An Open Letter to All Airlines - Quit Whining and Hedge Your Fuel Costs

I received an email from United Airlines (UAUA) today, "An open letter to all airline customers" was the subject line. In it, they bemoan the fact that speculators are a larger percentage of traded contracts than years before and that they believe the speculators are responsible for driving up the price of oil, and thus their fuel costs. Look in your junk email box and you probably received it as well.

There has been a lot of debate over this recently, but as outlined in the WSJ a couple days ago, commodities speculators aren't dealing in the underlying, just the cash settlement difference of the futures contracts. Unless there has been significant hoarding or some other tangible change in the supply or demand for the commodity, speculators, and hedgers for that matter, don't materially affect the underlying price. If prices are getting too disconnected from fundamentals, then other speculators will come in and short contracts, driving the price to equilibrium.

In futures markets, there are only 2 types of participants - hedgers and speculators. Another category might be called "investors", since many have noted that a lot of institutional money has moved into the market, to capture asset class exposure, but that begs the question whether commodities are truly assets, since they don't pay any dividends, interest or generate earnings. In a sense, these institutions are speculating that the commodities will generate a real return over time, which is debateable.

Typically speculators buy from hedgers, or other speculators betting against them. The airlines missed the boat by not buying oil futures and thus hedging their fuel costs. Of course Southwest famously did and has reaped tremendous benefits for it. Few other industries have such an overwhelming exposure to a potentially hedgeable cost as the airlines and oil. The admonitions should be towards the airlines who didn't manage their businesses prudently, and we're all paying for that - not from what the speculators are doing.

Comments

[Brneyed294:]

I cannot understand how you you don't understand...the airlines didn't have the cash to hedge. Southwest won't have it for long, either. Speculators DO need to accept the responsibility of perpetuating this problem and driving airlines to the brink of bankruptcy. Read the rest of the headlines....layoffs, capacity cuts, etc. This is not a drill or a pr ploy. Get in the real world.

2008 Jul 14 09:24 AM

[Jrho:]

Demand and Supply are not some abstract ideas; they are reflected in the contracts written. Speculators can certainly create "vertual demand" , and subsequently push up the price, which attracts more speculations.

2008 Jul 14 09:33 AM

[airline hedger:]

What are airlines hedging? there is no offset. Fixing the cost of fuel two years out without selling any offsetting revenues is very risky given the possible outcome of lower fuel and lower ticket prices. You could be "hedged" and get nailed both ways, hardly a definition of a hedge. Option premium is also extremely expensive and must be paid upfront. It is not so simple Danny Boy, if it was why don't you go out and buy some futures instead of writing this uninformed dribble.

2008 Jul 14 09:33 AM

[ualguy:]

I agree with Brneyed. Mr Knight needs to get his facts straight and look at both sides of this issue before he whines about clutter in his e-mail. 1600 of my colleagues lost their jobs over the last couple of weeks and I applaud UA and the other airlines for doing all they can to stay in business. It’s clueless hacks like Mr Knight that give the airlines a sour reputation they don’t deserve.

2008 Jul 14 09:40 AM

[Eric WSU:]

Also, during bankruptcy, many airlines were not allowed to hedge (creditors wouldn't allow the cash outlay required). Please do some research before you open your mouth.

Also, who wants to hedge at $147/barrel. I'm sure SWA isn't hedging here either.

2008 Jul 14 09:40 AM

[fatcat:]

The time to hedge was when oil was 60 dollars.Unless you think its going to 200 and stay there,its too late...Am I thinking wrong?

2008 Jul 14 09:43 AM

[hwydave:]

Hindsight is always 20/20, Mr. Knight.

2008 Jul 14 09:49 AM

[John of Del...:]

In about six months to one year you will see Southwest Airlines in the same boat as the rest of the other airlines. Hedging is a gamble and Southwest has been lucky. As the price of oil keeps going up the gamble is greater. Southwest management is seeing this as a big problem for them in the future.

2008 Jul 14 09:49 AM

[Joemic33:]

Very good, danny............ Hedge your fuel!!! Easy to say in HINDSIGHT!!!!!

2008 Jul 14 10:21 AM

[esw:]

In reply to John of Delaware - whether or not a hedge is a gamble depends on why you hedge. For an airline, with unavoidable exposure to fuel costs, a hedge is a natural and intellgient instrument; an insurance policy, really, to lock in an average fuel price. It is no more a gamble than for any of us to purchase life or disability insurance. In fact, it is sound, conmservative fiscal policy. Southwest was not lucky - Southwest was fiscally conservative and is benefitting, although at $146 a barrel for its unhedged needs that benefit is diluted substantially.

2008 Jul 14 10:23 AM

[esw:]

To Eric WSU - When in bankruptcy, it's too late to hedge. The time to hedge is when you do not need to; when you have the cash or the credit required. For the airlines, the late 90s were such a time. That only SWA both did hedge and did not cash in those positions after 9/11 again speaks to the difference between Southwest's world view and that of most other airlines.

2008 Jul 14 10:29 AM

[aadriver:]

Dan - some air lines did have hedges. I worked for American Airlines. We had hadges in 2003. When we went through our restructuring, it was later found out the executive management team built themselves a $50+ million lifeboat that secured their pensions in case of bankruptcy. The value of our hedges at the time was the same value. All of a sudden, we did not have any hedges. Any guess as to where the money went, Dan?

2008 Jul 14 10:30 AM

[esw:]

Mr. Knight's point (and my understanding of the situation tells me he is largely correct) is that speculation is not driving the price of oil significantly versus other factors - although he does not name those I suspect we can safely infer dollar devaluation and the excess of demand over refining capacity - and that airlines should stop complaining about things they cannot control (barring a completed political Hail Mary) and get their own houses in order. If the best an airline employee has to offer in rebuttal is an ad hominem attack, I think it bolsters his point.

2008 Jul 14 10:35 AM

[User 200305:]

That's all well and good but purchasing hedges requires significant cash up front which most of the airlines you criticize did not have post-9/11 when Southwest conducted some of their hedging. There's some blame to those airlines, but it's clear by any econmist's view that the price of oil is not reflecting true supply and demand.

2008 Jul 14 10:37 AM

[esw:]

Can anyone point to a reputable economist (other than the Air Transport Association's) who will credit speculation for a substantial share of the current per bbl price of oil?

2008 Jul 14 10:45 AM

[JDB1:]

You are clueless. I traded oil for over 15 years and speculation is the culprit. You have people in the game that have no "wet barrels". No one takes delivery as it's a paper shell game. If you don't believe it, buy a contract of WTI at Cushing OK and try to take delivery. If by chance, you get it, try and move it somewhere. Shut the NYMEX down and see what happens to the price of oil!

2008 Jul 14 10:46 AM

[HedgeModel:]

Hedge is not something simple to be discussed as a golden rule.
Each company has its model to make money and each model is not necessarily similar of it's peers (sometimes completely different of it’s . If companies don’t understand very, very well the impacts of costs/income during periods of time, they are speculating in things they are not specialized in….when you play hard ball with a pro….i prefer to bet on pros and short your incapacity.
When management fails to decide about hedging variable cost or variable income policies, leaving extreme important decisions to god, invisible hands or simply leaving decisions to a one on one situation without treating the matter uncovered (by the management, board and important investor pre-tested/decided approach), it´s legitimate specs to short this companies as they know (good bets) they will suffer and suffering is blood smell for specs.
Incapacity of developing hedging strategies to defend the interest of investors against market oscillations is one of major threats of capitalism.
Models are designed to mitigate risk not directly related to the core businesses of companies.
Good controvertial subject Dan. Cheers from Brazil!!!

2008 Jul 14 10:51 AM

[Get a Clue!:]

For those of you who say Southwest will be in trouble "as soon as their hedges run out" are totally clueless! Southwest is profitable because of their hedges, and will continue to buy more hedges with those profits and continue to be profitable and continue to buy hedges (get the flow here?) All they have to do is raise their already low prices a couple of dollars if they want to buy more hedges, and till have the lowest prices and lowest cost structure in the industry.

A solid company with a very bright future as the others drop by the wayside.....

2008 Jul 14 12:03 PM

[Brneyed294:]

To: Get a Clue! If Southwest isn't concerned about oil speculation than why would Gary Kelly, Southwest's Chairman and CEO, participate in the letter Mr. Knight refers to in his article? No one is saying Southwest is in trouble but they recognize that all of the current airlines with their fleets will not be able to withstand these inflated oil prices.

2008 Jul 14 03:48 PM

[Stop Whining:]

Regardless of who's fault the high price of oil is, the airlines have to do what they can to make a profit. Airlines aren't subsidized by the Gov. like some businesses that we use are. When the USPS raises prices to mail a letter or package you don't here people crying like you do when airlines raise fares or adds fees for things that used to be free. The airlines are a business just like any other business with a goal of having a good balance sheet. Why do we now pay more for groceries? Because it cost more to get them on the shelf at the store. Do you here people whining about that?

I sometimes believe the public thinks they should be able to get on a plane and fly 800 miles and pay almost nothing. A typical 2 engine jet will burn approx 4700 gallons of fuel to make that trip, thats right 4700 gallons. So do the math when you have 400-500 airplanes in your fleet and in the air on average about 8hrs a day that fuel bill adds up. I don't know who is to blame but it amazes me that if somebody hiccups in the Mideast the oil price per bbl will spike.

I believe southwest Airlines glory days are number due to this problem and by the way Airtran Airlines is taking action now by cutting employees wages by 10% and deferring delivery of aircraft and they are also a low cost carrier like Southwest. Its obvious this is affecting all airlines.

2008 Jul 14 03:50 PM

[Texas_Guy:]

In terms of gold and silver, oil is nearly the same price as 1964. The problem is that once President Nixon took us off the gold standard, and the currency was only backed by a weak promise to pay, the value of the US Dollar has depreciated significantly. Since the US $ is the world's reserve currency, and oil is receipted in $$, the cost is simply a reflection of the loss of purchasing power of the US $. Thank you local politician along with the Federal Reserve for that the next time you see them.

2008 Jul 14 04:06 PM

[fresnolink:]

I totally agree. I found it quite odd that Southwest joined the whine. I suppose they assume that a gov't intervention in this area would benefit them as much as it would the other airlines (especially if the benefit of their past hedges is beginning to expire due to mere time and fuel usage), even if such intervention would not necessarily benefit the consumer or the industry in the long run (eg, eliminating incentives to replace inefficient planes or overpriced staff). Hmmm...

2008 Jul 14 04:20 PM

[gs liar:]

Another arrogant article from Losing Alpha. Obviously Mr Dumb Kinight has never traded anything. Speculators can manipulate any type of trading in a stock or option. It happens daily. I seen firsthand how just a small group of traders can run up or down quickly and maintain the price level. Wash-Trading or painting the tape. Whenever you are above the law like Goldman then it's easy.

2008 Jul 14 05:31 PM

[BioInvestor:]

Good point: no one can! Speculators have become the new boogie man. If futures were settled in oil, that would be one thing, but they're settled in cash. Sure, they may be marked to the spot price, but so what. There are commodities with inflation that don't have a derivatives market; there are commodities with derivatives that don't have inflation. I don't know what people mean by speculators--it's seldom defined--but I too don't see evidence that it has anything to do with futures, forward contracts or options on futures.



On July 15, esw wrote:

Can anyone point to a reputable economist (other than the Air Transport Association's) who will credit speculation for a substantial share of the current per bbl price of oil?

2008 Jul 14 08:34 PM

[dkco:]

Wow - what an onslaught of replies from all ends of the spectrum. First, I want to make it clear that my post was not as much an indictment on the airlines for not hedging their fuel costs (which in hindsight or foresight would be a wise business decision - oil prices have been volatile for years), but to chastise the industry for blaming "speculators" for their ills and the recent run up in oil prices.

Speculators are the "life blood" of any derivative market, providing liquidity, price discovery, and viability for hedgers. Sure, sometimes in markets speculators drive prices up, but other speculators come in, as I mentioned in the post, and sell to the buyers believing the fundamentals don't justify current prices. Remember, someone has been selling to the speculators all the way up - who will be crying for their heads when they make big profits when (if) oil prices decline?

Again, the bogey man isn't functioning markets, with speculators and hedgers, it’s the underlying supply/demand fundamentals and myriad other economic dynamics that affect the price of oil (and all commodities). If I was to concede any restrictions to the marketplace, I would consider raising the margin requirements on contracts, to reduce some of the leverage involved, which we've seen to be the essence of the troubles in the housing market.

I can't reply to all, but in general, I thank you for posting your replies and spurring discussion. Let's all hope for lower oil prices, and perhaps lower airline fares as well.

2008 Jul 14 09:00 PM

[User 226363:]

First most of the airlines do not have the money to hedge for months and years inadvance. Second what happens if the price of fuel goes down but you have already paid inadvace at a higher price? The government needs to go after the speculators just they would after a hurricane, tornadoe, big fire (like in the West), when some people raise their prices much higher.

2008 Jul 14 11:25 PM

[esw:]

On July 14, User 226363 wrote: "The government needs to go after the speculators just they would after a hurricane, tornadoe [sic], big fire (like in the West), when some people raise their prices much higher."

1) Welcome to Seeking Alpha, Vice President Quayle.
2) Please offer proof of, or otherwise make a reasonable case for, the speculative element you allege.

2008 Jul 15 09:14 AM

[Flyboybob:]

Mr. Knight,
You may have missed the fact that the "open letter to passengers" was signed by ALL of the U.S. airlines including your beloved Southwest, who in particular will cease to exist if these oil/fuel prices don't come down soon. Southwest's gamble on fuel hedging is now quickly expiring and when these "new" fuel costs kick in, Southwest's budget fliers will not be able to afford the "luxury" of flying. This is critical for ALL the airlines as well as this country. This isn't whining, this is very, very real. You should be very, very afraid for what Wall Street and this Administration are doing to this country and it's "blue collar" citizens.

2008 Jul 15 12:42 PM

[Joemic33:]

Hey DanK,

Hindsight or foresight, It takes plenty of garbanzoes to hedge!!!!


On Jul 14 09:00 PM DanK wrote:

> Wow - what an onslaught of replies from all ends of the spectrum.
> First, I want to make it clear that my post was not as much an indictment
> on the airlines for not hedging their fuel costs (which in hindsight
> or foresight would be a wise business decision - oil prices have
> been volatile for years), but to chastise the industry for blaming
> "speculators"... for their ills and the recent run up in oil prices.
>
>
> Speculators are the "life blood" of any derivative market, providing
> liquidity, price discovery, and viability for hedgers. Sure, sometimes
> in markets speculators drive prices up, but other speculators come
> in, as I mentioned in the post, and sell to the buyers believing
> the fundamentals don't justify current prices. Remember, someone
> has been selling to the speculators all the way up - who will be
> crying for their heads when they make big profits when (if) oil prices
> decline?
>
> Again, the bogey man isn't functioning markets, with speculators
> and hedgers, it’s the underlying supply/demand fundamentals and myriad
> other economic dynamics that affect the price of oil (and all commodities).
> If I was to concede any restrictions to the marketplace, I would
> consider raising the margin requirements on contracts, to reduce
> some of the leverage involved, which we've seen to be the essence
> of the troubles in the housing market.
>
> I can't reply to all, but in general, I thank you for posting your
> replies and spurring discussion. Let's all hope for lower oil prices,
> and perhaps lower airline fares as well.

2008 Jul 16 09:04 PM