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.


13 Responses to The Downside of Fuel Hedging

  1. If you need a stable cash flow and fuel represented 35%+ of your operating costs I don’t think hedging is that bad of an idea. I think the big question is what % of your costs do you hedge?

    The largest single cost for the average American airline is fuel (35%), the largest single cost for the average American family is housing (35%). Imagine how difficult it would be to budget your family income if your housing costs went from fixed (a one year rental agreement or longer term mortgage) to variable and if the daily change in price could be + or – 10%. Think of all the excess cash you would have to have on hand in case of sudden price shocks.

    • Jim M says:

      Literally this is EXACTLY why hedging works. It also keeps investors relatively happy. No one likes a company that has wild profit swings, and keeping a large sum of cash on the books has real negatives also.

  2. SEAN says:

    Airlines absolutely need to hedge there fuel costs. As you said oil right now is trading near $80 pb, but looking out longterm prices are only going to rise even if there’s pullback from time to time.

    We have reached peak production in oil extraction. That doesn’t nessessarily indicate we are running out of oil, rather it meens there’s less oil in easily extractable locations. Therefore, what oil is extracted will be deeper, require more refineing & in the end cost more.

    I’m not going to get into further detail here do to length, for more on this go to http://www.theoildrum.com where most questions can be answered.

    • Jason H says:

      Unless fracking is put in a moratorium we are nowhere near peak production. Wells that used to be seen as too “dry” to continue using here in Colorado are now in operation due to fracking.

      • SEAN says:

        there’s an enormous problem with fracking, poisoning the water supply with chemicals used to get the oil & gas out from deep bedrock.

  3. Rhetorical question: Does Delta’s cost of fuel include the cost of the hedges? US Airways also makes the argument that fuel prices tend to go up and down with the economy which affects the travel market and fares. One “hedge” I find interesting is Delta’s refinery purchase. That, along with a fuel efficient fleet and capacity discipline, may turn out to be the ultimate hedge. If Delta’s refinery experiment works, look for other airlines to copy the move.

  4. A says:

    I too think that a hedge is a wise move just so the airline can have some degree of certainty what they’ll be paying for their biggest expense. Not sure I’d be entering the swaps market like Delta did as I wouldn’t take that risk, but unlike a bank, Delta can buy futures and actually take delivery. Who cares if prices fluctuate, at least you’d know what you’re paying tomorrow, or next week or next month.

  5. BW says:

    Key point: oil must be a lot more expensive than what you thought it would be for hedging to be worthwhile. So the stability you guys keep talking about is already (sort of) build into the market. Something drastic would need to happen to change that, such as an event that spooks the market and pushes the prices up a large amount in a short time (like political strife in a major oil producing nation or a refinery explosion).

  6. I’m kinda curious how their costs look on a seat mile flown basis. Another “hedge” is flying an efficient fleet, thats something that the market can’t quickly take away from you..

  7. wftristan says:

    The majority of large co’s be it oil – cocoa – Oj etc will use a futures hedge to Stabilise their costs – I used to Execute these trades in the coffee/cocoa open outcry mkts in the 90’s.

    its fairly simple – you have 100 tons of physical (oil)
    you sell the equivalent futures contracts against it

    so you are now long physical and short futures.

    market goes up – you profit on the physical/lose equivalent on the future
    market goes down you profit on the future (because you were short) /lose on the physical.

    tristan

  8. Personally, I have been shorting oil since the day Delta announced their intention to buy an oil refinery. Given the airline industry’s terrific track record when it comes to timing major capital investments (not) it seemed like a sure thing.

    Also given the airline industry’s history of profitable, well run investments outside their core business, I am saving up my pennies in the belief that a recently modernized refinery in the NE will be available on the cheap in a couple years.

    I’ll go so far as to predict that the sale of the aforementioned refinery will close on the day that oil prices begin a dramatic and prolonged price increase.

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  10. Phil says:

    Never mind the question of whether to hedge or not to hedge… (personally I believe peak oil has nothing to do with current prices and more to do with the likes of trading desks at goldman, cs etc creating unreal demand to handle speculative betting…) but what I really wanted to say is that is one of the best layman’s description of a swap contract and MTM accounting (and how stupid it is) I think I have ever read. Very elegantly put

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