Even the Best Fuel Hedges Can Lead to Turbulence

At Southwest, Wright recalls that the company first dabbled in fuel-cost hedging when prices spiked in the early 1990s but did not get systematic about it until 1999, when oil cost less than $11 a barrel. "Today we have changes of $11 in one day," she notes. "The reason we did it wasn't to make money. We're not that smart. We're a long-lead-time business. We have to know how many airplanes to order, and we have to put out our schedules months in advance. You don't want to go into a situation where prices are out of your control. We wanted to be able to build a business plan where we would pretty well know what our costs would be. We thought of it as insurance."

In many other industries, hedging against large or unexpected increases in fuel or other commodity prices is practiced on a regular basis. "Railroads do it, and some public transit systems do it for diesel fuel for buses," says aviation consultant Robert W. Mann, president of R.W. Mann of Port Washington, N.Y. "Precious metals and gold producers do the inverse, selling forward if they like the current prices. A large baker may do it, locking in wheat prices. Anybody who is a consumer of a commodity and whose prices can be distorted by rises in prices in that commodity can be a hedger."

Barry Siler, a Houston oil-and-chemicals trading consultant who helped Southwest devise its hedging strategy in the 1990s adds that the big baking companies that choose to hedge against rising wheat prices may also need to lock in prices for natural gas used in their ovens. In addition, he cited chemical producers who try to guarantee what they will pay for natural gas and oil, and petroleum refiners themselves. Refiners consume energy to produce energy and, ironically, want to pay as little as they can for a product that they sell for as much as they can.

Even individual consumers can be hedgers. Putting 5% of an investment portfolio into gold-backed mutual funds or stocks, as some advisors suggest, may work as a hedge against the uncertainty now gripping equities markets. Siler points out that in states or cities where electric utilities are deregulated, homeowners often have a choice of energy providers and can agree in advance to buy power at a set price for months at a time.

In some surface-transportation businesses, there is less hedging of fuel costs than one might expect, according to consultants and industry officials. One reason for its limited use by trucking companies and railroads is that they have been able to include fuel surcharge clauses in contracts with shippers, passing along higher prices for diesel fuel this year.

Some major railroads, including Norfolk Southern (NSC Quote) and BNSF, have done more fuel hedging than others, but it has been limited and they have not come to depend on the practice as much as airlines do. Norfolk Southern hedged a small portion of its diesel-fuel needs up to 36 months in advance from 2000 to 2004 and saved money, says Bill Romig, the railroad's treasurer. Like other railroads, however, Norfolk Southern determined that there would be less uncertainty in its own finances if the company used only surcharges to offset higher fuel prices. Hedging "was adding unnecessarily to our financial volatility," he recalls. Now "we are adequately recovering our fuel prices from surcharges."

Similarly, some but not all large cruise-ship operators hedge their need for fuel. Miami-based Royal Caribbean Cruises (RCL Quote), one of the world's largest cruise lines, has used hedging this year for about half of the 1.22 million metric tons of fuel it anticipates using in its ships. Even with the hedging, the company expects to spend $772 million on fuel. Patrick Sinclair, RCCL's vice president for energy management, argues that the wisdom of using hedging was made quite clear on September 22 -- the day oil futures rocketed by $25 a barrel. Hedging "gives us much more stability in a whole range of planning processes. We don't react to daily fluctuations .... It allows us to plan more consistently and not react to market conditions."