airline hedging of oil

can someone plz explain how hedging your costs of oil is considered a risky gamble as in the following quote: how is hedging your future costs of oil more risky than going with wahtever the oil prices are? thx. “airlines that are in bankrupt are not allowed to hedge their costs of oil because that is considered a risky gamble”

have you ever had the BLT sub from Jimmy Johns ? so money…

Airlines hedge against oil prices by buying oil futures contracts I’m assuming. Futures can be expensive if oil prices don’t act the way the airline expects. For instance if the airline goes long oil futures contracts at $40 and at expiration oil is $60, the company benefits. Although if oil is $30 at expiration, the airline is obviously at a loss. Also, since airlines need oil as much as man needs air to breathe, you can imagine how much of a loss they’d have on a futures contract if prices didn’t play out as they had hoped.

also, i believe that airlines were restrited by lender covenents that would not allow them to enter certain hedging contracts

A good example would be Southwest’s third quarter 2008, where it had something like $250 million in mark-to-market noncash charges because oil prices moved against its hedges.

gold mine companies can short gold futures on the basis of anticipated gold…gold might not come … similarly bankrutpt companies might not be in business for long and then hedges become bets

Airlines do not normally trade the actual futures to hedge their fuel costs. For the most part they use cashless collars and call options on the futures contracts. Also, they frequently use heating oil contracts rather than crude oil in order to better match their risk, since heating oil (like jet fuel) includes a refining margin. Aside from the collateral posting and ultimate cash settlement costs discussed above, there is also business risk to hedging fuel. Take Southwest for example. They have over half of their oil needs for 2009 locked in at $51/barrel, and oil is around $42 today. Some of there competitors are going to be “going with whatever the oil price currently is” as the OP put it. Those competitors will be able to charge lower fares that Southwest will be forced to match the lower fares and may be forced into losses. Why would the competitor lower fares? Well, airlines are market share crazy, often to the detriment of their health. And why would Southwest be forced to match? With such high fixed costs, they have to fill up the aircraft or they lose a ton of money. It costs almost exactly the same amount to fly from New York to Dallas with 100 people on board as it does with 35. Granted, Southwest isn’t in terrible shape with their contracts only $9 out of the money, but it could have been much, much worse if they locked in higher or if oil drops back to $11/barrel like in 1998/99.

tobias, where did you get that info about the price Southwest has locked in oil at? Annual Reports?

It seems like all of the answers are displaying the downside of the hedging strategy. Tobias mentioned southwest paying $51 when the current price is $42. From what I remember, when prices were at $140/barrel southwest was locked in at a much lower rate and they were doing well. There’s obvious risk to locking in a price, but is that any riskier than paying market price?

“airlines that are in bankrupt are not allowed to hedge their costs of oil because that is considered a risky gamble” The bottom line is that it costs something versus nothing. in bankruptcy, you want to pay as little as possible for everything and and going variable is risky in itself, but I think airlines in bankrupcy have more to worry about than variable input costs which are completely out of their hands. Hedging oil prices only makes sense when you have a 100 year time horizon as it protects you against those rare circumstances that can push you into bankruptcy. When in bankruptcy, your horizon is a few months/years and you don’t expect oil to climb from $20 to $150 in 2 years and sustain at that level.

chad17, they discuss it on their quarterly conference calls and disclose it in their 10Ks and Qs. SanFranMatt, while it is true that there is risk either way, there is safety in numbers. As I described above, an airline needs to protect themselves from being priced out of business by their competitors. If that involves some hedging, so be it. If it involves exposing yourself to spot prices, so be it. While the other airlines routinely hedge some amount of their oil needs, Southwest went out on a limb and hedged many years into the future. While this looked like a brilliant call up until about a month or two ago, it did drastically shift their risk profile. They were long so much oil that they essentially became an energy firm that happened to have an airline. Airlines are learning from their past fuel hedging mistakes. Delta, for example, is now paying for call options (instead of trying to put on cashless collars) so that they can lock in a fuel price cap while still participating should the cost of fuel drop. They now consider paying for the calls a cost of doing business, and that’s a healthy development in my opinion.

Good info tobias.

tobias is our airline guy and we always like his commentary.

Southwests hedges roll off next year, the stock will be a short. DAL, AMR and AAI are in much better positions

thanks guys

Hedging is RARELY actual hedging, unless you’re doing the physical oil trade where you take delivery this month, store it, and deliver it next month all with a spread trade. Think about it: You hedged your cost of oil @ 50. Oil is now 150, your competitors are jacking up their ticket prices. Are you really going to keep your prices cheap just because you “hedged” the cost? Hell no. Same as the other way. You hedged @ 100, oil’s now 30. Competitors are lowering their ticket prices. Can you keep your prices the same just because you lost on your hedge? No, you’ll probably go bust because of your “hedge” losses.

easier to forecast and model if its hedged at a static price