for continued consideration in the Senate, would "make hedging more expensive [and] drive energy market activity overseas." And the FIA, Managed Funds Association, CME Group, Intercontinental Exchange and others have started a Web site and coalition of their own, the Coalition to Protect Competitive Markets, aimed at educating Congress about the dangers of hastily enacted legislation that could harm the markets. In defense of criticisms of their efforts, an ATA spokesperson says, "Unfortunately over the last 20 years [speculation] limits have been reduced, abolished or circumvented through various loopholes," meaning provisions in the Commodity Futures Modernization Act of 2000, or what some call the Enron Loophole. "We are not asking for an end to all speculation. We simply want Congress to return things to the way they used to be before these regulations were weakened," the spokesperson says.