As we saw in our previous discussion, commodities are attractive to investors because of their negative correlations to equity prices.We can explore this phenomenon further by looking at specific sectors within the S&P 500 index (see chart to left).
Investors looking for diversification will examine their assets and attempt to find other asset classes to reduce risk while maintaining or increasing returns.We can see the benefits of commodity investment by looking at the S&P’s components (see charts to the right).
The consumer discretionary sector of the S&P shows strong negative correlations to a broad range of commodity prices, especially raw materials (see chart to the left).Other sectors also appear vulnerable – the financial sector and health care have low correlations with many different classes of commodities.
Some sectors have low correlations with specific groups of commodities (see chart to the right). An investor with large holdings in consumer staples’ stocks would look to meats or metals to help offset risk.Sector examination also reveals that some areas have positive correlations with specific commodity groups.The utilities, industrials, and energy sectors maintain strong correlations with energy commodity prices.Similar patterns hold between raw materials commodities and energy and utility stocks.Portfolio managers would not use these pairs of assets for diversification purposes since their prices generally move in the same direction.
Challenges of New Investment The rise of commodities as an asset class has combined with surging global demand to create new challenges for exchanges and investors alike.Historically, commodity markets were small and specialized.People used the markets to hedge risk and exchange goods.Today, new participants like pension funds, high net worth individuals, and even retail investors are able to trade commodities.
Exchanges face controls challenges as investment increases.Trading platforms need to be upgraded to cope with the volume of transactions they process.Additionally, some exchanges have difficulty finding staff with adequate experience and expertise to handle open-outcry trading.
Most importantly, new investment has created structural challenges for commodity markets themselves.Aggressive, high volume trading and more ambitious funds pose new challenges for traditional users of the markets.The nature of trading is changing and increased investment means that traditional hedgers, sellers, and buyers will have to adapt their behavior to achieve their goals.Higher volatility in the markets increases the cost of trading and the risk of financial failure.Consumers must become more educated about commodities since they face more indirect exposure through pension funds or purchase investment products they don’t fully understand.Since commodities markets were traditionally specialized, they have received less regulatory scrutiny than equity markets.This puts new participants at greater risk if they do not fully understand their investments.
Will the Cycle Continue? Previous commodity cycles returned to equilibrium as production met demand.Today’s global economy has led analysts to ask important questions about the supply of commodities in the future.A general rise in prosperity has broadened global demand beyond the traditional models focused on the United States, Europe, and developed countries.Some wonder if we are nearing the limits of supply, even with increased investment.This is especially important for finite resources like crude oil, and the market’s uncertainty has led to high, volatile prices.
This dramatic rise in prices caused by the twin forces of globalization and investment has led some to question whether or not prices are in a speculative bubble.Prior commodity booms were grounded in scarcity, but today’s climate incorporates higher levels of uncertainty.In our next discussion, I will explain the extent to which index funds and other investments have allowed institutional investors to make commodities a part of their portfolios.I will also examine speculation and discuss how global demand has fueled market uncertainty.Finally, I will attempt to gauge the effect all of these variables have on today’s commodity prices.
Recent History Before we can quantify how much money investors and speculators have shifted into commodities in the last five years, we need to understand why they have become attractive investments.
Commodities experience bull market cycles every twenty to thirty years (see chart to the left).The cycle begins when prices are low and supply is abundant.Producers struggle to survive and don’t have enough revenue to reinvest in infrastructure.Since there is adequate supply for the market, expansion doesn’t make economic sense.Eventually the lack of new production prevents commodity supplies from keeping pace with global demand during economic expansion.Economic activity requires a steady supply of goods like oil, food, and metals.These commodities provide the energy and raw materials for commerce.
Eventually, global demand causes commodity prices to rise and the resource becomes scarce.When this happens, producers receive more money for their raw materials while costs stay relatively stable.This gives companies the latitude they need to invest in infrastructure and grow capacity.These investments usually don’t pay immediate dividends because expansion can take a long time to show results.For example, it can take several years for a new oil rig to produce steady amounts of crude oil.While producers wait for new investments to yield results, prices will continue to rise.The supply and demand for a commodity will level off as greater quantities of the commodity enter the market.Demand can also slacken if economic conditions deteriorate.Prices will remain level or fall, and the cycle will begin again.
Prior to 2002, the last major boom in commodities occurred in the early 1970’s.Energy prices soared because of global instability and a shortage of supply.The cycle ended during the dot-com boom of the late 1990’s, when commodity prices fell to record lows.
Commodity Prices After the Dot-Com Bubble When the dot-com bubble burst in 2001, commodity prices reached their lowest point.After this, a combination of economic recovery and shifting investment strategies created a remarkable bull market cycle.
As prices remained low, the global economy began to recover and demand increased.This was especially true for emerging economies like China and India.A boom in manufacturing and general prosperity created jobs and increased disposable income for these countries’ citizens.This rise in affluence, combined with strong retail demand in the United States and Europe, caused demand for commodities of all types to increase.
This increase in demand was a unique element of globalization from 2002 to today.In 2001, the domestic American economy was drifting after the collapse of the tech bubble and the September 11 terrorist attacks.To help stimulate activity, the Federal Reserve sharply lowered interest rates.This created an influx of money into the banking system, much of which fueled the now-infamous domestic housing bubble.Cheap lending permitted consumers to pay more for homes and to leverage their existing equity to make discretionary purchases. Developing nations produced most of these products and received capital windfalls as money flowed from the United States.This stimulated their own consumers’ demand and created new classes of individuals with disposable income.As you might expect, these people wanted the same luxuries and conveniences enjoyed elsewhere in the world.The end result was a surge in demand for the commodities necessary to produce housing, transportation, food and consumer products these consumers sought.
This increase in demand had a predictable effect on commodity values.Supplies were not able to keep pace with demand and prices increased.Prices began to creep upward in 2002 and momentum began to build in the sector (see chart to the right).We are currently in a period of high prices and supply shortages.
Commodities trade at large price multiples to what they did just a few years ago (see chart to the left).Firms are able to sell raw materials for three to five times what they could in 2002.The increase in price is not unique to one particular commodity – food, metals and energy have all seen dramatic increases when compared to major financial indices and sectors.This means that firms have adequate capital to invest in infrastructure.Theoretically, this will rebalance supply and demand, but as we will see, there are reasons why this may not occur in the immediate future.
New Investment Strategies While the global economy enjoyed new levels of prosperity, another phenomenon began to affect commodity prices:the view of commodities as an asset class.When equities lost value in the tech collapse investors sought returns in other areas.As commodity prices increased with global demand, portfolio managers and institutional investors began to investigate the viability of commodities as part of a diversified investment portfolio.Analysts found that commodities held low or negative correlations with many of the major equity indices.
The goal of modern portfolio theory is to maximize the return achieved for each unit of risk.Correlation is important for investors seeking optimal portfolio performance.By adding assets with low correlations, managers can increase returns while holding risk steady or reducing it.The negative correlation coefficients of commodities to equities created this possibility within institutional portfolios.
It’s important to note that negative correlations between commodity prices and equities are not inherently causal. Stocks do not necessarily lose or gain value because commodity prices rise.In some cases, the relationship is clear:a well-run oil company will probably gain value if oil prices rise, and a furniture maker might lose value if the price of timber increases.In other cases, stocks and commodities might move in opposite directions without a clear reason:an increase in rubber prices might have a negative correlation with the value of a technology company.This is important for portfolio managers to consider as they try to diversify their investments for optimal performance.
The chart to the right shows the correlations of many commodities to major American equity indices.Each correlation coefficient reflects the price movements of the commodity and index since the indicated date.As you can see, the correlation coefficients have decreased dramatically since 2001.This decline shows why commodities are attractive to portfolio managers.Commodities are earning superior returns and providing important diversification.
The two charts to the left show specific commodities and their correlation to the S&P 500.Since 2001, metals have been positively correlated with the S&P.However, when the time period is narrowed to 2005 or 2007 onward, the correlation is nearly zero or negative.Similar movements are seen with energy prices.Since 2007, correlations have dropped significantly.
In our next discussion, I will look at correlations in more detail by examining some specific S&P 500 sectors.Also, I will explain some of the challenges investors and exchanges face because of increased commodity investment.
The first set of entries on commodity trading have been posted. In the first discussion, I detail the history of commodity trading and explain how wheat futures ultimately laid the foundation for modern exchanges. In the second entry I explain why futures change in value and explain their attractiveness to investors and speculators. In future entries I will discuss recent capital inflows into commodities and investigate speculation in energy markets.
I also wanted to thank the following blog carnivals which have featured articles from Economic Outlook.I appreciate the support and encourage everyone to check out the other featured articles on personal finance, investing, and the economy.
Set up of Trading Exchanges Today’s exchanges are much like their predecessors from the 1800’s.Trading floors are set up in pits where traders stand facing one another.Pit traders use open outcry and hand signals to communicate transactions.Each pit is assigned one or more futures contracts to trade.The two main commodity exchanges in the United States are the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX).The Chicago Board of Trade offers T-bond, soybean, corn, wheat, and other futures and is the largest commodity exchange in the world.The NYMEX also offers a variety of commodities including coffee, sugar, frozen orange juice, gold and heating oil.
Traders in the pits are members of the exchange in which they work.Non members trade through brokerage firms who hold memberships in the exchange.Also, modern exchanges have strong relationships with clearing houses.Clearing houses partner with exchanges to ensure capitalization in the event of adverse price fluctuations.They also serve as counter-party to all transactions, set margin requirements and provide a mechanism for settling contracts.
Modern Futures Contracts Today’s contracts are similar to those that have been used for centuries to guarantee the future delivery of a good.The contract has a finite life with standardized quantities to make it easy to trade and close positions.Investors use the contracts to hedge against price fluctuations or take advantage of price movement.
Each contract consists of one party taking the “long” position.He agrees on a fixed purchase price to buy the underlying commodity from the seller at the contract’s expiration.The other party takes the “short” position and must provide the underlying commodity at maturity.
The value of a contract fluctuates over its life.The price of a commodity changes daily relative to the fixed price at origination.This means potential profits and losses for traders.Additionally, seasonal influences and unexpected events like weather or terrorism can change the value of the commodity and cause variance in the value of a contract.Even futures for non-tangible goods like T-bonds are subject to this kind of price movement.Central banks like the Federal Reserve or ECB can change interest rates and alter the value of bond futures.Ultimately, the market price for a futures contract reflects the current cash price of the commodity plus the market’s expectations for future prices and economic factors.
Delivery and Settlement Although futures contracts began as a promise to deliver a physical commodity, most contracts are now settled in cash.Gains and losses are debited and credited at daily marked-to-market prices in a person’s account.When the contract expires, the parties settle the difference in the spot price and the fixed price.
If one party needs the physical commodity, he will usually purchase it on the cash market.He will pay the current market price and use the proceeds from the settled futures contract to offset whatever difference there is between the contract price and the spot price.In total, he will pay the amount specified in the original contract.The chart to the left shows an example of this kind of settlement.
If parties don’t settle in cash, brokerage firms monitor contracts nearing expiration and inform owners that they must either close the position or prepare to take delivery of the commodity.If a person doesn’t want the commodity he has two options.First, he can try to sell the long position to someone else.However, most traders prefer the second option – selling a short position equal in quantity to the long position.This means that the short and long positions will offset each other and the trader will receive whatever gains or losses in value the contract has incurred.If for some reason a trader does accept delivery of a commodity, the brokerage firm will issue a receipt allowing him to pick up his merchandise from a warehouse or distribution center.
Attractiveness for Speculators and Investors Commodity markets are attractive for both speculators and investors.Businesses (like airlines) and institutions can hedge commodity prices, currency values, industries, or even whole economies through careful commodity trading.The proliferation of options on futures contracts has made hedging more economical and practical since the 1980’s.
Commodity markets are also attractive to speculators.Futures prices tend to change more quickly than real estate or stock values.However, these rapid fluctuations mean that speculators can lose money quickly as well.Commodity investing also offers high leverage.Commodities require lower margins (10%-15%) versus at least 50% for stocks.Open outcry trading makes it harder to trade on insider information, and the events that cause price fluctuations are less prone to asymmetric information (weather changes versus inside deal knowledge, for example.)The broad and liquid commodity market has smaller commission charges, too.
All of these factors make commodity trading tempting for speculators.In our next series of entries, we will look at recent capital inflows into commodities and investigate the role speculation has played in the rise in oil prices.
After discussing oil and fuel hedging, I was asked to give more information on commodity trading in general and to comment on speculation in the oil markets.The flow of capital into commodities has been one of the most important economic developments over the past five years.In the next series of entries, I will try to give perspective to this phenomenon and explain why commodities have attracted so much investment.I plan to cover three main topics:
Brief history of commodity trading
Inflows of capital
Speculation in the energy sector
History of Commodity Trading For as long as people have engaged in trade, they have needed a system to organize the delivery of goods and make commerce more efficient and predictable.The ancient Sumerians began the standardization process with the trade of sheep and goats.Sumerian farmers used an early form of commodity money - clay tokens baked in the shape of the livestock they were trading.When a farmer pledged a certain number of goats to a dealer, he would put an equal number of tokens in a vessel, seal it, write the number of goats on the outside, and give it to the dealer.
When the farmer delivered the stock, the dealer would break open the jar and count the tokens to make sure he received the proper number of animals.Over time, farmers and dealers began to forgo placing tokens in the jar and simply wrote down the quantity to be delivered.These clay etchings were the first form of futures contracts.Since there were no large state banks to sponsor these agreements, farmers would turn to local banks and moneylenders to help guarantee their reputation and secure contracts with dealers.Eventually, classical civilizations built global markets by trading gold and silver for other goods.States which had efficient systems for backing and clearing contractual activity on trade routes grew their economic power.
The Beginning of Modern Trading Modern commodity trading has much in common with the first contracts conceived by the Sumerians.The concept of a futures market has its roots in Chicago.In the 1840’s, Chicago emerged as a major commercial center.Railroad and telegraph lines connected Chicago to large markets on the east coast and to new westward expansion.The invention of the McCormick reaper increased wheat production throughout the Midwest and farmers came to Chicago to sell their crops to dealers who could use this infrastructure to distribute grain all over the country.
As more farmers brought their grain to Chicago, problems began to emerge. There were no standards for weighing and grading wheat, so farmers had to visit multiple dealers to find the best price.Since the city lacked adequate warehouse space for, it was difficult for farmers to transport their wheat as they negotiated payment.This led to dissimilar prices for the same raw good and unpredictability for both buyers and sellers.
To help remedy this situation, the Chicago Board of Trade was established in 1848 as a central place for farmers and dealers to meet and negotiate prices.Buyers and sellers would exchange cash for the immediate delivery of wheat.With all of the buyers and sellers in one place, a more fluid market developed where prices and negotiations were transparent.Because weights and grades were standardized, farmers and dealers could set prices based on aggregate supply and demand.
The Emergence of the Futures Contract As the centralized market became more successful, farmers and dealers began to commit to futures exchanges of grain for cash.For example, a farmer might come to the market in February and promise to deliver 5,000 bushels of wheat in June for a set price today.This has advantages for both parties – the farmer knows how much he will be paid and the dealer knows his price in advance.These contracts were written down and occasionally guarantees (small amounts of money) were paid to secure the agreement.
As these contracts became more common, their terms were standardized.Once there were enough active contracts, banks began to securitize them and use them as collateral for loans.Additionally, contracts began to change hands before their delivery dates.If a dealer decided he didn’t need the wheat he was promised, he would sell his contract to someone who did.Conversely, if the farmer realized he would not be able to deliver enough wheat, he would transfer the contract to someone who could fulfill the obligation (and pay a premium to encourage the new farmer to accept the additional obligation.)
As time went on contracts were traded more frequently.Farmers and dealers realized that the value of the contracts changed depending on events in the market.Bad weather could ruin harvests and raise prices.Declines in demand could cause prices to drop.When trading, buyers and sellers would weigh these factors when valuing a contract because the future contained a fixed price relative to the floating rate in the market.The chart to the left shows how the value of a contract might change in two different scenarios.Eventually, people who had no intention of selling wheat or taking possession of the grain began to enter the market.They tried to buy contracts with low values and sell them when market forces pushed their prices higher.These people were the first speculators in the growing futures market.
Modern Commodity Trading Today, commodity trading has expanded far beyond wheat in Chicago.Goods as diverse as gold, oil, coffee, and orange juice are actively traded.All commodities have the following three qualities:
The good is standardized, raw and unprocessed (wheat is a commodity; flour is not).
The item must have an adequate shelf life for delivery.
There must be price fluctuation and uncertainty (risk and profit potential) for the good.
There is no need for a futures market if a price is stable.Additionally, the market for the commodity must be liquid enough that trading is possible.
I wanted to give a quick update on some articles I have planned for the next few weeks.After the series on the airline industry and fuel hedging, I received a request to discuss commodity trading in general.I think this is a good idea, especially given the debate over speculation in oil prices. Look for these entries to appear early next week.
Discussing commodities could encompass an entire blog unto itself.To make sure I keep focused, I will give a brief history of how and why commodity exchanges were formed.After that I will detail the recent flow of capital into commodities and explain how this affects global prices.Finally, I will reconcile increases in the supply and demand of oil with recent trading patterns and anomalies.
I still want to talk about GM’s struggles, the M&A landscape in the energy industry and the bizarre Yahoo/Microsoft saga.I’m planning on these topics after commodities unless something unexpected develops.I’m also considering a series on large trading losses, but this will largely depend on whether or not I can find adequate source material to document why the losses occurred.
Airlines that started hedging when oil traded at lower levels also face challenges.For example, Southwest’s $61/barrel hedges gradually expire through 2012.The company is 55% hedged in 2009, 30% in 2010, and 15% in 2011 and 2012.This leaves the company with many important decisions about how to continue its strategy.Using collars to construct price bands will be successful if oil prices continue to rise, but could be devastating if prices fall.Internally, Southwest is discussing a call-option strategy that would protect the airline from catastrophically high prices (above $200/barrel) but would allow the airline to participate in market declines.
Even if Southwest’s hedges expire entirely, the company will have adequate time to adjust its business model appropriately, a luxury many of its competitors do not enjoy.Ultimately, the key benefit of successful hedging is this security to make long-term plans to deal with fuel cost issues regardless of where prices go.Delta’s treasurer Paul Jacobson echoes this idea:
We view our program as insurance.Our goal is to minimize the volatility of fuel expenses. To do that, you’ve got to be in the market actively without an opinion as to what energy prices will do.
Good hedging strategies give companies the time they need to plan routes and fare structures that match stable fuel costs.
Public Relations
Now that we’ve learned why airlines struggle financially and examined some potential remedies, we need to cover one more important problem: the industry’s inability to manage public relations.
Airlines are doing a terrible job of explaining to consumers why they need to raise fares.Rather than increase ticket prices, airlines have tried a nickel-and-dime approach which has only alienated travelers who are assailed by rising fuel prices every day.Airlines are charging for checked baggage, implying that the extra weight of passenger cargo directly impacts the amount of fuel consumed on a flight.Some airlines are considering taking this measure one step further by actually weighing passengers and adjusting ticket prices accordingly.
This logic is completely flawed.The combined weight of passengers and their cargo make up only 1-2% of a plane’s total takeoff weight.Customers understand this intuitively and have reacted with collective skepticism to the airlines’ surcharge strategy.
This skepticism can be traced to a general lack of customer service savvy on the part of major carriers.The Bureau of Transportation Statistics reported that more than 25% of all domestic flights were either delayed or cancelled last year.In many cases, the airlines were not to blame.However, the airlines’ history of poor service and a lack of accountability have eroded public confidence to the point that airlines will be blamed for all service interruptions, regardless of cause.
Even as airlines struggle to maintain demand amidst fare increases they still commit preventable P.R. gaffes.Southwest flew planes without mandatory inspections and drew a record fine from the FAA.Shortly thereafter, American Airlines had to cancel over 3,000 flights due to concerns over faulty wiring in MD-80 aircraft.At first, the airline was not forthcoming about the reason for the cancellations.When a spokesperson was asked if the cancellations involved a safety issue, he simply walked off camera without answering.
Customer perception probably hit a low point in February 2007 when some JetBlue passengers were stranded in airplanes for up to eight hours with overflowing sewage, no food, and little water.JetBlue’s sluggish response ultimately forced the founder-CEO David Neeleman to resign in disgrace.
As a group, airlines do not focus on customer service as a business priority.Many carriers blame the decline on cost-saving cutbacks.Whatever the cause, airlines would be better able to weather economic downturns and fuel cost shocks if customers were more confident in their ability to provide a dependable product.Constant public relations blunders will only further erode consumer sentiment.
The Future
The road to airline profitability is a long one.Warren Buffett estimates that (in aggregate) airlines have lost more money than they have made since the Wright brothers first flight in 1903.There are many steps airlines can take to begin to return to profitability.The first is to remove domestic capacity but control public relations.Airlines need to remove overlapping routes and raise fares on existing routes to cover the costs of doing business.
Reducing capacity is difficult to manage.Airplanes are capital leases which cost airlines even if they are grounded.Therefore it is in the best interest of the airlines to fly as many routes as they can, but only if the routes are price appropriately and generate profits.As a former pilot points out, airlines can do this by distributing fuel costs to consumers directly, not through bag surcharges or other schemes (see example to the left).Demand will decrease as fares rise, but customers will be more receptive to honest discussions about the increases.Trying to obfuscate the obvious through trivial charges will alienate travelers.
Greater efficiency in operations will also help airlines control costs.Some help will come from the government and the FAA.Right now, flight patterns are governed by a series of ground-based facilities that track aircraft.Planes have to fly in certain patterns to stay within tracking range.New satellite-based GPS tracking systems will improve the routes planes can fly, the distance between planes, and the speed at which they travel.However, outfitting planes for this new technology will be expensive and the FAA doesn’t expect completion until 2025 at the earliest.Still, there are technological improvements in weather tracking and data communication that should help ease congestion in the long term.
Legacy carriers have one main advantage over low-cost carriers:international routes.Legacy carriers should consolidate their international positions and make sure that these routes are priced appropriately.International travelers are less price elastic than their domestic counterparts, and legacy carriers can exploit these higher fares to help offset losses elsewhere.There is also an additional bonus for the airlines – some return fares can be denominated in currencies trading at favorable exchange rates to the dollar.This can help to offset dollar depreciation and rising oil prices.
Cost control will remain important for airlines, but they must be discriminating in consolidation.Airlines should not merge unless the partners have many overlapping routes.Otherwise, the combined airline will simply have higher labor costs.
Airlines should also consider fuel hedging programs.Since oil prices are near record highs, it may not be a good time to buy swaps or collars if airlines expect a decline in prices.However, it would wise to set price ceilings through call options or other means to make sure that future gains produce less extreme effects.
There are also steps that airlines can take for free to help control public relations.First, stress polite, courteous customer service.Even if an airline has a rigid structure, it can provide friendly service to customers.Also, airlines need to be honest with consumers.Acknowledge safety issues, be flexible when possible, and remember that higher prices mean customers have tough decisions to make.A responsive, courteous airline will be in a better position to win the business of a shrinking customer pool.
Ultimately, airlines will be forced to cut capacity if fuel prices stay at historic highs.Some of this will come through bankruptcy.Since many carriers have already filed Chapter 11, subsequent bankruptcies may require liquidation rather than restructuring.Surviving airlines will be able to consolidate routes and increase fares accordingly.The best strategy is to remove capacity, cover the cost of doing business with appropriate fares, and exploit market opportunities as they present themselves.
If airlines want more flexibility than swaps, futures, or forwards can provide, they may turn to call options to secure a ceiling for fuel prices.A call option gives the owner the right to buy a commodity at a particular “strike price” until the maturity date of the option.
Buyers of call options pay a premium for the right to buy the commodity at the specified price.The amount of this premium depends on the value of the underlying commodity, the volatility of its price, and the time to maturity of the call.As you might expect, the price of a call increases if the value of the underlying commodity is highly volatile or if the option has a long time to maturity.
Since the call gives the owner the right to buy at a specific price, the owner will make money when the market price of the commodity exceeds the strike price.Theoretically, the owner could exercise the option at the lower price and immediately sell at the higher price, making arbitrage profits.For this reason, more volatile commodities command higher option premiums since the likelihood that the price will fluctuate above the strike price is greater.Similarly, options with a long time until maturity are worth more since the owner has more time for the price to increase above the strike price.
Airlines often purchase heating oil or crude oil call options to avoid liquidity concerns for OTC jet fuel options.These energy calls are expensive since oil has a volatile price.This means that buying call options is effective for setting price ceilings, but also cost-intensive (see example to the left).In this case, the airline will exercise the option when jet fuel rises over $2.70/ gallon.For the airlines to actually save money, the price must surpass $2.80 (which includes the distributed option premium.)
Call options are attractive because they set price ceilings but still let airlines take advantages of price drops.In the example, if fuel never reaches $2.70, the airline simply pays the market price and lets the option expire.The airline will lose the $1,000 it spent on the call, but it can buy fuel at a lower cost.If the price was fixed in a swap contract, the airline would not have this flexibility.
If airlines want to ensure price protection through call options but offset some of the expense they have an alternative:option collars.
Collars (Zero-Cost & Premium)
Collars involve the sale of a put option to help offset the cost of purchasing a call.A put option gives the owner the right to sell a commodity at a given strike price.In return for this right, the buyer will pay the option writer a premium which is then applied to the purchase of the call (see example to the right). The first step to build a collar is to buy a call option with a strike price above the current price of the commodity the airline wants to hedge.In this example, the airline pays $1,000 for an option to buy jet fuel at a strike price of $3.75/gallon.This gives the airline the protection it wants against an increase in prices.
Next, to help offset the cost of the call the airline will sell a put option.The airline will receive a premium for the put.However, since the put has a strike price below the current market price, the airline will have a cost floor it will pay for jet fuel (see example to the left).In this case, the airline is liable to the option holder for any decrease in price below $3.45.The airline will purchase its own fuel at market price but be forced to pay the difference between the price and the strike price to whomever exercises the option.As the example illustrates, the net activity will result in the airline paying the strike price rather than the lower market value for its fuel. A graphical representation of the call, put, and combined collar are shown at the end of this entry.
Collars have several advantages.They offer considerable protection for a low cost because the sale of the put offsets some or all of the cost of the call.Also, there is no speculative return – the airline has a set band of prices within which it will pay for its fuel.It is also possible to create premium collars that offer more protection from increases and greater ability to profit from price decreases.The airline can sell calls with lower strike prices (and pay higher premiums) while selling calls with lower strike prices (and receive lower premiums.)Airlines can tailor collars to match their tolerance for risk and variance in fuel prices.
Timing is important in the construction of collars.If an airline creates the hedge at the wrong time, its band of prices can be set too high.If prices drop far below the airline’s price floor, competitors will have a cost advantage that could threaten the airlines position.However, if a collar is created at the right time, it can lock in favorable prices for months or even years.
Hedging Today
Now that we have seen the ways airlines can hedge fuel prices, it’s time to examine how they are being applied today.Most airlines have operated without substantial hedges since 2006.There are two main reasons for the lack of activity.
First, most airlines don’t have the credit profile that would allow them to hedge without cash collateral.Cash reserves are often the only cushion airlines have against bankruptcy.Without upfront cash, airlines have difficulty finding counter-parties willing to take on default risk when entering into hedging contracts.
Second, hedging only protects against future price increases.There’s no way for airlines to retroactively hedge at lower prices, so now is a difficult time to get started.For example, Delta started hedging after emerging from Chapter 11.When the price of oil dropped in 2006 because of the September 11 terrorist attacks, Delta’s hedges had a net trading loss of $108 million.A similar fate could befall airlines who start hedging if prices fall from today’s highs.
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
Swaps / Futures
Call options
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 YorkHarbor 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.
This afternoon I would like to thank the following blog carnivals which have featured Economic Outlook discussions.Blog carnivals bring together articles dedicated to particular topics and publish them as a group on a regular schedule.If you are curious about economics and want to hear the opinions of many other writers, give these carnivals a try.
The Investing Carnival hosted by Dividend Growth Investor focuses on investment strategies.As you would expect, articles focus on growing passive income through stocks with increasing dividend payments.
I have finished filming the conclusion of the series on the airline industry, and the final three parts will be posted late tonight or early tomorrow morning.Topics include fuel hedging (swaps, futures, forwards, calls and collars), public relations, and recommendations for the future. After the holiday, I will return with a look at the US automotive industry, Yahoo’s ongoing struggles and more Energy Journals.
I am an MBA graduate from the Goizueta Business School at Emory University. This site offers my unique perspective on today's economic issues.
Feel free to contact me through the email address on my profile.
All work copyright Kramer Strategic Services, LLC.
As we saw in our previous discussion, commodities are attractive to investors because of their negative correlations to equity prices. We can explore this phenomenon further by looking at specific sectors within the S&P 500 index (see chart to left).
Investors looking for diversification will examine their assets and attempt to find other asset classes to reduce risk while maintaining or increasing returns. We can see the benefits of commodity investment by looking at the S&P’s components (see charts to the right).
The consumer discretionary sector of the S&P shows strong negative correlations to a broad range of commodity prices, especially raw materials (see chart to the left). Other sectors also appear vulnerable – the financial sector and health care have low correlations with many different classes of commodities.
Some sectors have low correlations with specific groups of commodities (see chart to the right). An investor with large holdings in consumer staples’ stocks would look to meats or metals to help offset risk. Sector examination also reveals that some areas have positive correlations with specific commodity groups. The utilities, industrials, and energy sectors maintain strong correlations with energy commodity prices. Similar patterns hold between raw materials commodities and energy and utility stocks. Portfolio managers would not use these pairs of assets for diversification purposes since their prices generally move in the same direction. 
