Southwest Airlines Fuel Hedge Program: Why Southwest Hedged Fuel - Research Paper Example

Module Southwest Airlines Fuel Hedge Program: Why Southwest Hedged Fuel Executive Summary The airline industry is highly competitive and dependent on jet fuel prices, forcing industry players to seek fuel price risk management strategies, such as hedging, in order to manage costs. This study provides a short overview of the airline industry and the concept of hedging in the industry before focusing on Southwest Airlines approach to hedging. The performance of the airline when applying their approach to hedging, as well as the relevant literature, is used henceforth to provide a rationale for fuel price hedging by Southwest Airlines. US Airline Industry Background An overview of the US airline sector reveals an industry setting with numerous considerations where heightened competition and fuel costs are key determinants of performance. Global fuel prices are highly volatile, a trend which has been observed over the last two decades (Carter, Rogers and Simskin 1). Fuel costs greatly impact an airline’s operations since they constitute about 17% of total costs, second to labor costs only. Moreover, ticket prices usually reflect fuel prices, hence, determining profit margins, financial outlooks and forecasts. The competitiveness in the US airline industry translates into a situation where the rising fuel costs cannot be passed to the service consumer. Southwest Airlines, as a major player in the US industry, among other things, specializing in short-haul, provides high-frequency and low fare point-to-point services which in the long run can be largely impacted by such volatilities in the fuel prices (Morrell and Swan 713-714). The inability to pass on fuel costs to consumers forces airlines to consider other strategies for surviving fuel prices fluctuation. Hedging is one of such strategies considered by airlines, such as Southwest, as a solution to the fuel price volatility problem. Hedging: Fuel Price Risk Management: Drastic changes in fuel prices are some of the major risks that may cripple airlines. For instance, political volatility in the Middle East- a major source of crude oil- disrupts global oil prices in two ways. First, war increases the local demand for fuel, hence, lesser exports. Secondly, normal extraction of oil may be disrupted during military operations. Carter et al. (4-5) provide an example of such a situation using the Gulf War, where the average spread rose by 8.1 times, from 3.5 cents to 28.5 cents per gallon. Trempski (1) offers another point of view concerning the jet fuel price volatility stating that a barrel of crude oil price rise from $10.82 in 1996 to $69.91 in 2005, had a negative impact on the heavily oil-dependent industry. Control of global fuel prices is not within the power of airlines such as Southwest; hence, there is a need for alternative strategies. Airlines use several instruments to hedge their fuel including over-the-counter (OTC) swaps, future contracts that are exchange traded, exchange traded or OTC call options and OTC or exchange traded collars (Carter et al. 4). Hedging in the airline industry, however, follows a unique format, where risk management is done on fuels other than jet fuels. The first reason for this is based on the refining process; products from the same distillation step share similar characteristics and highly correlated prices and future commercial outlooks. Hence, heating oil can be used to hedge jet fuel prices owing to the fact that their price changes and future contract price changes are highly correlated. Jet fuel is refined from crude oil, thus, crude oil is also heavily applied in hedging jet fuel. The second reason is based on the nature of the jet fuel market which is not sufficiently liquid to warrant future contracts. Derivative contracts on jet fuel have to be based on OTC trading. On the other hand, exchange traded contracts for crude oil and heating oil are active and liquid enough, accompanied by low credit risks. Therefore, airlines interested in hedging traditionally use crude oil or heating oil for management of their fuel price risks (Carter et al. 4). OTC instruments include collar structures and swaps derivatives traded directly between airlines and investment banks. This approach is considered more customizable, allowing airlines to implement largely dynamic hedging strategies through variation of products over the fuel price cycle. Exchange-traded futures, on the other hand, take care of the absence of jet fuel contracts in the US and use heating oil and crude oil purchases (as explained earlier). The lack of a perfect scenario brings about the basis risk due to shifts in the relationship between the spot price of the hedged item and the future prices of the selected contract (Cobbs and Wolf 3). Southwest Airlines and Hedging: An analysis of fuel price risk management by Southwest Airlines over time reveals significant insight on the rollout, achievements and challenges in Southwest’s hedging practices. The analysis reveals a shift in the hedging practices between the late 1990s and early in the new decade. This takes the discussion back to the late 1990s, where Southwest employed a hedging practice of involving small proportions of its jet fuel. The airline applied mixed instruments including call options on crude oil prices and swap agreements for jet fuel prices as of 1999. A shift in hedging strategy is observed from 2000 onwards where the management decided to hedge bigger portions of its fuel requirements through derivative contracts. Between 2001 and 2004, Southwest hedging strategy involved shorter term hedges through heating oil options and longer term hedging through crude oil, at higher levels than competitors as shown below: Table 2: US Airlines Fuel expenses and Hedging as of December 2003 Source: Cobbs and Wolf. Jet Fuel Hedging Strategies: Options Available for Airlines and a Survey of Industry Practices, 2004, (10). The period between 2005 and 2008 saw Southwest Airlines increase the hedging horizon in practice. Whereas in 2003 the airline had 82% of its 2004 oil hedged and 60% of its 2005 oil needs hedged, the hedging only covered a two year horizon. By the end of 2004, the airline introduced an industry-unique hedging strategy involving long-term horizon hedging. The horizon spread from 2005 to 2009 unlike any other in the volatile airline industry. As of June 2008, the airline had hedged 80% for the remainder of 2008 (at $60 per barrel), 70% for 2009 ($66), 40% for 2010 ($81), 20% for 2011($77) and lastly, 20% for 2012 ($76) (Carter et al. 5-6). The Wisdom behind Southwest Airlines Fuel Hedge Program: The unique hedging strategy adopted by Southwest Airlines can be analyzed in two ways: 1) evidence on financial performance attributed to the hedging; 2) a review of literature on the rationale for hedging in the airline industry. According to Carter et al. (5), today Southwest’s financial performance is heavily reliant on the airlines’ fuel derivatives position. This is, perhaps, best exemplified by the firm’s financial performance during the recent global financial crisis; Southwest Airlines managed to post profits in the quarters of 2008 while competitors reported huge losses. Leading up to this, an analysis of the global jet fuel prices over the last decade indicates a general positive trend, which has been translated into significant gains of the airline due to its long horizon hedging program, as it is shown in the table 2. Out of $816 million in operating income in 2007, the bulk $686 million was from hedging gains. By the 2nd quarter of 2008, the firm’s $474 million in operating income consisted of $205 million gained through fuel hedging. Besides this, an extra $345 million was realized in the net income due to unrealized gains on the existing fuel derivatives that had been marked up to existing jet fuel market prices. The airline’s assets also boomed to $23.3 billion by June 2008 in comparison to $16.8 billion at the end of 2007 (6). Bailey (2007) reports fuel hedging as one of the main competitive advantages of Southwest Airlines over competitors in 2007. The reporter explains the case by stating that the long term nature of Southwest’s fuel hedging enables the firm to purchase fuel for $51 a barrel through to 2009, while competitors have to purchase jet fuel at the market price of $91 a barrel. Table 2: Spot Fuel Prices from Gulf Coast, 2001-2008 Source: Carter et al. Southwest Airlines Jet Fuel Hedging, 2008. Carter, Rogers and Simkins (1) conducted a study on the US airline industry to investigate whether fuel hedging was economically prudent. The scholars reviewed the fuel-hedging behavior of US airlines, including Southwest, between 1994 and 2000. Firstly, they note that higher fuel costs impact negatively on the firms’ cash flows. The results of the study indicated that hedging of fuel prices is directly correlated with the firm value; hedging is associated with capital investments, with the industry average revealing 12%-16% increases in firm value due to hedging practices. The Defense Business Board (4) notes that a number of commercial airlines have successfully used hedging to reduce budgetary uncertainty, control cash flow volatilities, reduce volatility in income, insure against financial distress and manage long term fuel expenditures. CONCLUSION The airline industry’s competitiveness and reliance on jet fuel for financial performance translates into the pursuit of strategies to manage the risks on jet fuel prices. Hedging, usually executed as either over-the-counter or exchange traded contracts, is the approach of choice. Southwest Airlines hedging program uniquely entails using long-horizon derivatives. Such an approach could either buffer the firm from rises in the volatile oil prices or lead to losses in case jet fuel prices fall. However, the firm has seen financial success through this form of hedging as evidenced by its thriving even during the financial downturn. Other literature also supports hedging as a potential approach to managing the highly volatile fuel costs. Works Cited Bailey, Jeff. Southwest Airlines gains Advantage by Hedging on Long-Term Oil Contracts. The New York Times. 2007. Web. 23 Jan. 2012. Carter, D. et al. Southwest Airlines Jet Fuel Hedging. Finnmann. 2008. Web. 23 Jan. 2012. Carter, D., Rogers, D. and B. Simkins. Fuel Hedging in the Airline Industry: The Case of Southwest Airlines. US: Case Research, 2004. Print. Cobbs, Richards and Alex Wolf. Jet Fuel Hedging Strategies: Options Available for Airlines and a Survey of Industry Practices. USA: Kellogg, 2004. Print. Defense Business Board. Fuel Hedging Task Group: Report to the Senior Executive Council. Department of Defense, 2004. Web. 23 Jan. 2012. Morrell, P. and W. Swan. “Airline Jet Fuel Hedging: Theory and Practice.” Transport Reviews, 26.6(2005): 713-730. Print. Trempski, Robert. “Does Fuel Hedging Add Value? Quantitative Analysis but Qualitative Conclusion in the Case of the US Airline Industry.” Undergraduate Economic Review, 5.1(2009), 1-22. Print. Read More