Who loses when airlines win?

April 27, 2006 12:44 PM

How does an airline such as Southwest Airlines benefit from hedging it's fuel usage or by using futures contracts?

I understand that most airlines take financial positions to protect themselves from rising fuel costs. Who's the loser when Southwest's bet pays off, though? Say Southwest has a contract to buy jet fuel at a dollar a gallon, and the going rate is 2 dollars a gallon. Who funds the difference, or does the fuel supplier just eat the loss?

posted by feloniousmonk to work & money (7 comments total)

They either eat the loss, or if they can get away with it charge their non-hedged clients a slightly higher rate to make up the difference.
posted by PenDevil at 12:53 PM on April 27, 2006

It's highly improbable that Southwest would actually take delivery when the contract expires. Just like options, the percentage of those actually being exercised are minute in comparison to the average open interest that gets traded throughout the life of the contract.

The opposite party might be someone who is hedging on the opposite side - Southwest would put on a long hedge position (since they're hedging against gas prices going up), and the fuel supplier, most likely, is putting on a short hedge. So they could, for all intents and purposes, level each other out, prior to expiration, or the opposite side could be a speculator who yeah, had to kind of take it up the ass on that contract if he shorted it and just sat there, not doing anything.

But nine times out of ten, the fuel is never actually going to be delivered if the hedging is done in the actual futures market. They're just trying to offset some of their cost increase by making money on the opposite side of the transaction in the futures market.
posted by mckenney at 12:59 PM on April 27, 2006

If I understand it correctly, the supplier actually loses if the price goes up. Loses in the sense that they could have realized a higher price for their commodity had they sold short. On the other hand, if Southwest could be screwed if their crystal ball is on the fritz the next time they need to buy. It takes a good amount of skill and luck to work things to your advantage.
posted by SteveInMaine at 1:09 PM on April 27, 2006

As these contracts expire, are the airlines, or anyone else who is reliant on petroleum products, pretty much just out of luck? To my mind, the same financial wager that seemed viable in 1999 seems foolish in 2006.

My admittedly amateurish understanding is that one of the reasons that the major airlines are under such pressure is that they didn't have the same posititions vis a vis fuel as the newer airlines did. Does this even the playing field, at least in that respect?
posted by feloniousmonk at 1:15 PM on April 27, 2006

From Southwest's 10-K:

"Airline operators are inherently dependent upon energy to operate and, therefore, are impacted by changes in jet fuel prices. Jet fuel and oil consumed in 2005, 2004, and 2003 represented approximately 19.8 percent, 16.7 percent, and 15.2 percent of Southwest’s operating expenses, respectively. The Company endeavors to acquire jet fuel at the lowest possible cost. Because jet fuel is not traded on an organized futures exchange, liquidity for hedging is limited. However, the Company has found commodities for effective hedging of jet fuel costs, primarily crude oil, and refined products such as heating oil and unleaded gasoline. The Company utilizes financial derivative instruments as hedges to decrease its exposure to jet fuel price increases. The Company does not purchase or hold any derivative financial instruments for trading purposes.

The Company has utilized financial derivative instruments for both short-term and long-term time frames. In addition to the significant hedging positions the Company had in place during 2005, the Company also has significant future hedging positions. The Company currently has a mixture of purchased call options, collar structures, and fixed price swap agreements in place to hedge over 70 percent of its 2006 total anticipated jet fuel requirements at average crude oil equivalent prices of approximately $36 per barrel, and has also hedged the refinery margins on most of those positions. The Company is also over 60 percent hedged for 2007 at approximately $39 per barrel, over 35 percent hedged for 2008 at approximately $38 per barrel, and approximately 30 percent hedged for 2009 at approximately $39 per barrel."

You can find this in the "Notes to the Consolidated Financial Statements" - other airlines will have similar sections in their financial filings. Something to note is that hedging is a continuous activity. You wouldn't hedge all your fuel requirements for the next 7 years all in one go. You'd use a mix of short- and long-term hedges and adjust your portfolio regularly, and to keep costs down you probably will not hedge your entire expected consumption.
posted by mullacc at 1:36 PM on April 27, 2006

Well, I think if any major consumer or supplier or producer doesn't have the wherewithal to hedge a position, they deserve what they're going to get.

Normally, the position wouldn't just stop being once the contracts expire - it looks like crude oil has montly contracts, which means monthly expirations. Prior to the contract expiring, the airlines will probably roll out the position to a later month of expiration and keep on doing that in perpetuity.

I'm not quite sure how the supplier/producer would lose money if the price goes up - if he's drilling it and selling it, he's going to be the winner when the price increases. He'd likely take a short hedge to protect himself from a potential downturn in the market, limiting his profits, but he wouldn't lose. Unless he was a reallly bad trader.
posted by mckenney at 1:41 PM on April 27, 2006

The answer to "who funds the difference" is the person on the other side of the options transaction from SWA. When SWA bought options to buy oil in the future at certain prices, somebody sold the options to SWA. This was not necessarily a producer. It could have been a speculator betting that oil would fall rather than rise. Whoever wrote (sold) the options contract to SWA could have later sold his position to some other investor, and that person could have sold to someone else, etc. By the end of the contract, SWA's counterparty is probably 1000 times removed from the original seller.

When the music stops and the option contract expires, it's that last counterparty that funds the difference. But because the option has been bought and sold so many times, that last counterparty is probably not stuck with the whole loss. He probably bought the thing at a discount because everybody could see which way oil was heading.
posted by Mid at 4:17 PM on April 27, 2006