Even the Best Fuel Hedges Can Lead to Turbulence

Southwest More Aggressive

In the airline industry, most carriers have used fuel-cost hedging on a more limited basis than Southwest, Terwiesch notes. That is primarily because the other carriers determined they could not afford to pay the fees -- in effect, the insurance premiums -- required. In other words, the airlines were betting that oil prices would not increase as much as they did earlier this year, he says. Currently, most airlines are using various forms of hedging for about half of their fuel needs.

Wharton public policy professor W. Bruce Allen has another theory about the airlines' limited hedging. Most airlines "do not seem to be very nimble," he notes. Evidence of that, he believes, can be found in how long it took many carriers to change their basic business models after the end of the dot-com boom and September 11, 2001, by reducing their labor and other costs to compete with Southwest and other smaller, low-cost airlines. The cost savings for several major airlines did not come until they had been through Chapter 11 bankruptcy protection or had won labor-cost concessions from unions by threatening the bankruptcy route, Allen says.

Wharton insurance and risk management professor Neil A. Doherty suggests another reason for companies to avoid hedging: How the practice is viewed by investors. The number of academic studies of the topic is relatively small, he says, but they indicate that the market's opinion -- as measured by a company's ratio of book value to market value -- does not seem to appreciate hedging efforts if it is not a core corporate activity. Airlines, among other industries, are in business to provide a service, and how well they perform is not directly linked to how much hedging they do. When investors "buy an airline, they are looking for other reasons to invest: the quality of management, the routes, labor efficiency, the things they really control," Doherty points out. "Fuel is a large cost but an airline is not in the business of controlling fuel costs. Airlines hire managers who understand the business but are not specialists in fuel."

The savings for Southwest from hedging were especially important this year as the surge in oil prices threatened the viability of most other airlines. Only in the last two months or so, as oil prices retreated from their highs, have airline analysts changed their predictions of this summer that several major airlines could need bankruptcy court protection or be forced to liquidate in 2009 if fuel costs continued to rise.

As celebrated as Southwest has been for its hedging strategy, Terwiesch notes that "other major airlines also have been hedging more than five, even 10 years. They were just hedging less.... Southwest would typically be 80% or 90% hedged, the others 10% or less. So you cannot say others are idiots and forgot to hedge.... Southwest was not fuel-hedging to make money off that. It is about risk management. You buy a homeowners' insurance policy, not because you will make money, but because you want to be protected."

Another point to note, Terwiesch says, was that Southwest did not save money on its actual fuel costs every year since it started hedging in earnest. When fuel prices went down unexpectedly before 2001, Southwest wound up paying more than spot-market prices for some of its fuel.

Nor should anyone forget what poor financial shape the older "legacy carriers" (those in business before airline deregulation in 1978) were in after the 2000-2001 recession, according to Terwiesch. "We had one house burn down after another." For airlines with poor credit "it is very difficult to engage in hedging. You have to pay a risk premium. Like a mortgage for someone with bad credit, it's not at 6%, but 8% or 9%."

With some carriers, the thinking was, "We are losing money anyway," Terwiesch says. "If fuel prices go up, we can go into bankruptcy, we can go to our unions and get concessions. If fuel prices go down, then bingo. But Southwest over the entire time period was making money. If you are making money, risk is very, very concerning. Any sudden change in fuel costs would upset those nice quarter-after-quarter results. It makes a CFO nervous to have uncertainty."

Southwest CFO Wright could not agree more. When it bought its "insurance policy" by hedging the great majority of its fuel needs a decade ago, the company won the equivalent of a $4 billion lottery prize -- much to the surprise of some of its executives. "The numbers are staggering," she says. "We envisioned controlling our costs. I don't know that we ever thought it would be $4 billion."

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