Topic of the Week: Fuel Hedging

People love to claim that Southwest’s fuel hedging strategy was brilliant last decade for keeping costs low. Others say it was terrible because it postponed Southwest from having to face a new reality of higher fuel prices. In the last quarter, Southwest paid 20 cents more per gallon on average than US Airways, an airline that does not hedge. So, what do you think about hedging?

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18 Comments on "Topic of the Week: Fuel Hedging"

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David
Guest
Hedging is portrayed in some of the business press as a way of making money for a company. It’s not. The purpose of hedging is to reduce uncertainty or risk and increase control over costs or revenues. A similiar idea concept applies with insurance. If you don’t buy insurance, you save a premium and in good years, you make money, but in bad years you have a very large bill to pay medical fees or repair your home. If you do buy insurance, you gain control over your unknown costs – you know that you won’t have to spend a… Read more »
marshall
Member

Hedging is insurance in a way. That said, I think Southwest’s very successful hedges a few years ago only delayed a day of reckoning that is sure to come. Their labor costs are out of whack, and Gary Kelly knows it. Still, I have some level of faith that they will find a way to address it.

Jason
Guest
It comes down to the cost of the hedge versus the value of that hedge. In a one off scenario you can not tell whether Southwest is a winner or loser as events are discrete and they fuel prices moved against them on this occasion. In general though, there is a business in selling insurance. This means that most likely the seller of the insurance is profitably running a business which is a cost then passed on the the flyer. In the new airline model of charging usage based fees i like the idea of applying that idea to the… Read more »
Roger
Guest

Damned if you do, damned if you don’t…

Southeasterner
Guest

Nothing was wrong with hedging until 1999-2000 when Glass-Steagall was removed and the Commodities Modernization Act was enacted (the Enron loophole). Since then non-commercial interest in futures has grown from less than 20% of total contracts to now representing 50-60%. With the entry of non-commercial players volatility in commodity prices has increased 18 fold.

If you remove the financial players from the futures markets we would again have a functional system to insure airlines from price shocks.

DAB
Guest
To my knowledge, Southwest was not hedging. The evidence for that was when oil was going up, they suspended their “hedging” program since they didn’t see the point in hedging over $38/bbl, or whatever the number was. Hedging and insurance are not exactly the same thing. Insurance is paying for the offset of risk. Hedging is mathematically and methodologically maintaining a financial position through a disciplined trading strategy. Obviously what I was remembering was early in the last decade, and maybe they modified and actually built a properly executed and disciplined program. Another point on the thing is that to… Read more »
DAB
Guest

Note: in my 4th paragraph, I mixed up the word basis. In the first sentence, I mean it in the usual sense. In the last sentence, I mean basis as in the trading world of the difference in cost between point a and point b.

David SF eastbay
Member

Fuel hedging is the Las Vegas of the airline business.

DesertGhost
Guest

US hasn’t completely ruled out hedging. It feels the cost isn’t worth the risks. Hedging does entail risk. Insurance, per se, exists to mitigate risk. So you essentially insure against risk with a risky strategy.

Hedging is useful when there’s a lot of price volatility. Oil has been trading in a rather narrow range for quite a while. Hedging is less effective in this environment. I believe if US perceives that oil prices will become volatile, it will hedge.

DesertGhost
Guest

The last sentence of the first paragraph might be clearer if it read, “Hedging attempts to mitigate risk with what is essentially a risky strategy.”

Don
Guest

The only thing that matters in this industry is profits which they have no problem with. They know what they are doing. I don’t think fuel will ever reach $150/barrel. But if it does they will be fine.

spumilia
Member

As DAB suggests, hedging really means buying Jet fuel as you sell tickets… matching the sales with the purchase of input costs on a percentage basis.
I think that is a smart business decision.
Going long Jet fuel is not hedging. I am not sure what Southwest was doing.
In the past they were speculating.

jimmbbo
Member

Hedging is gambling by another name… solid business practices don’t include roulette, blackjack or predicting fuel prices, because there are far too many things that can spike fuel prices that are outside the Company’s control…

A well run business handles the realities of the marketplace, and doesn’t spend shareholder money betting they can outguess a volatile marketplace.

Mike Felts
Guest

Actually hedging is nothing of the sort of what you are describing. Hedging is effectively paying a risk premium in order to remove the volatility of the marketplace and has a place in a number of legitimate business practices.

john
Guest

Didnt Herb once say that hedging fuel was basically the same thing as gambling? (might have that wrong – and/or it may have been in the 90s)

Ivan B Zhabin
Guest
Good topic. 2 comments 1) Hedging costs money. The better your financial position is, the less it costs. Southwest management ended up looking brilliant in making a long-term hedging bet at the time that they did. In a sense they did it because a)they could and other airlines could not and b) There was little downside, as fuel prices had been quite low 2) I think it is an accepted fact that Southwest was losing money as an airline and the hedge was making money (I don’t even know if they hedged JetA, probably heating oil). They were better off… Read more »
Chris
Guest
Several comments here are off the mark, but that’s primarily because “hedging” hasn’t been defined very well. Simple, insurance-like hedging is very straitforward. You essentially pay a price to lock in a maximum future price for fuel. This is like insurance. You pay a fixed fee, if the event happens (fuel goes above the “insured” price), you get a payout it. If fuel doesn’t exceed the strike price, nothing happens. Just like insuring against your house burning down or getting into a car accident. The only risk here is that you paid for something you ultimately didn’t need (thus adding… Read more »
Mike
Guest
As others have noted, hedging, in the true sense of the word, is far from gambling, in fact it’s quite the opposite. If an airline doesn’t hedge they are essentially saying one of two things: 1. We don’t think oil prices will rise significantly 2. If oil prices rise significantly we are confident that we can pass on the higher fuel price, maintain adequate profit margins and remain competitive. One of the other issues that is rarely addressed when airline hedging is being discussed is that it takes credit (cash, credit lines and/or a strong balance sheet) to hedge and… Read more »
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