Even the Best Fuel Hedges Can Lead to Turbulence

In the second half of 2008, a barrel of oil has sold for anywhere from $147 in July to around $60 recently. In a matter of hours on Sept. 22, it rose by a record $25 a barrel before falling back in the afternoon and plunging the next day. Such swings can produce a lot of turbulence for fuel-hungry industries such as airlines.

The problem, of course, is that no one can accurately forecast what the price will be in three days much less three months, a fact that has played havoc this year with the finances of airlines and other industries that need a steady supply of fuel to function. For example, when oil prices were peaking in the summer, most airlines struggled to pay the bill, but Southwest Airlines (LUV Quote) drew accolades because of its successful use of hedging against rising oil prices. Its competitors were forced to raise fares and add fees because they were either too strapped for cash to lock in fuel prices when they were low, or less prescient about the summer price spike.

Laura Wright, Southwest's chief financial officer and one of the architects of the hedging program, estimated last summer that Southwest had saved $4 billion since the late 1990s in what it would have paid to fuel its fleet of 737 jets had it not locked in fuel prices years in advance.

Unfortunately for Southwest, oil prices fell in the third quarter almost as rapidly as they rose in the first and second. The Dallas-based carrier was among many airlines in the third quarter that had to account on its books for fuel contracts that were priced higher than the current market. Over the next four years, Southwest could pay the equivalent of $60 to $90 a barrel for a large portion of its fuel needs. That may or may not be a smart bet, but Wright and other Southwest executives say they still believe in the hedging program. After all, it is one of the main reasons that 2008 is expected to be the airline's 36th straight profitable year.

An Insurance Policy

Hedging works as insurance, designed to reduce the risk of losing money if the price of any commodity goes up or down. Fuel-price hedging can take several forms, including contracts to buy a set amount at a future date at a certain price, and collars, which provide the right to buy fuel within a set range of prices.

This betting against fuel-cost volatility is done in many industries, but it has taken on enormous importance for airlines. For years, fuel represented 10% to 15% of most airlines' operating costs, but this summer, as crude prices soared, its cost-share shot up to between 35% and 50%, according to the Air Transport Association, a trade group that represents most U.S. carriers. Although they tried, airlines were unable last summer to raise fares or cut operating costs enough to offset such a jarring increase.

Christian Terwiesch, a Wharton professor of operations and information management who has studied the airlines, notes that the industry is especially vulnerable to fluctuating energy costs because "jet fuel is a very significant part of the cost structure of an airline. Jet fuel prices are traditionally very volatile. They have gone from $2 a gallon in 2007 to $4 in July 2008. In February 2004, it was still $1 a gallon."

Terwiesch says such volatility "is absolutely bad. [The airlines'] net margins are thin to begin with. If you take that cost and double it, it's easy to understand why all hell breaks loose."