The Airline Industry (Part 5): Hedging - Swaps and Futures

Background

If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk.
- Scott Topping, Treasurer for SWA

One way airlines can stabilize variable costs is through fuel hedging. Successful hedging will mitigate unexpected increases (or decreases) in the price airlines pay for jet fuel. In this discussion, we will examine the hedging tools available to airlines and the costs and benefits associated with each.

A good hedging strategy attempts to level fuel prices in a predictable way. Companies try to accomplish the same thing when they monitor foreign exchange exposure, interest rate risk, or credit exposure. The goal of hedging is not to make money or speculate in fuel. Instead, the objective is to remove the volatility in fuel prices and provide a stable framework upon which the company can build long-term strategies.

Southwest Airlines has the best fuel hedging program in the industry. Successful hedging has saved Southwest over $3.5 billion on jet fuel purchases since 1999. Last year, Southwest saved $727 million and in the first quarter of 2008 posted hedging gains for $291 million versus $34 in profit. These gains have been expensive: Southwest spent $52 million on premiums last year and $14 million in the first three months of this year. However, 70% of Southwest’s fuel needs are priced at $51/barrel instead of $140/barrel today. In contrast, other airlines have 20%-30% of their fuel needs hedged at $100/barrel.

To put these numbers into practical terms, Southwest has purchased jet fuel at an average price of $1.98 per gallon in the first quarter of this year. Although this is a 20% increase from the same time last year, other companies have fared far worse. American Airlines has paid an average of $2.73 per gallon for fuel (a 50% increase) and United has paid $2.83. Successful fuel hedging can provide a company with stability and cost advantages over its competitors.

How Companies Hedge

Hedging involves the purchase of contracts or derivative instruments in such a way that the airline can predict what it will pay for jet fuel. Unfortunately, jet fuel contracts are typically not exchange traded. This presents several problems for airlines. Over-the-counter (OTC) contracts are less liquid, meaning there are fewer available buyers and sellers willing to write or buy contracts. Additionally, OTC contracts lack the standardization and guarantees of their exchange-traded counterparts.

Airlines overcome this obstacle by using other commodities as a proxy for jet fuel. For example, the New York Mercantile Exchange (NYMEX) has active markets for heating and crude oil contracts. Since jet fuel prices are highly correlated with the price of oil, airlines will often use these commodities in lieu of OTC contracts. Southwest stated in its most recent quarterly filing:

Because jet fuel is not traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel…
However, we have found that financial derivative instruments in other commodities, such as crude oil, and refined products such as heating oil and unleaded gasoline, can be useful in decreasing exposure to jet fuel price volatility.

The downside to substituting other commodities for jet fuel is that the prices of the two commodities can sometimes uncouple. This introduces basis risk - the gap between the value of the hedge and the value of the commodity whose price you want to protect. For example, when Iraq invaded Kuwait in 1990, jet fuel prices quintupled versus the price of heating oil. Companies who hedged only heating oil were exposed to the price spike. A solution to this problem is to add additional contracts (like a differential swap) to correct for the price of jet fuel versus the proxy commodity. This issue will be discussed in more detail when we look at individual hedging transactions.

Hedging Strategies

1. Swaps / Futures
2. Call options
3. Collars

Swaps, Futures, and Forwards

Swap contracts allow airlines to pay a fixed amount for jet fuel over the life of the contract. An airline and another company (the counter-party) will agree to a fixed price for a gallon of jet fuel, a quantity of fuel to be purchased, and a timeframe for the contract to remain active. The airline then purchases fuel at market price during the life of the contract.

At the end of the contract, the airline reviews the average price it paid for fuel. The average price is usually calculated using an unbiased price reference, like Platt’s New York Harbor jet fuel price quotations (see example to the left). If the average price paid is above the fixed price, the counter-part will repay the airline the difference in what it paid versus the fixed price. However, if the average price is below the fixed price, the airline must pay the counter-party the difference. The main disadvantage to swap contracts is their zero-sum nature. One party’s gain is the other’s loss. Airlines accept this risk in return for the absolute stability swaps provide.

Futures are another fixed-price instrument. Futures allow an airline to take delivery of a commodity at a set price on a date specified in the contract. Since they are traded on exchanges, the terms of futures contracts are standardized and guaranteed. The values of futures contracts are marked-to-market on a daily basis.

If the terms of futures contracts do not meet the airline’s needs, it can negotiate forward contracts that have a similar structure but offer customized quantities, timeframes, and prices. Forwards are not exchange traded but have greater flexibility if the airline can find a suitable counter-party for the transaction. However, forwards are not marked-to-market until the expiration of the contract, meaning that substantial gains or losses can mount for either party to the transaction. This can introduce unwanted credit risk or other complications, especially for airlines experiencing financial difficulties.

It is not necessary for airlines to actually take possession of the commodity in forwards and futures contracts. The airline can sell the contract to someone willing to take delivery or simply offset its cash position according to the rules of the exchange. This is especially important if the airline is attempting to hedge fuel using heating oil or another commodity that the airline does not want to physically possess.

Both swaps and futures allow airlines to lock in fixed prices for fuel or proxy commodities. However, the structure of the contracts is different. Under a swap, airlines buy fuel and reconcile the difference at the contract’s maturity date. Under futures and forwards, the airline negotiates the fixed price and takes possession of the fuel at a later time. However, futures allow the airline to exit its hedged position by selling the contract early and recognizing gains (or minimizing losses) since they are marked-to-market and exchange-traded. Ultimately, all three instruments give the airlines stability in fuel prices and protection from upward price movements. However, they also limit the airline’s flexibility should prices decline. For this reason, airlines often turn to call options or collars for their hedging needs.

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