SOUTHWEST AIRLINE- FUEL HEDGING

An airline is a company that provides air transport services for traveling passengers and freight. Airlines lease or own their aircraft with which to supply these services and may form partnerships or alliances with other airlines for mutual benefit. Generally, airline companies are recognized with an air operating certificate or license issued by a governmental aviation body.Airlines vary from those with a single aircraft carrying mail or cargo, through full-service international airlines operating hundreds of aircraft. Airline services can be categorized as being intercontinental, domestic, regional, or international, and may be operated as scheduled services or charters.Finance theory does not provide a comprehensive framework for explaining risk management within the imperfect financial environment in which firms operate. Corporate managers, however, rank risk management as one of their most important objectives. Therefore, it is not surprising that papers on the question why firms hedge are mushrooming. This paper critically reviews this literature and analyses the implications for risk management practice. It is distinguished between two competing approaches to corporate hedging: equity value maximising strategies and strategies determined by managerial risk aversion. The first category suggests that managers act in the best interest of shareholders. They hedge to reduce real costs like taxes, costs of financial distress and costs of external finance or to replace home-made hedging by shareholders. The second category considers that managers maximise their personal utility rather than the market value of equity. Their hedging strategy, therefore, is determined by their compensation plan and reputational concerns. There is ambiguous empirical evidence on the dominant hedging motive. It depends on the environment in which firms operate (e.g. tax schedule) and on firm characteristics (e.g. capital intensity). In general, one can observe that (i) hedging taxable income is of minor importance, (ii) firms with a high probability of financial distress hedge more, (iii) companies with greater growth opportunities hedge more, (iv) managers with common stockholdings hedge more than managers with option holdings and (v) high ability managers hedge more than low ability managers. The total benefits of hedging are not the sum across the various motives. Therefore, a manager has to concentrate on a primary motive to implement an effective risk management programme: If his primary motive is to minimise corporate taxes, he will hedge taxable income. If his primary concern is to reduce the costs of financial distress and if he can faithfully communicate the firm?s true probability of default, his hedging strategy will focus on the market value of debt and equity. If hedging is prompted to reduce the demand for costly external finance, he will hedge cash flows. If the manager is concerned with his reputation, he will focus on accounting earnings. Once he has focused on a certain exposure, the manager has to decide whether he wants to minimise the volatility of this exposure or simply avoid large losses.Southwest AirlinesSouthwest Airlines Co. is a major U.S. airline and the world's largest low-cost carrier, headquartered in Dallas, Texas. The airline was established in 1967 and adopted its current name in 1971. The airline has nearly 46,000 employees as of December 2014 and operates more than 3,400 flights per day.[6] As of June 5, 2011, it carries the most domestic passengers of any U.S. airline. As of November 2014, Southwest Airlines has scheduled service to 93 destinations in 41 states, Puerto Rico and abroad.Southwest Airlines has used only Boeing 737s, except for a few years in the 1970s and 1980s, when it leased a few Boeing 727s. As of August 2012, southwest is the largest operator of the 737 worldwide with over 650 in service, each averaging six flights per day. Early historySouthwest Airlines began with the March 15, 1967 incorporation of Air Southwest Co. by Rollin King and Herb Kelleher to fly within the state of Texas. Kelleher believed that by staying within Texas, the airline could avoid federal regulation. Three airlines (Braniff, Trans-Texas and Continental Airlines) started legal action which was not resolved for three years. Air Southwest prevailed in 1970 when the Texas Supreme Court upheld Air Southwests right to fly within Texas.[9] The Texas decision became final on December 7, 1970 when the U.S. Supreme Court declined to review the case, without comment. The story of Southwests legal fight was turned into a childrens book, Gumwrappers and Goggles by Winifred Barnum in 1983. In the story, TJ Love, a small jet, is taken to court by two larger jets to keep him from their hangar and to stop him from flying. In court, TJ Loves right to fly is upheld after an impassioned plea from a character referred to as "The Lawyer". While no company names are mentioned in the book, TJ Loves colors were those of Southwest Airlines, and the two other jets are colored in Braniff and Continental colors. The Lawyer resembles Herb Kelleher. The book was adapted into a stage musical, Show Your Spirit, sponsored by Southwest Airlines and played only in cities served by the airline. On March 29, 1971 Air Southwest Co. changed its name to Southwest Airlines Co. with headquarters in Dallas. Southwest began scheduled flights on June 18, 1971, Dallas to Houston and Dallas to San Antonio with three 737-200s. The OAG for 15 October 1972 shows 61 flights a week each way between Dallas and Houston Hobby, 23 each way between Dallas and San Antonio and 16 each way between San Antonio and Houston; no flights were scheduled on Saturdays.Southwest Airlines founder Herb Kelleher studied California-based Pacific Southwest Airlines and used many of PSAs ideas to form the corporate culture at Southwest. Early flights used the same "Long Legs and Short Nights" theme for stewardesses on board typical Southwest Airlines flights. A committee including the same person who had selected hostesses for Hugh Hefner's Playboy jet selected the first flight attendants, females described as long-legged dancers, majorettes and cheerleaders with "unique personalities." Southwest Airlines and Herb Kelleher dressed them in hot pants and go-go boots. The New York Times wrote in 1971 that Southwest Airlines President Lamar Muse, "says franklyand repeatedlythat Southwest Airlines has been developed from its inception around the ideas that have proven to be successful for Pacific Southwest Airlines". "We don't mind being copycats of an operation like that", referring to a visit he and other Southwest executives made to PSA as they assembled their operating plans. PSA welcomed them and even sold them flight and operations training. Muse later wrote that creating the operations manuals for his upstart airline was "primarily a cut and paste procedure" and it is said that "Southwest Airlines copied PSA so completely that you could almost call it a photocopy." Fuel HedgingFuel Hedging is a contractual tool some large fuel consuming companies, such as airlines, use to reduce their exposure to volatile and potentially rising fuel costs. A fuel hedge contract allows a fuel-consuming company to establish a fixed or capped cost, via a commodity swap or option. The companies enter into hedging contracts to mitigate their exposure to future fuel prices that may be higher than current prices and/or to establish a known fuel cost for budgeting purposes. If such a company buys a fuel swap and the price of fuel declines, the company will effectively be forced to pay an above-market rate for fuel. If the company buys a fuel call option and the price of fuel increases, the company will receive a return on the option that offsets their actual cost of fuel. If the company buys a fuel call option, which requires an upfront premium cost, much like insurance, and the price of fuel decreases, the company will not receive a return on the option but they will benefit from buying fuel at the then-lower cost.The cost of fuel hedging depends on the predicted future price of fuel. Airlines may place hedges either based on future prices of jet fuel or on future prices of crude oil.[1] Because crude oil is the source of jet fuel, the prices of crude oil and jet fuel are normally correlated. However, other factors, such as difficulties regarding refinery capacity, may cause unusual divergence in the trends of crude oil and jet fuel.A company that does not hedge its fuel costs generally believes one, if not both, of the following: 1. The company has the ability to pass on any and all increases in fuel prices to their customers, without a negative impact on their profit margins. 2. The company is confident that fuel prices are going to fall and is comfortable paying a higher price for fuel if, in fact, their analysis proves to be incorrect. Typically, airlines will hedge only a certain portion of their fuel requirements for a certain period. Often, contracts for portions of an airline's jet fuel needs will overlap, with different levels of hedging expiring over time.During the 2009-2010 period, the studies for the airline industry have shown the average hedging ratio to be 64%. Especially during the peak stress periods, the ratio tends to increase.Southwest Airlines has tended to hedge a greater portion of its fuel needs than other major U.S. domestic carriers.[3] Southwest's aggressive fuel hedging has helped the airline avoid some of the pain of the recent airline industry downturn resulting from high fuel costs. Between 1999 and 2008, Southwest saved approximately $3.5 billion through fuel hedging. Jet fuel represents a critical expense category for any airline that bears its own fuel costs and most airlines bear at least 80% of its fuel costs. Fuel has consistently been one of the largest expense categories for domestic airlines. During 2003, fuel costs represented, on average, over 16% of the total operating expenses for all U.S. domestic airlines. Moreover, airlines are generally unable to increase fares to offset any significant increase in fuel costs. From 2001 to2003, these same airlines experienced a 25.9% compound annual increase in jet fuel costs while average airline pricing decreased by 0.1%, as measured by revenue per available seat mile. Jet fuel costs have gone up over the past several years laying a constant pressure on airlines to maintain a profitable operation. Savings in the lines of operation and fuel cost turn out to be the profit earned.

In a fuel driven industry like Commercial Aviation, sudden hikes and fluctuations in fuel prices can have an immense effect on the business plan, not to mention adding to the difficult task of budgeting of Future fuel expenditures. If fuel costs are not actively managed, they can lead a company into losses. Airlines can mitigate their exposure to volatility and sudden hike in fuel costs, as well as natural gas and electricity costs, through hedging. Hedging allows the fuel market participants to fix prices in advance, while reducing the potential impact of volatile fuel prices.Hedging items is a standard practice in almost every field that involves finance, including Market players in precious metals like Gold, Silver and Platinum. While fuel costs may be hedged, there is no perfect hedge available in either over-the-counter or exchange traded derivatives markets. Over-the-counter derivatives on jet fuel are very illiquid which makes them rather expensive and not available in quantities sufficient to hedge all of an airlines jet fuel consumption.

Hedge Or Not to Hedge

Being unhedged is the ultimate short position; this infers we are constantly expecting the fuel prices to go down which is an ultimate utopian scenario. Although airlines sometimes lose money hedging, overall those that hedge have a 5% to 10% better financial performance than those that dont. Hedged airlines can make investments in their operations and equipment; make other important decisions that positively affect their firm's overall value. Hedging is about having an insurance policy against prices rising. A position that is not hedged i.e., the holder of a naked position has taken no step to reduce the risk inherent to the position.

Price risk is the biggest risk faced by all investors. Although price risk specific to a stock can be minimized through diversification, market risk cannot be diversified away. Price risk, while unavoidable, can be mitigated through the use of hedging techniques. Price risk also depends on the volatility of the securities held within a portfolio. Investors can use a number of tools and techniques to hedge price risk, ranging from relatively conservative decisions such as buying putoptions, to more aggressive strategies.

Case of Southwest

Scott Topping, the Director of Corporate Finance for Southwest Airlines was concerned about the cost of fuel for Southwest. High jet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew that since the industry was deregulated in 1978, airline profitability and survival depended on controlling costs.

After labor, jet fuel was the second largest operating expense for airlines. If airlines could control the cost of fuel, they can more accurately estimate budgets and forecast earnings. It was Scotts job to hedge fuel costs, however, he knew that jet fuel prices are largely unpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overall upward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. On September 11, 2000, the Gulf Coast jet fuel spot price was 101.25 cents/gallon a whopping increase of 255 % in the spot price since the low in 1998. The prior days (June 11, 2001) spot price for Gulf Coast jet fuel closed at a price of 79.45 cents/gallon. While this price was lower than the highest level, Scott knew that future jet fuel prices would be uncertain.Senior management asked Scott to propose Southwests hedging strategy for the next one to three years. Because of the current high price of jet fuel, Scott was unsure of the best hedging strategy to employ. Because Southwest adopted SFAS 133 in 2001, Scott needed to consider this in his hedging strategy.

Averrage fuel cost per gallon in 2000 was 0.789 of Southwest, fuel and oil expense per ASM increased 44.1 percent in 2000, primarily due to the 49.3 percent increase in the average jet fuel cost per gallon.

Scot thought that might be the prices of fuel would decrease next year, he cannot be sure energy prices are hard to predict. If the cost of jet fuel continued to rise, the cost of fuel Southwest would rise according to without hedging.On the other hand if the price of fuel is droped, the Southwest would un-hedged.

By viewing all these things ,Scott identifies the five alternatives, which are

Do nothing Hedge using a plain vanilla jet fuel or heating oil swap . Hedging using options Hedge using a zero-cost collar strategy Hedge using a crude oil or heating oil futures contract.

Analysis of Southwest Airline

Fuel prices in 1999 and 2000 are increased, due to which cost of the fuel of airlines has increased with a considerable amount. The airline has no control on the volatility of the prices, so it is difficult to control fuel cost and total costs.

YEARFUEL COST PER GALLON

20000.7869

19990.5271

19980.4567

19970.6246

19960.6547

19950.5522

19940.5392

Southwest Airlines have to choose the best option among the following alternatives based on two possible scenarios:

1) Fuel price decline 2) Fuel price rise.

1) Hedging using a Plain Vanilla Jet Fuel Swap : This alternative is simple and basic form of swap. A certain amount of floating price is exchanged for a fixed price over a certain period of time. The airline pays a fixed price and receives a floating price both indexed to expected jet fuel use during each monthly settlement period.

Based on the amount of fuel hedged, and the possible scenario, the airline can either make a profit from the swap or a loss from its swap. The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel hedge. The airline fuel usage is estimated to be 1100 million gallons

2) Hedging Using a Plain Vanilla Heating Oil Swap- This is similar to the jet fuel swap in its operation The swap is in Heating Oil futures prices and the rise or decline of these prices would act as an offset to the Fuel price volatility since the correlation between Jet fuel prices and heating oil prices are high, as both are byproducts of crude oil and assuming the basis has not changed. The loss or gain in the futures contract will be offset by the lower cash price of jet fuel or by higher cash price of jet fuel respectively. As a result, the airline effectively pays a fixed price for jet fuel.

3) Hedging using a Crude Oil Call option- The call option gives the right to buy a particular asset at a predetermined fixed price (strike price) at a time up until the maturity date. In case of price rise, the call option can be exercised and the option would make a profit, and would offset the loss from the actual price rise of the commodity. In the case of a price decline, the call option may not be exercised, giving it an advantage over other hedging strategies and hence would benefit considerably from the price decline.

Comments on Overall Analysis

Coming to the overall analysis of the Hedging strategies, Hedging Costs and Net Fuel Costs or Total Fuel Costs incurred by the airline when all the discussed strategies are employed. The costs are shown in $ millions. The two main objectives of Southwest Airlines in fuel hedging are to maintain fuel expenses at a constant level or minimum variance and to minimize the fuel costs.

It is important to note that when no hedging takes place, there is no offset of risk or protection against fuel rise. In this case, the fuel costs is the total fuel cost incurred by the airline. In scenario 1, the total fuel cost is $432.3 million and $1315.6 million in scenario 2.

Conclusion

After carefully considering all the hedging strategies, in the primary and the sensitivity analysis, it can be recommended that the best strategy, which can be used to maintain constant and minimum fuel costs, is the Full Hedge Heating Oil Futures Contract. This strategy also has a very low basis risk compared to the other strategies using Crude Oil. It is therefore advised that Scott Topping utilizes this strategy for Southwest Airlines.