Delta Airlines and its use of derivatives

[Will Durant]

http://www.ajc.com/news/content/business/delta/1004/19airoil.html

Delta had long-term hedge contracts to buy fuel at 76 cents a gallon but sold them in February for $83 million in cash. The move was a bet that oil prices were going to fall. But jet fuel prices skyrocketed to $1.58 a gallon, and Delta — which burns about 2 1/2 billion gallons of jet fuel a year — has lost millions of dollars in the untimely sale. Delta said in July that surging fuel prices would cost it $680 million more this year than last. But the airline issued that statement when oil was selling for about $40 a barrel. Since then, oil prices have surged more than 25 percent.

Well, that's a big :duh: for Delta.

[Asynchronous]

According to Marketplace (on NPR) yesterday, Delta sold them to raise cash. i.e. they hoped prices would fall, but realistically, they had debts to pay and the hedges were marketable.

[Maine-iac]

Wonder who the lucky buyer was? :)

[Will Durant]

According to Marketplace (on NPR) yesterday, Delta sold them to raise cash. i.e. they hoped prices would fall, but realistically, they had debts to pay and the hedges were marketable.
Was the risk really worth it? They went through $83M in 11 days.

If oil stays at $50 a barrel, Delta estimates its "liquidity needs" will increase by $600 million next year.

I'm not an airline expert, but from a cash flow perspective that seems like a bad move. (In hindsight of course, but then again execs get paid the big bucks for FOREsight.)

[DW Simpson]

If they sold them in February, their then-CFO bolted in April just in time.

http://www.cfo.com/article.cfm/3013261/c_3042552?f=archives&origin=archive

[A Student]

This is a perfect example of the difference between "speculation" and "hedging".

There has to be some negligence (fraud even?) in the financial statements if Delta advertised these derivatives as hedges against rising future fuel prices, and then sold them hoping for a gain. Saying they are hedges would imply risk mitigation which wasn't there in practice...

[The Mad Hatter]

Hedging requires discipline - something that many large stock companies lack.

It's a tired analogy but suppose that Delta had discontinued insurance payments under hope that none of its planes would crash this year...

[Will Durant]

Hedging requires discipline - something that many large stock companies lack.

It's a tired analogy but suppose that Delta had discontinued insurance payments under hope that none of its planes would crash this year...
Wouldn't that be in some ways less risky than what they actually did?

A plane crash wouldn't cost them $600M and how many planes of their planes crash a year. The fuel decision though was basically a 50-50 bet on having to shell out $100M's of extra dollars.

[Maine-iac]

Not the insurance on the plane, the liability insurance. One crash could exceed $600M in liability pretty easily if the plane was loaded and the airline at fault.

[Will Durant]

Not the insurance on the plane, the liability insurance. One crash could exceed $600M in liability pretty easily if the plane was loaded and the airline at fault.
OK.

So we're saying that selling this hedge was the SECOND most stupid thing Delta could have done, right after cancelling its insurance.

It still seems pretty bad to me. It was a bad gamble, plain and simple. As Student said, these contracts are for hedging not speculation.

[The Mad Hatter]

Not the insurance on the plane, the liability insurance. One crash could exceed $600M in liability pretty easily if the plane was loaded and the airline at fault.
OK.

So we're saying that selling this hedge was the SECOND most stupid thing Delta could have done, right after cancelling its insurance.

It still seems pretty bad to me. It was a bad gamble, plain and simple. As Student said, these contracts are for hedging not speculation.

I agree with you that Delta was stupid. The analogy was only meant to demostrate the stupidity. The difference is that most companies know better than to stop insurance payments in order to increase cash flow; but they don't see hedging as the same kind of activity.

[DW Simpson]

http://money.cnn.com/2006/01/26/technology/dumbest_timeline/index.htm

April 15 [, 2005] -- While other airlines post a combined first-quarter loss of more than $2 billion, Southwest's profits triple to $76 million, thanks to the carrier's decision to lock in fuel prices at $26 a barrel through hedging strategies. As the market price jumps to more than $55 a barrel, Southwest saves $173 million in the quarter.

[E]

I agree with you that Delta was stupid. The analogy was only meant to demostrate the stupidity. The difference is that most companies know better than to stop insurance payments in order to increase cash flow; but they don't see hedging as the same kind of activity.
To make matters worse, they did away with those yummy honey roasted peanuts in favor of bland pretzels. Is it so wrong to ingest a few calories when flying coach?

[Samuel]

I've always believed that there is no such thing as a fuel price hedge in the airline industry: all of it is speculation. The reason is that some airlines use derivatives to protect against increased oil prices and some do not. If oil prices go up, the airlines that have not purchased derivatives will be at a competitive disadvantage as they have to pay increased costs. If oil prices go down, the airlines that have purchased the derivatives will be at the competitive disadvantage as they have to bear the costs of the derivatives without any gain (and those contracts are expensive).

Assuming an efficient market, an airline can't expect to save money through derivatives. That seems to be a point people miss. Considering that airlines don't actually hedge using jet fuel derivatives (there is no such market, they use similar goods as proxies) and there are substantial transaction costs to holding the derivatives, I think that the best decision for an airline is not to use derivatives. I would also argue that is best for consumers.

That is a tough case to sell right now, because fuel prices have gone up and are making the companies that did use derivatives look like geniuses. Arguing against derivatives in the airline industry right now is like arguing that a guy was stupid to go to vegas and put all his money on a single number in roulette --after he did so and won.

[Kenny]

Maybe I misunderstand the futures market, but what "substantial costs" exist to holding a futures contract? As far as I know, there aren't any.

Next, the purpose of the hedge is not necessarily to save money but to have known, fixed costs that you can plan for. You cannot plan for changing fuel prices, but if the airlines hold a short position in a product that moves in the same direction as jet fuel they will know their basic costs enough in the future to plan for them. While not a perfect hedge it will be a reasonable proxy.

[Samuel]

Maybe I misunderstand the futures market, but what "substantial costs" exist to holding a futures contract? As far as I know, there aren't any.

Next, the purpose of the hedge is not necessarily to save money but to have known, fixed costs that you can plan for. You cannot plan for changing fuel prices, but if the airlines hold a short position in a product that moves in the same direction as jet fuel they will know their basic costs enough in the future to plan for them. While not a perfect hedge it will be a reasonable proxy.

This is probably overly simplistic analysis, but a quick check of Southwest's financials shows that it currently has $641 million in hedge contracts on its balance sheet. That is more than its net income last year, and about twice its net income in any previous year. That seems "substantial" to me.

I know the theoretical reason for a hedge, but imagine if no airlines were hedged. They would all bear the brunt of fuel price increases equally, probably forcing price increases to compensate. I don't understand why that needs to be hedged several years out, as operations in a high fuel price environment should still be able to provide the revenues needed to compensate for high fuel costs due to higher costs.

[Kenny]

This is probably overly simplistic analysis, but a quick check of Southwest's financials shows that it currently has $641 million in hedge contracts on its balance sheet. That is more than its net income last year, and about twice its net income in any previous year. That seems "substantial" to me.

I know the theoretical reason for a hedge, but imagine if no airlines were hedged. They would all bear the brunt of fuel price increases equally, probably forcing price increases to compensate. I don't understand why that needs to be hedged several years out, as operations in a high fuel price environment should still be able to provide the revenues needed to compensate for high fuel costs due to higher costs.
Yes, they may have a "substantial" liability on their balance sheet, but what is the cost associated with it?

As far as price increases are concerned, I doubt airline tickets are nearly as elastic as fuel prices. I don't know the actual numbers but there are very few travelers that "must" fly at any particular time. Vacationers and tourists have the option of choosing closer destinations to which they can drive. Business people have the alternative of teleconferencing in at least 50% (I would guess this # is closer to 75% or more if necessary) of it's meetings. Meanwhile, oil and the subsequent fuel products are used in various markets, making the airline industry a minor player, not able to affect the price by much. This means they are forced to accept the increased costs of fuel, but are unable to pass the full cost onto consumers, particularly in the volatile manner in which the fuel prices have behaved recently.

[My children asked me to include these - :slug: :duh: ]

[Samuel]

Yes, they may have a "substantial" liability on their balance sheet, but what is the cost associated with it?


That is why I said I was oversimplifying a bit, there is no way I'm digging through the financial statements to find a nebulous disclosure to decipher to find the cost of the derivatives.:shake2:
As far as price increases are concerned, I doubt airline tickets are nearly as elastic as fuel prices. I don't know the actual numbers but there are very few travelers that "must" fly at any particular time.

I agree to the extent that airlines can not pass 100% of fuel price increases on to consumers, however the main reason they can not right now is that there is an oversupply of airline seats and that some of the airlines have hedged against fuel price increases.

It is a complex case to argue, especially over the internet. I tend to believe that in general companies best protect the interests of diversified shareholders by remaining unhedged. From an economic perspective, the worst case is for some companies to hedge and some not to hedge. Now companies to a large degree are competing based on that decision, and not how well they run the day to day operations of an airline.

[Kenny]

That is why I said I was oversimplifying a bit, there is no way I'm digging through the financial statements to find a nebulous disclosure to decipher to find the cost of the derivatives.:shake2:
You're shaking your head at me? Because you can't answer a simple question, even in general terms? First of all, if it is such a "substantial" liability (please note the difference between liability and cost) why would you need to decipher a "nebulous disclosure"? Shouldn't it be painfully obvious? Second, if you know that using derivatives like futures contracts does not save SW money bc they carry such a substantial liability, then you should be able to tell me what those costs are in general terms without needing to look at the financials. What are the costs to any company to hold a futures contract?


I agree to the extent that airlines can not pass 100% of fuel price increases on to consumers, however the main reason they can not right now is that there is an oversupply of airline seats and that some of the airlines have hedged against fuel price increases. Let me see if I understand what you are saying. It wasn't fair for some companies to protect themselves against rising fuel prices because their competitors are now unable to pass the increased fuel prices along to consumers. Consumers that have shown that airline prices are less elastic than fuel prices bc they have chosen to find other means of transportation

It is a complex case to argue, especially over the internet. Seems like the written word would be the easiest place to discuss a complex topic because your are not required to think quickly. You can contemplate your answer and articulate it in the best manner possible before actually posting it.

I tend to believe that in general companies best protect the interests of diversified shareholders by remaining unhedged. From an economic perspective, the worst case is for some companies to hedge and some not to hedge. Now companies to a large degree are competing based on that decision, and not how well they run the day to day operations of an airline.
I'm not even sure what to say here. It is in the shareholder's best interest for a company to participate in a volatile market and have no idea what the long term costs of a project are going to be? Do you even understand the definition of a hedge? I don't want an industry that must invest billions of dollars into infrastructure, these are investment that will be amortized for 30 to 40 years, to be surprised by their operating costs a year down the road. The decision to have known, fixed costs is exactly what these companies should be competing on. It is an integral part of their day to day operations. Your idea that all hedging is pure speculatoin is ridiculous. Please refer to the example above, the choice of an airline not to hedge the fuel costs (particularly in a volatile market) is like choosing not to buy insurance on the planes.

[Kenny]

I'm trying to make this easy for you. If oil prices go down, the airlines that have purchased the derivatives will be at the competitive disadvantage as they have to bear the costs of the derivatives without any gain (and those contracts are expensive).

Assuming an efficient market, an airline can't expect to save money through derivatives. That seems to be a point people miss. Considering that airlines don't actually hedge using jet fuel derivatives (there is no such market, they use similar goods as proxies) and there are substantial transaction costs to holding the derivatives, You made several statements about the costs of derivatives in your original post. Please explain what those costs are.I think that the best decision for an airline is not to use derivatives. I would also argue that is best for consumers.Please do so. I would like to hear some actual arguments besides "I believe" and "from an economic perspective". What economic principles would you be refering to? Please keep in mind the airline industry is not anywhere near an efficient or perfectly competitive market. There are very substantial barriers to entry.

That is a tough case to sell right now, because fuel prices have gone up and are making the companies that did use derivatives look like geniuses. Arguing against derivatives in the airline industry right now is like arguing that a guy was stupid to go to vegas and put all his money on a single number in roulette --after he did so and won.
This is an actuarial BB. Everyone here understands the statistical argument associated with this choice so I don't think it would be a difficult argument to make, before or after the man won the money. Should we make a poll?

[WWSituation]

This is probably overly simplistic analysis, but a quick check of Southwest's financials shows that it currently has $641 million in hedge contracts on its balance sheet. That is more than its net income last year, and about twice its net income in any previous year. That seems "substantial" to me.

I know the theoretical reason for a hedge, but imagine if no airlines were hedged. They would all bear the brunt of fuel price increases equally, probably forcing price increases to compensate. I don't understand why that needs to be hedged several years out, as operations in a high fuel price environment should still be able to provide the revenues needed to compensate for high fuel costs due to higher costs.

If no airlines were hedged, then the entire industry would see substantial discounts to their P/E multiples. Removing(reducing) that source of volatility from their earnings reduces the Beta and thus adds back the value to the equity under just about any analyst's pricing model net of the cost of doing so.

Looking at the value of the hedge contracts tells you absolutely nothing about the costs without knowing the spreads that the dealers charge. I don't know what oil contracts go for these days, but I assume that the market is pretty liquid. In the interest rate market, for example, the cost per notional is under a basis point. I would expect oil contracts to be more expensive than interest rate contracts, and if companies are using OTC arrangements, I could see it being even more expensive.

So who can tell us roughly what type of spreads are being assessed in the oil futures markets?

[Chubbs]

Wonder who the lucky buyer was? :)

They sold them on E-Bay and they were bought by that crazy casino that buys all the virgin mary stamped grilled cheeses

[Eimon Gnome]

If no airlines were hedged, then the entire industry would see substantial discounts to their P/E multiples. Removing(reducing) that source of volatility from their earnings reduces the Beta and thus adds back the value to the equity under just about any analyst's pricing model net of the cost of doing so.

Looking at the value of the hedge contracts tells you absolutely nothing about the costs without knowing the spreads that the dealers charge. I don't know what oil contracts go for these days, but I assume that the market is pretty liquid. In the interest rate market, for example, the cost per notional is under a basis point. I would expect oil contracts to be more expensive than interest rate contracts, and if companies are using OTC arrangements, I could see it being even more expensive.

So who can tell us roughly what type of spreads are being assessed in the oil futures markets?
Agreed. In fact, the oil hedge is also keenly related to their cost of capital in general, not just the Equity portion. Let me explain.

Airlines typically lease their aircraft, like a company leasing its home office. The leases are a form of debt. They have to pay them, or risk a default. So the airlines do not put up the cash for the planes, they agree to pay a fixed amount into a leasing company, and someone else puts up the money to buy the planes. Using a hedge on oil prices helps in both the upside and downside. If oil fell to $4 a barrel, and other airlines started to charge $22 for trips to London, that would be V Bad for making those lease payments. The airline would need something to augment the ticket receipts to make its lease payments, or face a potential default on its leases.

Its a complicated biz, fer sure. And nasty hard to turn a profit.

Wish I could answer the bid/ask and carry cost of an oil forward. Been too long out of the market to even guess.

[Samuel]

Kenny, there are several costs to a futures contract, assuming it is a "hedge" to begin with, which I am disputing. Investment banking fees (including the spread on the transaction), legal fees, accounting fees, and exposure to the unhedged portion of the contract.

The major issue I have is not those fees, but that I don't consider it to be a hedge. A hedge should reduce both upside and downside risk to your business. I contend that hedging as it is done in the airline industry increases both upside and downside risk, and thus should be considered as speculative. Why? Because some airlines do not hedge. In the case that the price of jet fuel falls, those that hold the futures are in trouble.

A simple example: Samuel Airlines does not hedge. Kenny Airlines uses futures to lock in a price of $50 a barrel of jet fuel five years from now. Is Kenny Airlines protected against oil price fluctuations? Not at all. If the price is $30 a barrel in 5 years, Kenny Airlines will be in a very difficult position to compete, much like Samuel will be if the price jumps to $70 a barrel. The risk to both would be much less if neither hedged, or if both hedged. Of course if both hedged they would still have the expenses and risks outlined in the first paragraph.

Kenny, you brought up the point of managing cash flows. It is a fair point--in the short term there are efficiencies created by knowing what expenses will be. But airlines are hedging several years down the line, and you do not manage cash flows that far in advance.

A final general point about hedging: in finance 101 you learn that management's goals should be to increase shareholder returns, and one should assume a diversified shareholder. Take for instance the very popular strategy of hedging international cash flows. If U.K. companies are hedging longer term cash flows from the U.S., and U.S. companies are hedging longer term cash flows from the U.K., as a diversified shareholder I lose as I've diversified against the exchange rate risk already by owning both U.S. and U.K. interests. My risk is not decreased by the hedging activity, but my profitability is eroded by banking fees.

[Eimon Gnome]

The major issue I have is not those fees, but that I don't consider it to be a hedge. A hedge should reduce both upside and downside risk to your business. I contend that hedging as it is done in the airline industry increases both upside and downside risk, and thus should be considered as speculative. Why? Because some airlines do not hedge. In the case that the price of jet fuel falls, those that hold the futures are in trouble.
.
I think this is too restrictive a definition for "hedge". Whether or not a competing firm hedges, should not be relevant. Simple example.

Two insurance company's sell identical, market value annuities. Both contain interest rate guarantees and an "upside kicker" if the S&P total returns exceed 10% during the year.

Insurer Prudent Man purchases puts and shorts the future M&E fees through a program of delta hedging. Insurer Shifting Sands does not.

If the interest rates stay above the guarantee and equity markets do well, Shifting Sands will be awash in cash compared to Prudent Man. They will be able to offer higher commissions and effectively squeeze Prudent Man out of the distribution for MV annuities.

Shifiting Sands will enjoy a competitive advantage if markets "do well" for them. But, I don't see any reason why Prudent Man's actions are not a hedge.

If the equity analysts understand the difference between the two company's strategies, then won't investors - both equity and debt - demand a higher return from Shifting Sands? They are taking a systemic risk, and they will expect to get paid for that, I believe.

[Maxprime]

I think this is too restrictive a definition for "hedge". Whether or not a competing firm hedges, should not be relevant. Simple example.

Two insurance company's sell identical, market value annuities. Both contain interest rate guarantees and an "upside kicker" if the S&P total returns exceed 10% during the year.

Insurer Prudent Man purchases puts and shorts the future M&E fees through a program of delta hedging. Insurer Shifting Sands does not.

If the interest rates stay above the guarantee and equity markets do well, Shifting Sands will be awash in cash compared to Prudent Man. They will be able to offer higher commissions and effectively squeeze Prudent Man out of the distribution for MV annuities.

Shifiting Sands will enjoy a competitive advantage if markets "do well" for them. But, I don't see any reason why Prudent Man's actions are not a hedge.

If the equity analysts understand the difference between the two company's strategies, then won't investors - both equity and debt - demand a higher return from Shifting Sands? They are taking a systemic risk, and they will expect to get paid for that, I believe.
As for whether or not they should - it's the tollbooth principle. If the market didn't provide an economic incentive, they wouldn't be doing it.

I also don't understand how this is speculation over a hedge. Speculation is thinking about where the market is going. Hedging is reducing losses (or reducing the hit to gains for financial services) due to an unfavorable move by the market. Unless I'm mistaken, they have no incentive to (and I doubt) speculate on whether or not the price of fuel will drop because they will make profits off of it. If they were buying contacts in that direction as well then they would be speculating.

[Kenny]

Kenny, there are several costs to a futures contract, assuming it is a "hedge" to begin with, which I am disputing. Investment banking fees (including the spread on the transaction), legal fees, accounting fees, and exposure to the unhedged portion of the contract.

The major issue I have is not those fees, but that I don't consider it to be a hedge. A hedge should reduce both upside and downside risk to your business. I contend that hedging as it is done in the airline industry increases both upside and downside risk, and thus should be considered as speculative. Why? Because some airlines do not hedge. In the case that the price of jet fuel falls, those that hold the futures are in trouble. Your argument is that bc one firm in an industry does not hedge, all activities any other firm does to hedge a position becomes speculation?

A simple example: Samuel Airlines does not hedge. Kenny Airlines uses futures to lock in a price of $50 a barrel of jet fuel five years from now. Is Kenny Airlines protected against oil price fluctuations? Not at all. If the price is $30 a barrel in 5 years, Kenny Airlines will be in a very difficult position to compete, much like Samuel will be if the price jumps to $70 a barrel. The risk to both would be much less if neither hedged, or if both hedged. Of course if both hedged they would still have the expenses and risks outlined in the first paragraph. What you are describing is Samuel airlines speculating that prices are going to decrease (or at least ignoring the real cost of not reducing its volatility) and Kenny Airlines hedging against an upward movement in the market. Hedging your position is not about a "set it and forget it" action. As market prices move Kenny Airlines will continue its hedging activities. If prices continue up, nothing is required. If prices decline Kenny Airlines can reverse it's position by entering into an opposing contract to sell the same amount of jet fuel. There is certainly the possibility of losing some money on the contract and having to sell at $48 instead of $50, however, by choosing to hedge Kenny's cost of capital decreases bc it has less volatility and it is better able to predict future cash flows.

Kenny, you brought up the point of managing cash flows. It is a fair point--in the short term there are efficiencies created by knowing what expenses will be. But airlines are hedging several years down the line, and you do not manage cash flows that far in advance. See above, hedging requires adjustments to avoid the situation you have described. That does not magically make it speculation.

A final general point about hedging: in finance 101 you learn that management's goals should be to increase shareholder returns, and one should assume a diversified shareholder. Take for instance the very popular strategy of hedging international cash flows. If U.K. companies are hedging longer term cash flows from the U.S., and U.S. companies are hedging longer term cash flows from the U.K., as a diversified shareholder I lose as I've diversified against the exchange rate risk already by owning both U.S. and U.K. interests. My risk is not decreased by the hedging activity, but my profitability is eroded by banking fees.
You do not increase shareholder value by going bankrupt. You increase shareholder value by balancing profit and risk. Accepting uneccesary risk is not the way to do that.

[Kenny]

I also don't understand how this is speculation over a hedge. Samuel is claiming it is speculation. I do not believe EG is making that claim.

[Samuel]

I think this is too restrictive a definition for "hedge". Whether or not a competing firm hedges, should not be relevant.

Certainly airline "hedging" like we've been discussing meets the accounting definition of a hedge. I'm less interesting in discussing definitions and more interested in discussing what good management policy is.

Simple example.

Two insurance company's sell identical, market value annuities. Both contain interest rate guarantees and an "upside kicker" if the S&P total returns exceed 10% during the year.

Insurer Prudent Man purchases puts and shorts the future M&E fees through a program of delta hedging. Insurer Shifting Sands does not.

If the interest rates stay above the guarantee and equity markets do well, Shifting Sands will be awash in cash compared to Prudent Man. They will be able to offer higher commissions and effectively squeeze Prudent Man out of the distribution for MV annuities.

Shifiting Sands will enjoy a competitive advantage if markets "do well" for them. But, I don't see any reason why Prudent Man's actions are not a hedge.

If the equity analysts understand the difference between the two company's strategies, then won't investors - both equity and debt - demand a higher return from Shifting Sands? They are taking a systemic risk, and they will expect to get paid for that, I believe.

That example differs substantially from what we have been discussing from airlines. Essentially you are proposing Shifting Sands sell a bunch of options and hope for the best, not lock in a price for a variable factor of production. My perspective is that hedging in the case you just outlined is a positive way to manage risk.

[Samuel]

What you are describing is Samuel airlines speculating that prices are going to decrease (or at least ignoring the real cost of not reducing its volatility) and Kenny Airlines hedging against an upward movement in the market. Hedging your position is not about a "set it and forget it" action. As market prices move Kenny Airlines will continue its hedging activities. If prices continue up, nothing is required. If prices decline Kenny Airlines can reverse it's position by entering into an opposing contract to sell the same amount of jet fuel. There is certainly the possibility of losing some money on the contract and having to sell at $48 instead of $50, however, by choosing to hedge Kenny's cost of capital decreases bc it has less volatility and it is better able to predict future cash flows.


Kenny, defining Samuel Airlines as speculating in the hypothetical makes almost everyone a speculator. Very few industries hedge their future variable production costs for services that have not been rendered. Typically those reflected in future period pricing.

As for various hedging strategies, there is no such thing as a free lunch. Your expected savings will be zero from hedging no matter what strategy you use and assuming efficient markets, less of course transaction costs.

A lot of academics agree with me on this, btw. Warren Buffett does as well.

[ahow]

Thus far, I don't think anyone has really mentioned the fact that the earth is not producing oil at anywhere close to the rate we are consuming it. About the only situation in which purchasing futures on oil are a bad idea is in a short-term timeframe (and maybe something catastrophic such as war). Bottomline is, oil prices are pretty consistently going to go up...

[Eimon Gnome]

Certainly airline "hedging" like we've been discussing meets the accounting definition of a hedge. I'm less interesting in discussing definitions and more interested in discussing what good management policy is.



That example differs substantially from what we have been discussing from airlines. Essentially you are proposing Shifting Sands sell a bunch of options and hope for the best, not lock in a price for a variable factor of production. My perspective is that hedging in the case you just outlined is a positive way to manage risk.
Agreed on both points. The example was just to illustrate a good hedge, even if it does "harm" in some situations.
I am not so interested in the accounting definition either. So let's stick to the Delta case.

Would you agree that if XYZ airline does not hedge oil, then buying XYZ stock, or purchasing it's debt, amounts to a short on oil? If oil prices rise, the investor loses in both cases - either the straight short or through the purchase of the XYZ securities.

So, as the CFO of XYZ, why not attempt to broaden the potential market for capital providers. Don't restrict yourself to only those investors that wish to simultaneoulsy short oil.

It can't be wrong to hedge oil*. You can only gain. Those that want to purchase your stock can always short oil in a separate transaction, if that is their point of view. And you gain those that do not want to short oil.

[* I agree with your earlier point, also. Don't execute a simple short. If oil prices drop too far, new entrants will eat your lunch. You have to consider something other than a simple forward contract. It's a tough problem.]

[DW Simpson]

Bottomline is, oil prices are pretty consistently going to go up...

Not necessarily.

If an adequate oil sythetic is produced, the demand for oil falls. If more ethanol plants (http://news.google.com/news?hl=en&ned=us&ie=UTF-8&q=ethanol+plants&btnG=Search+News) are built, the demand for oil falls. If Sweden & Russia (http://www.actuarialoutpost.com/actuarial_discussion_forum/showthread.php?t=73365) are successful in finding alternative fuels, and other countries follow, the demand for oil falls. If liquid natural gas (http://www.actuarialoutpost.com/actuarial_discussion_forum/showpost.php?p=1179668&postcount=6) or other liquid fuels (http://www.actuarialoutpost.com/actuarial_discussion_forum/showthread.php?t=73935&highlight=liquid+natural+gas) become appropriate, the demand for oil falls.

[Kenny]

Kenny, defining Samuel Airlines as speculating in the hypothetical makes almost everyone a speculator. Very few industries hedge their future variable production costs for services that have not been rendered. Typically those reflected in future period pricing.After giving your example some more thought, I realized you were correct, what you described was not hedging. If that is what is occuring, then airlines are not hedging their position because they are not protecting themselves from a drop in oil prices. However, if they enter into the futures contract and simultaneously pruchase an options contract for the opossite position, they will be hedged against movements in either direction (i.e. long futures, long puts or short futures, long calls).

As for various hedging strategies, there is no such thing as a free lunch. Your expected savings will be zero from hedging no matter what strategy you use and assuming efficient markets, less of course transaction costs. What do yo mean by efficient markets? Are you referring to the Efficient Market Hypothesis or something else? I don't remember saying anything abou hedging being about saving money. If I did, then I misspoke. The purpose of hedging is to reduce volatility and protect yourself from adverse movements in the market.

A lot of academics agree with me on this, btw. Warren Buffett does as well. No offense if I don't take your word for it. I would be interested in reading some articles that discuss this, however. Do you have a link?

[Morrison]

Any anticipated shortage in Oil should be reflected in the Futures price. Unless the buyer has some special knowledge not available to the broader market, the buyer of Oil futures certainly is taking a financial risk.

[A Student]

Financial 101 does say that there is no economic incentive for a company to diversify their risks because "smart" investors will be diversifing themselves. This is true under a strict set of assumptions - one of which is that there are no bankruptcy costs.

I would argue that because shareholders get nadda in an airline bankruptcy, that shareholders would be willing to support some hedging of major variable costs (ex fuel) in order to reduce the probability of bankruptcy.

[Samuel]

Agreed on both points. The example was just to illustrate a good hedge, even if it does "harm" in some situations.
I am not so interested in the accounting definition either. So let's stick to the Delta case.

Would you agree that if XYZ airline does not hedge oil, then buying XYZ stock, or purchasing it's debt, amounts to a short on oil? If oil prices rise, the investor loses in both cases - either the straight short or through the purchase of the XYZ securities.

So, as the CFO of XYZ, why not attempt to broaden the potential market for capital providers. Don't restrict yourself to only those investors that wish to simultaneoulsy short oil.

It can't be wrong to hedge oil*. You can only gain. Those that want to purchase your stock can always short oil in a separate transaction, if that is their point of view. And you gain those that do not want to short oil.


By buying an unhedged airline stock, you are exposed to the risk that oil prices will rise. But much of that is easily diversifiable--if you diversify through the hedged and unhedged portion of the airline industry you will eliminate the competive risks we have been discussing. What you are left with is the risk that higher energy costs will diminish demand if and when the cost is passed on to the consumer. This is a general business risk, in many ways similar to the risk of a general economic slowdown or a terrorist attack.

An example that is not airline related, but I think quite similar. In the construction supplies industry, steel is a major component of many products, but hedging steel prices is uncommon. A few years ago steel prices jumped approximately 80% in a very short time. At least in the company I looked at, the change was remarkably minor. Prices were raised to compensate for the increased price. Certainly the price increase had some effect on demand, and there was a bit of pressure on margins, but the effect was not drastic.

In hindsight, I would say that there was a risk of rising steel prices in the market, but it was relatively small, even at extreme levels. Imagine the effect, however, if half the market was hedging the price of steel. The small risk would have become large, and would be there for everyone.

[Samuel]

After giving your example some more thought, I realized you were correct, what you described was not hedging. If that is what is occuring, then airlines are not hedging their position because they are not protecting themselves from a drop in oil prices. However, if they enter into the futures contract and simultaneously pruchase an options contract for the opossite position, they will be hedged against movements in either direction (i.e. long futures, long puts or short futures, long calls).

They may be able to do that (the airline industry consumes a lot of fuel, I don't know if the market is deep enough to support that level of options purchasing). But I still maintain that there is no such thing as a free lunch. If you protect against upside risk, and protect against downside risk, what happens if the market stays the same? You will then still have more costs than an airline that remained unhedged.

What do yo mean by efficient markets? Are you referring to the Efficient Market Hypothesis or something else? I don't remember saying anything abou hedging being about saving money. If I did, then I misspoke. The purpose of hedging is to reduce volatility and protect yourself from adverse movements in the market.

All true. But there are risks you can effectively protect against, and risks you can't.

No offense if I don't take your word for it. I would be interested in reading some articles that discuss this, however. Do you have a link?

Sorry, no link. I did look for Warren Buffett's criticisms, but they actually seemed to be about something else. Any upper division undergrad or graduate finance book that discusses derivatives in depth from management's perspective will probably have a section on this. It will be presented as a theory among several.

[Kenny]

Sorry, no link. I did look for Warren Buffett's criticisms, but they actually seemed to be about something else. Any upper division undergrad or graduate finance book that discusses derivatives in depth from management's perspective will probably have a section on this. It will be presented as a theory among several.
Interesting. I've got Hull on my shelves right now. Without looking I would guess the strict assumptions required for your argument are not present in the airline industry. I'll wait to agree with you until you've actually presented some evidence for your statements.

[Kenny]

An example that is not airline related, but I think quite similar. In the construction supplies industry, steel is a major component of many products, but hedging steel prices is uncommon. A few years ago steel prices jumped approximately 80% in a very short time. At least in the company I looked at, the change was remarkably minor. Prices were raised to compensate for the increased price. Certainly the price increase had some effect on demand, and there was a bit of pressure on margins, but the effect was not drastic.

In hindsight, I would say that there was a risk of rising steel prices in the market, but it was relatively small, even at extreme levels. Imagine the effect, however, if half the market was hedging the price of steel. The small risk would have become large, and would be there for everyone.
In this case hedging the price of steel would be stupid. Obviously whatever product/service you reviewed had steel as either a minor input to total costs, or the price is elastic enough to pass the costs on to the consumer. That is not the case in the airline industry so your example doesn't really translate to oil futures and the airline industry.

[Eimon Gnome]

By buying an unhedged airline stock, you are exposed to the risk that oil prices will rise. But much of that is easily diversifiable--if you diversify through the hedged and unhedged portion of the airline industry you will eliminate the competive risks we have been discussing. What you are left with is the risk that higher energy costs will diminish demand if and when the cost is passed on to the consumer. This is a general business risk, in many ways similar to the risk of a general economic slowdown or a terrorist attack.

This is where we part company. I will gladly fill your order on an oil futures contract. I decline to do the same for a "terrorist attack futures".

Oil is a very liquid (groan) commodity. It's reasonable to think of oil, the commodity, as a systemic risk. Buying more oil futures, does not diversify your risk in oil. Buying more airline stocks does not appreciably diversify your exposure to oil.
If some airlines hedge, then those give you little exposure to oil. But it doesn't change the exposure on the airline stocks that don't hedge.

If by diversify, you mean that individual capital partners do their own oil hedging, then that is something different. You caan hold to that, but be prepared to have a much higher cost of capital than your hedging competitor.

[DW Simpson]

http://www.washingtonpost.com/wp-dyn/content/article/2006/01/18/AR2006011802255.html

Southwest Airlines Posts 54 Percent Profit Increase
Fuel Costs Hurt American Despite More Revenue

By David Koenig
Associated Press
Thursday, January 19, 2006; Page D02

DALLAS, Jan. 18 -- Southwest Airlines Co. reported a 54 percent jump in fourth-quarter profit as the bets it made on fuel prices allowed it to dodge for a little longer the spiraling costs that led to a $604 million loss for the parent of American Airlines, the nation's biggest carrier.

...

Southwest again cashed in on a winning bet it made several years ago on the direction of fuel prices. The carrier bought options that locked in prices on most of its fuel needs through 2009. As a result of this hedging, Southwest paid about $1.20 per gallon for fuel, its second-biggest cost after labor, in the fourth quarter.

Beginning this year, however, Southwest has less of its fuel hedged, and the carrier expects its average cost of fuel to rise to $1.45 a gallon in the first three months of this year. Still, chief executive Gary C. Kelly said the company has a favorable outlook on the first quarter and expects profit to rise 15 percent this year.

[DW Simpson]

http://www.washingtonpost.com/wp-dyn/content/article/2005/10/20/AR2005102001967.html

Airlines That Hedged Against Fuel Costs Reap Benefits

By David Koenig
Associated Press
Friday, October 21, 2005; D02

DALLAS, Oct. 20 -- Southwest Airlines Co. and the parent of Alaska Airlines turned in strong third-quarter results on Thursday, cashing in winning bets they made on the direction of fuel prices.

U.S. airlines are seeing strong demand for travel, and they've even had a bit of success in pushing up ticket prices, but high fuel prices have kept giants like American Airlines in the red.

Not so at Southwest and Alaska Air Group Inc., which were more aggressive than their rivals in taking options to buy fuel far into the future at set prices, a practice known as hedging.

Southwest said Thursday it earned $227 million, or 28 cents per share, in the third quarter, including an $87 million gain from its hedging. Analysts had expected 18 cents per share, according to a survey by Thomson Financial, and the results beat Southwest's year-ago profit of $119 million, or 15 cents per share.

Seattle-based Alaska Air Group, which operates Alaska Airlines and Horizon Air, used hedging to save on half the fuel it bought. Its profit rose to $90.2 million, or $2.71 per share. Excluding the impact of special items, net income would have been $71.5 million, or $2.16 per share, still enough to beat Wall Street's forecast of $2.12 per share.

JetBlue Airways Corp. reported a profit of $2.7 million, or 2 cents per share, when analysts were forecasting a penny per share loss. But JetBlue was not as insulated from fuel prices as Southwest and Alaska, and it fell short of a year-ago profit of $8.1 million, or 7 cents a share.

New York-based JetBlue also said high fuel costs would push it to a loss for the fourth quarter and the year as a whole.

Airlines have long taken steps to guard against spikes in fuel prices, usually buying options to acquire fuel at set prices. Southwest was more conservative than other carriers but stepped up its hedging against high fuel costs after prices spiked in 1999.

Other carriers were too weakened after the industry downturn in 2001 to make hedging deals, and now it's too late to get the kind of deals that Southwest and Alaska got, said Betsy Snyder, an airline credit analyst for Standard & Poor's.

Southwest, however, said it will pay the equivalent of $26 a barrel of oil -- less than half the current price -- for 85 percent of the fuel it will need in the fourth quarter. Alaska locked in 50 percent of its fuel for this year at about $30 a barrel of oil.

Hedging let Dallas-based Southwest cut its average cost of fuel to 95 cents per gallon in the third quarter -- far less than the other carriers who have released results for the July-to-September period. Alaska Airlines paid $1.56 a gallon, and JetBlue paid $1.70 -- and expects $2 a gallon the rest of the year. Continental Airlines Inc. paid $1.88 a gallon, and AMR Corp.'s American Airlines paid nearly $1.89.

JetBlue hedged against only about 20 percent of its fourth-quarter fuel at about $30 a barrel, and American Airlines only 8 percent at $48 a barrel, leaving them at the mercy of open market prices.

Fuel was 19.6 percent of Southwest's operating expenses, compared with 23.7 percent at Continental, 27 percent at Alaska and Horizon, 29 percent at American and 31.4 percent at JetBlue, according to figures provided by the companies.

Southwest is poised to continue reaping this advantage, with deals to buy more than half its fuel through 2007 at prices far below current levels.

There are limits to Southwest's maneuvering. The company warned that even with hedges, its price for fuel in the fourth quarter could jump to $1.25 a gallon or higher because of hurricane damage to refineries on the Gulf Coast.

All the carriers reported strong demand for travel, with planes flying more full than a year ago. Combined with recent price increases, that resulted in higher revenue.

JetBlue said revenue jumped 40 percent from a year earlier, to $453 million. Still, analyst Ray Neidl of Calyon Securities said high oil prices could force JetBlue to raise prices and drive away customers. He downgraded the stock.

Southwest's revenue rose 19 percent, to $1.99 billion, and Alaska said sales gained 10 percent, to $846 million.

Shares of JetBlue dropped $1.49, or 7.6 percent, to close at $18.05 on the Nasdaq Stock Market. Shares of Southwest fell 51 cents, or 3.3 percent, to $15.07, and Alaska shares dipped 16 cents, to $29.34, on the New York Stock Exchange.

[Maxprime]

It seems like some idiot really got screwed by selling futures of such low oil prices when we're at war in the middle east.

[A Student]

It seems like some idiot really got screwed by selling futures of such low oil prices when we're at war in the middle east.

I wouldn't necessarily say that the co selling oil futures is an idiot. Its possible that an oil services company determined that if oil remains at $x per barrel it can successfully proceed on projects which will produce oil in the distant future, but if between committing to the project and the actual production/sale of the resulting oil, oil prices fell below $x/barrel, then the company would lose money, the oil price hedge may be worthwhile.

Also, since everybody should know that we are were in a war in the mideast (although we weren't at the time of Southwest's purchases) that should have been priced into the futures contract.

Bottom line, you can't judge the success of a hedging program afterwards based on whether you would have been better off with or without the hedging program. The success should be determined based on whether the program insulated you against the risks you were concerned about.

[Samuel]

Interesting. I've got Hull on my shelves right now. Without looking I would guess the strict assumptions required for your argument are not present in the airline industry. I'll wait to agree with you until you've actually presented some evidence for your statements.

What evidence can I possibly present? I've explained a concept enough that if you understand economics and derivatives then you can evaluate it on your own. Potentially I could find someone else saying the same thing and link to this forum, but that is an appeal to authority, not evidence.

[Samuel]

This is where we part company. I will gladly fill your order on an oil futures contract. I decline to do the same for a "terrorist attack futures".

Oil is a very liquid (groan) commodity. It's reasonable to think of oil, the commodity, as a systemic risk. Buying more oil futures, does not diversify your risk in oil. Buying more airline stocks does not appreciably diversify your exposure to oil.
If some airlines hedge, then those give you little exposure to oil. But it doesn't change the exposure on the airline stocks that don't hedge.

If by diversify, you mean that individual capital partners do their own oil hedging, then that is something different. You caan hold to that, but be prepared to have a much higher cost of capital than your hedging competitor.

I agree that terrorist attack futures aren't plausibly workable. It would be possible though for airlines to hedge against the risk of decreased economic activity by shorting the S&P500.

In an environment where 50% or so of your competition is unhedged, I do not think that remaining unhedged will affect your cost of capital.

By diversifying I was referring to owning representatives of the industries in the economy (such as owning the S&P500). This will leave you exposed to the risk of oil prices through the risk to the general economy, which you could manage through options on oil prices.

[Eimon Gnome]

.....In an environment where 50% or so of your competition is unhedged, I do not think that remaining unhedged will affect your cost of capital.
Well, in reference to the post above, about Southwest's hedging... here's a qutoe from the CEO of Southwest, on Dec 5.

We've not stressed our balance sheet, having reduced leverage in recent years, and we enjoy the best credit rating in the industry. We're in business to make profits, not grow for growth's sake.

As best I can tell, Southwest is the only major carrier with an A rating from S&P. You can bet that saves them a bundle on the financing costs of planes. They get to amortize the leases (about 7-10 years) at a rate 200 to 300bp lower than their competitors. Thats a nice chunk of change.

Now, I'm not saying that hedging is the sole factor in the high credit rating, but I am sure it contributes. A strong balance sheet and prudent risk management does pay off, imho.

[Kenny]

What evidence can I possibly present? I've explained a concept enough that if you understand economics and derivatives then you can evaluate it on your own. Potentially I could find someone else saying the same thing and link to this forum, but that is an appeal to authority, not evidence.
I'm still waiting for you to define efficient market. It is one of your primary assumptions, so I want to be sure we are discussing the same thing. Are you referring to an efficient market related to the dissimenation of information, such as the EMH?

When I get a chance I will go back and review your arguments again.

[DW Simpson]

I just emailed this:

Subject: Message for Laura Wright, CFO at Southwest, about oil price hedging

Dear Ms. Wright,

A discussion of Southwest's oil hedging strategies has broken out at an actuary discussion forum. You may find this at

http://www.actuarialoutpost.com/actuarial_discussion_forum/showthread.php?t=39699

The original discussion focused on Delta's failed strategies, but about midway through the first page, Southwest's strategies were considered.

I hope you will find them interesting.

Best regards,
Claude Penland, ACAS, MAAA
Partner - Websites & Internet Strategy
D.W. Simpson & Company, Inc.
http://www.dwsimpson.com
claude.penland@dwsimpson.com

CHICAGO | SYDNEY | MELBOURNE | LONDON | MUMBAI | HONG KONG | LOS ANGELES | MILWAUKEE | ATLANTA | LEXINGTON

[Samuel]

As best I can tell, Southwest is the only major carrier with an A rating from S&P. You can bet that saves them a bundle on the financing costs of planes. They get to amortize the leases (about 7-10 years) at a rate 200 to 300bp lower than their competitors. Thats a nice chunk of change.

Now, I'm not saying that hedging is the sole factor in the high credit rating, but I am sure it contributes. A strong balance sheet and prudent risk management does pay off, imho.

As I think I mentioned in my first post, this is a very difficult discussion to have because oil prices did go up and the companies that were hedged won. It is also a difficult discussion to have because the companies that were hedged also tended to have lower cost structures. Looking at debt ratings now after a major oil shock that helped the hedgers shore up their balance sheets and helped sink the non hedgers is too late in my opinion.

I will say this: I'm not sure what the historical practice was 10 years ago. But the article DW Simpson posted suggests that hedging was commonplace, and if that is accurate, then in my opinion prudent management would be to not break from the pack and continue hedging (even though I would argue that the industry would be better off without hedging overall, individual companies can't change that situation).

[Samuel]

I'm still waiting for you to define efficient market. It is one of your primary assumptions, so I want to be sure we are discussing the same thing. Are you referring to an efficient market related to the dissimenation of information, such as the EMH?

When I get a chance I will go back and review your arguments again.

An efficient market is where the price of futures and forwards is set taking advantage of all available information. Thus if I can buy a future or forward at $50 a barrell 5 years from now, my expected gains or losses from the purchase will be zero.

[Will Durant]

Kenny, there are several costs to a futures contract, assuming it is a "hedge" to begin with, which I am disputing. Investment banking fees (including the spread on the transaction), legal fees, accounting fees, and exposure to the unhedged portion of the contract.
Are you really trying to argue that exposure to the UNHEDGED portion of the contract is a cost of the HEDGED portion of the contract?

[Will Durant]

Potentially I could find someone else saying the same thing and link to this forum, but that is an appeal to authority, not evidence.
Unlike your references to academics and Buffet, which was evidence?

[Samuel]

Are you really trying to argue that exposure to the UNHEDGED portion of the contract is a cost of the HEDGED portion of the contract?

I'm arguing that exposure to the unhedged portion of the hedging instrument is a cost.