In the second half of 2008, a barrel of oil has sold for anywhere from $147 in July to around $60 recently. In a matter of hours on September 22, it rose by a record $25 a barrel before falling back in the afternoon and plunging the next day. Such swings can produce a lot of turbulence for fuel-hungry industries such as airlines.
The problem, of course, is that no one can accurately forecast what the price will be in three days much less three months, a fact that has played havoc this year with the finances of airlines and other industries that need a steady supply of fuel to function. For example, when oil prices were peaking in the summer, most airlines struggled to pay the bill, but Southwest Airlines drew accolades because of its successful use of hedging against rising oil prices. Its competitors were forced to raise fares and add fees because they were either too strapped for cash to lock in fuel prices when they were low, or less prescient about the summer price spike.
Laura Wright, Southwest’s chief financial officer and one of the architects of the hedging program, estimated last summer that Southwest had saved $4 billion since the late 1990s in what it would have paid to fuel its fleet of 737 jets had it not locked in fuel prices years in advance.
Unfortunately for Southwest, oil prices fell in the third quarter almost as rapidly as they rose in the first and second. The Dallas-based carrier was among many airlines in the third quarter that had to account on its books for fuel contracts that were priced higher than the current market. Over the next four years, Southwest could pay the equivalent of $60 to $90 a barrel for a large portion of its fuel needs. That may or may not be a smart bet, but Wright and other Southwest executives say they still believe in the hedging program. After all, it is one of the main reasons that 2008 is expected to be the airline’s 36th straight profitable year.
An Insurance Policy
Hedging works as insurance, designed to reduce the risk of losing money if the price of any commodity goes up or down. Fuel-price hedging can take several forms, including contracts to buy a set amount at a future date at a certain price, and collars, which provide the right to buy fuel within a set range of prices.
This betting against fuel-cost volatility is done in many industries, but it has taken on enormous importance for airlines. For years, fuel represented 10% to 15% of most airlines’ operating costs, but this summer, as crude prices soared, its cost-share shot up to between 35% and 50%, according to the Air Transport Association, a trade group that represents most U.S. carriers. Although they tried, airlines were unable last summer to raise fares or cut operating costs enough to offset such a jarring increase.
Christian Terwiesch, a Wharton professor of operations and information management who has studied the airlines, notes that the industry is especially vulnerable to fluctuating energy costs because “jet fuel is a very significant part of the cost structure of an airline. Jet fuel prices are traditionally very volatile. They have gone from $2 a gallon in 2007 to $4 in July 2008. In February 2004, it was still $1 a gallon.”
Terwiesch says such volatility “is absolutely bad. [The airlines’] net margins are thin to begin with. If you take that cost and double it, it’s easy to understand why all hell breaks loose.”
At Southwest, Wright recalls that the company first dabbled in fuel-cost hedging when prices spiked in the early 1990s but did not get systematic about it until 1999, when oil cost less than $11 a barrel. “Today we have changes of $11 in one day,” she notes. “The reason we did it wasn’t to make money. We’re not that smart. We’re a long-lead-time business. We have to know how many airplanes to order, and we have to put out our schedules months in advance. You don’t want to go into a situation where prices are out of your control. We wanted to be able to build a business plan where we would pretty well know what our costs would be. We thought of it as insurance.”
In many other industries, hedging against large or unexpected increases in fuel or other commodity prices is practiced on a regular basis. “Railroads do it, and some public transit systems do it for diesel fuel for buses,” says aviation consultant Robert W. Mann, president of R.W. Mann of Port Washington, N.Y. “Precious metals and gold producers do the inverse, selling forward if they like the current prices. A large baker may do it, locking in wheat prices. Anybody who is a consumer of a commodity and whose prices can be distorted by rises in prices in that commodity can be a hedger.”
Barry Siler, a Houston oil-and-chemicals trading consultant who helped Southwest devise its hedging strategy in the 1990s adds that the big baking companies that choose to hedge against rising wheat prices may also need to lock in prices for natural gas used in their ovens. In addition, he cited chemical producers who try to guarantee what they will pay for natural gas and oil, and petroleum refiners themselves. Refiners consume energy to produce energy and, ironically, want to pay as little as they can for a product that they sell for as much as they can.
Even individual consumers can be hedgers. Putting 5% of an investment portfolio into gold-backed mutual funds or stocks, as some advisors suggest, may work as a hedge against the uncertainty now gripping equities markets. Siler points out that in states or cities where electric utilities are deregulated, homeowners often have a choice of energy providers and can agree in advance to buy power at a set price for months at a time.
In some surface-transportation businesses, there is less hedging of fuel costs than one might expect, according to consultants and industry officials. One reason for its limited use by trucking companies and railroads is that they have been able to include fuel surcharge clauses in contracts with shippers, passing along higher prices for diesel fuel this year.
Some major railroads, including Norfolk Southern and BNSF, have done more fuel hedging than others, but it has been limited and they have not come to depend on the practice as much as airlines do. Norfolk Southern hedged a small portion of its diesel-fuel needs up to 36 months in advance from 2000 to 2004 and saved money, says Bill Romig, the railroad’s treasurer. Like other railroads, however, Norfolk Southern determined that there would be less uncertainty in its own finances if the company used only surcharges to offset higher fuel prices. Hedging “was adding unnecessarily to our financial volatility,” he recalls. Now “we are adequately recovering our fuel prices from surcharges.”
Similarly, some but not all large cruise-ship operators hedge their need for fuel. Miami-based Royal Caribbean Cruises, one of the world’s largest cruise lines, has used hedging this year for about half of the 1.22 million metric tons of fuel it anticipates using in its ships. Even with the hedging, the company expects to spend $772 million on fuel. Patrick Sinclair, RCCL’s vice president for energy management, argues that the wisdom of using hedging was made quite clear on September 22 — the day oil futures rocketed by $25 a barrel. Hedging “gives us much more stability in a whole range of planning processes. We don’t react to daily fluctuations …. It allows us to plan more consistently and not react to market conditions.”
Southwest More Aggressive
In the airline industry, most carriers have used fuel-cost hedging on a more limited basis than Southwest, Terwiesch notes. That is primarily because the other carriers determined they could not afford to pay the fees — in effect, the insurance premiums — required. In other words, the airlines were betting that oil prices would not increase as much as they did earlier this year, he says. Currently, most airlines are using various forms of hedging for about half of their fuel needs.
Wharton public policy professor W. Bruce Allen has another theory about the airlines’ limited hedging. Most airlines “do not seem to be very nimble,” he notes. Evidence of that, he believes, can be found in how long it took many carriers to change their basic business models after the end of the dot-com boom and September 11, 2001, by reducing their labor and other costs to compete with Southwest and other smaller, low-cost airlines. The cost savings for several major airlines did not come until they had been through Chapter 11 bankruptcy protection or had won labor-cost concessions from unions by threatening the bankruptcy route, Allen says.
Wharton insurance and risk management professor Neil A. Doherty suggests another reason for companies to avoid hedging: How the practice is viewed by investors. The number of academic studies of the topic is relatively small, he says, but they indicate that the market’s opinion — as measured by a company’s ratio of book value to market value — does not seem to appreciate hedging efforts if it is not a core corporate activity. Airlines, among other industries, are in business to provide a service, and how well they perform is not directly linked to how much hedging they do. When investors “buy an airline, they are looking for other reasons to invest: the quality of management, the routes, labor efficiency, the things they really control,” Doherty points out. “Fuel is a large cost but an airline is not in the business of controlling fuel costs. Airlines hire managers who understand the business but are not specialists in fuel.”
The savings for Southwest from hedging were especially important this year as the surge in oil prices threatened the viability of most other airlines. Only in the last two months or so, as oil prices retreated from their highs, have airline analysts changed their predictions of this summer that several major airlines could need bankruptcy court protection or be forced to liquidate in 2009 if fuel costs continued to rise.
As celebrated as Southwest has been for its hedging strategy, Terwiesch notes that “other major airlines also have been hedging more than five, even 10 years. They were just hedging less…. Southwest would typically be 80% or 90% hedged, the others 10% or less. So you cannot say others are idiots and forgot to hedge…. Southwest was not fuel-hedging to make money off that. It is about risk management. You buy a homeowners’ insurance policy, not because you will make money, but because you want to be protected.”
Another point to note, Terwiesch says, was that Southwest did not save money on its actual fuel costs every year since it started hedging in earnest. When fuel prices went down unexpectedly before 2001, Southwest wound up paying more than spot-market prices for some of its fuel.
Nor should anyone forget what poor financial shape the older “legacy carriers” (those in business before airline deregulation in 1978) were in after the 2000-2001 recession, according to Terwiesch. “We had one house burn down after another.” For airlines with poor credit “it is very difficult to engage in hedging. You have to pay a risk premium. Like a mortgage for someone with bad credit, it’s not at 6%, but 8% or 9%.”
With some carriers, the thinking was, “We are losing money anyway,” Terwiesch says. “If fuel prices go up, we can go into bankruptcy, we can go to our unions and get concessions. If fuel prices go down, then bingo. But Southwest over the entire time period was making money. If you are making money, risk is very, very concerning. Any sudden change in fuel costs would upset those nice quarter-after-quarter results. It makes a CFO nervous to have uncertainty.”
Southwest CFO Wright could not agree more. When it bought its “insurance policy” by hedging the great majority of its fuel needs a decade ago, the company won the equivalent of a $4 billion lottery prize — much to the surprise of some of its executives. “The numbers are staggering,” she says. “We envisioned controlling our costs. I don’t know that we ever thought it would be $4 billion.”
