The Downside of Fuel Hedging

Anyone seen the price of fuel lately? As I write this, oil is hovering around a mere $80 a barrel. That’s a far cry from where it was just a few short weeks ago. And when fuel goes down, it means those who hedge lose out. Let’s talk about why that is exactly. We’ll use Delta as an example.

Place Your Oil Bets

Delta announced earlier this week that it would take a $155 million loss this quarter because of fuel hedges. It will also post a paper loss of $800 million for future quarters, but that loss is just an accounting quirk and has nothing to do with reality. Aren’t hedges supposed to save you money, not cost you? Well yes, sort of. But it’s all about the type of hedge you use.

The Basics
The basic idea behind fuel hedging is to control the cost of fuel in the future. The most basic way to do that is to buy fuel in advance – lock it in for a set price and then be done with it. If the fuel price goes up, you don’t pay more. If it goes down, you don’t pay less. In the latter case, you could have bought it for less if you hadn’t hedged, but there is no additional penalty. These kind of hedges, however, can get expensive considering the volatility of fuel the last few years. So airlines use a whole bunch of different tools, each more complex than the last.

I believe Delta is losing money this quarter because of “swaps” that it has. Basically, that means Delta makes a bet with somebody else, a counter-party. Delta goes to that counter-party (maybe it’s a bank) and makes a deal. Think of it like an over-under. Let’s say Delta signs up for an over-under of $90 a barrel. If it goes over that, then the counter-party has to pay the difference between the $90 and the market price to Delta. If it goes under, then Delta pays the counter-party the difference. So, Delta was looking good when oil was over $100 a barrel, getting $10 a barrel from the counter-party. But now, Delta has to pay the counter-party $10 a barrel if oil is at $80. And that’s why Delta is out $155 million this quarter.

The $800 million loss is really just a guess and means nothing. Each quarter, Delta has to “mark to market” the value of its future hedges thanks to accounting rules. So if the hedges came due today, Delta would be out $800 million as compared to where they were last quarter. But they aren’t due today. They’re due in subsequent quarters and the value could be completely different by then. So the only real number here is the $155 million that is related to this particular quarter.

The upshot is that Delta now expects to pay $3.37 a gallon this quarter instead of the $3.28 it predicted before the impact of the hedges. Does that mean hedging is a bad strategy? It all depends on who you ask.

To Hedge or Not to Hedge
US Airways has stopped hedging completely. It says the cost of a hedging program is enough that it doesn’t make much sense. Is US Airways right? Well for the full year 2011, it paid $3.11 a gallon while Delta paid $3.06.

That’s a fairly small difference for such a dramatic strategy difference. It also doesn’t take into account the fact that Delta has a whole team devoted to hedging. There are infrastructure costs that aren’t reflected in the fuel price that narrow the gap even further. And remember, fuel prices had some real ups and downs last year. So I generally tend to think US Airways has a good idea. But let’s look at this very interesting chart to show a little more detail.

Oil Prices vs Airline Costs

What you see here is a blue line indicating the average price of a barrel of oil in each month. Don’t worry about the exact numbers here and the fact that the price of a barrel of oil doesn’t exactly correlate with the price of a gallon of jet fuel. Instead, focus on what this is telling us.

The airline logos you see are the average price per gallon in each of those quarters. As you can see, US Airways generally paid more than Delta when prices were flat or increasing. When prices were declining, US Airways paid less than Delta. There is something of a lag here, which I assume explains why US Airways paid more than Delta in Q2 2011, but the idea is sound. And I imagine in Q2 2012, US Airways will be paying less than Delta, but that airline won’t release guidance until next week.

Of course, if you knew the cycles, you would play the game differently. But you don’t know the cycles. So it really becomes an effort of trying to make your fuel costs more predictable in the short term. If it’s a long term change, then hedging just delays the inevitable (see Southwest). But if it’s short term, this would protect you from brief shocks. Of course, the way US Airways views it, it’s not worth all the money involved in securing those hedges in the first place. I’m inclined to agree.

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