To Hedge or Not to Hedge: For Airlines, Is That The Question?

The airlines - some of which have been hedging, some of which have not - are finding themselves in a difficult position: do they hedge the cost of their fuel with crude oil around $120 a barrel and jet fuel near $3.50 a gallon? These companies must decide whether it is time to lock into prices, or whether they should simply be at the mercy of the future spot price, hoping that when they need fuel months out, the market will be a little more "rational".

The recent high energy and commodity prices, along with the choices that all companies must make, help to drive home the point that hedging is not always the most profitable - or short-term earnings friendly - move, but may be a smart long-term play. As an example for airlines, when prices are rising, then yes, you get the benefit of buying fuel on the cheap, and possibly the added benefit of raising product prices along with your competitors to compensate for the higher overall fuel cost (even though you are hedged and not feeling the same impact).

But the story is different on the down side. As spot prices fall, you are locked into higher priced futures contracts for your raw material and energy needs, while your "risky" competitors who decided not to hedge, or simply could not hedge since they were not credit worthy and did not have the proper margin, are taking advantage of lower spot prices.

To add insult to injury, you no longer have pricing power, and may even see price cuts as your competitors put the squeeze on you. If options are employed instead of futures, such that you have the right but not the obligation to pay the higher strike prices as spot prices drop (compared to your obligation with a futures contract), you still do not get away unscathed. The options you buy will not come cheap, and are likely to be quite expensive during times when prices are volatile - just when you are probably most interested in hedging.

Of course, is this really what hedging is about - trying to time the market? Ideally, no. Let us look at the airlines again as an example. In an attempt to have some forward looking predictability, they book some revenue by selling tickets months in advance. Shouldn't they be hedging their fuel costs now, for payment months forward, to insure that given the prices they are currently selling tickets for that they can make a profit in future months based on revenues (ticket sales) and cost (fuel) they will realize at that time?

One would think so. Why do many fail to do exactly this?

Well, there are a number of reasons, but a short-term perspective which is more interested in making earnings next quarter is probably one of the biggest culprits, not to mention those pesky credit issues. It is the classic problem for risk managers, and not just those in the airline industry. They love you when the hedge "works", but hate you when it does "not work".

If done properly, the hedge works in both situations - high and low costs - but this is not what the CFO and investors always see. They only see how the company is paying $3.50 a gallon for fuel when the spot price is $3.00 a gallon. Reminding them that the company only paid $3.50 a gallon when prices were $4.00 a gallon a month ago doesn't compute, nor does the fact that you are able to help the company price its tickets properly in order to generate stable returns since you know in advance what your cost of fuel is going to be.

Ah, don't bother me with those details. Again they ask: "Why is our cost of fuel $3.50 now when spot prices are $3.00." Sigh....

Yet all of this discussion may miss the bigger issue. Anytime a company, or industry for that matter, can only show profits when it gets the hedge "right", or in other words, was fortunate or lucky enough this quarter and showed a profit since their hedge allowed them to cut costs or undercut their competitors, then it might be time to look for other companies or sectors to invest in. Next quarter they may not be as fortunate.

Companies that have the same problems with $10 per barrel oil, as with $100 per barrel oil (or for any commodity price as it swings from “cheap” to “expensive”), are simply at the mercy of the markets. These companies may make for an interesting trade at times, but in the end, you might as well take your money to the casino and bet on red or black.

At least then you could save transaction costs and the bid-ask spread (well, sort of), while at the same time not exposing yourself to further systematic and firm-specific risks.

Disclosure: none

Comments

[LongTimeObs...:]

No kidding. Charter carriers who selll in advance have done thios for decades.

Of course the best natural fuel hedge is the most efficient fleet, and SWA has a good lead in that area, too, unlike most other carriers who are flying equipment at least one generation older, hence 15% less efficient than SAW and most of their foreign flag competitors

2008 Apr 27 08:39 AM

[James Shaw:]

The purpose of hedging should be to make the company profitable.

If, say, $90.00 is break-even point, as long as the price is lower $90, you should always try to lock that price.

2008 Apr 27 09:00 PM