individual_assignment_chinhntv_fb00405_derivatives.pdf

Derivatives

Southwest Airlines: Fuel Hedging with Futures Contract

Name: Nguyen Thi Viet Chinh Roll number: FB00405 Class: FB0610 Lecturer: Nguyen Thi Mai Lan Subject: Derivatives

Derivatives

Nguyen Thi Viet Chinh_FB00405

Southwest Airlines: Fuel Hedging with Futures Contract

Executive Summary

Today, energy issue is very important, especially fuel such as: crude oil, heating oil,… It

is the main source of energy in a lot of core industries and it’s extremely important in

airlines industry. Because oil is one of energy sources non-renewable and rising in

demand Jet fuel costs have substantially risen over the past several years putting

consistent pressure on airlines to maintain positive cash flows. Airlines do something

the industry calls ‘hedging’ to protect fuel costs. Hedging broadly means locking in the

cost of future fuel purchases. This protects against sudden losses from rising fuel

prices. Locking in fuel prices also prevents sudden gains from decreasing fuel prices.

So airlines hedge fuel to stabilize fuel costs. Fuel is about 15% of the airlines’ costs.

Other costs are less volatile than fuel prices, so hedging fuel stabilizes overall airline

costs. More stable costs also mean more stable profits.

This paper is divided into several sections.Firstly, we have some overview about the

roles of futures and forward contract and how it is used in the world for hedging.

Secondly, some research by economists in history about how to use Futures and

forward contract for hedging in fuel industry. Next part, we analyze a specific case about

how Southwest airlines uses futures and forward contract to hedging rising fuel price.

We document the various strategies, including hedging using over-the-counter

derivatives, futures contracts, and not hedging, and evaluate the effectiveness and

merits of each.

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Table of Contents

Executive Summary ........................................................................................................ 2

1. Introduction ............................................................................................................... 4

2. Literature review ....................................................................................................... 5

3. Case study – Southwest airline use of oil futures ..................................................... 8

3.1 Southwest airlines – introduction ........................................................................ 8

3.2 Case background ............................................................................................... 9

3.3 Southwest airlines hedge using a crude oil or heating oil futures contract ........... 11

3.3.1 Hedging using a Heating Oil Futures contract ............................................... 12

3.3.2 Hedging using a Crude Oil Futures contract .................................................. 14

3.3 The effectiveness of Hedging with Futures and/or Forward ............................. 15

4. Conclusion .............................................................................................................. 17

5. References ............................................................................................................. 18

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1. Introduction

Jet fuel costs have substantially risen over the past several years putting consistent

pressure on airlines to maintain positive cash flows. While the costs are hedgable, there

is not a perfect hedge available in either the 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

airline’s jet fuel consumption. Exchange-traded derivatives are not available in the

United States for jet fuel, so airlines must use futures contracts on commodities that are

highly correlated with jet fuel, such as crude and heating oil. As such, airlines employ a

variety of strategies ranging from not hedging to fully hedging using a combination of

products.

Domestic airlines have a variety of hedging strategies available to them. These include

using both over-the-counter and exchange-traded derivatives and remaining unhedged.

Options, including collar structures, and swaps are the primary derivatives used by

airlines.

Many, including Southwest, have stated that they prefer over-the-counter derivatives to

exchange traded futures because they are more customizable.1 OTC derivatives are

traded directly between the airlines and investment banks, and as such have

counterparty risk that must be considered. Therefore, most airlines prefer to trade with

three or four different banks to diversify this risk and also to get the best pricing

possible.

Jet fuel futures contracts do not exist in the United States, so futures on crude or

heating oil must be used instead to hedge jet fuel purchases. Because these futures

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contracts are based on an underlying commodity other than jet fuel, they introduce

basis risk because they are not perfectly correlated. Basis is generally defined as:

Basis = spot price of hedged item, futures price of selected contract

Basis risk is a result of the relationship between the spot price and futures price not

remaining constant throughout the life of the hedge, thus generating ineffectiveness. At

the onset of the hedging relationship, the optimal hedge ratio will take into account the

current basis, as well as the difference in volatilities of and the correlation between the

spot commodity and the futures contract.

By not hedging, airlines are taking on the risk of rising commodity prices into their

business model. Some airline executives claim that this risk is present regardless of

whether they hedge or not. Zea reports that .airline executives often comment that

hedging is not a core competency, and that [according to the airline executives] as long

as competitors are not hedged, it will be a level playing field. However, Zea further

states that. Unfortunately, when fuel prices rise dramatically, airlines cannot pass all of

the cost on to their customers.

The true state of the industry is not one in which no airlines are hedged, but rather, the

airlines that are hedged have a competitive advantage over the non-hedging airlines.

2. Literature review

Previous studies have tended to focus more on foreign currency risk than fuel price risk.

Their starting point has been the CAPM assertion that risk management is irrelevant to

firm value since shareholders are better placed to do this themselves. The counter

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argument is that in the real world the CAPM theory does not hold because of factors

such as taxation, access to information and economies of scale in hedging operations.

Allayanis and Weston (2001) examined foreign currency derivative users in a large

sample of non-financial US firms between 1990 and 1995. They found that those that

used currency hedging had, on average, a 4.87% higher firm value (measured as

Tobin’s Q) than firms that did not. Their model explained variations in Q using a number

of different factors in addition to hedging. A dummy variable was used to distinguish

those firms that did hedge from those that did not. This was because of the lack of more

detailed data on hedging; the period they chose was dictated by the lack of any data

prior to 1990. Thus the research was not able to take into account the difference

between those firms that might have hedged 100% of their currency needs one year

ahead, and those that only hedged 20% of needs; and second, between those that

hedged three months out and those that hedged two years out.

Carter et al. (2003) essentially applied the Allayanis and Weston (2001) methodology to

airline fuel price hedging. They reach similar conclusions: airlines that employ hedging

trade at a premium. They also assert that this allows them to conserve cash at times of

industry downturn (which coincides with fuel price spikes), giving them the possibility to

buy assets at distressed prices. This does not seem to be supported by evidence, and

indeed larger airlines that are hedging are also usually cutting back on new capital

investment following a major downturn.

Cobbs and Wolf (2004) repeat the Carter results above as a rebuttal to the British

Airways CEO Rod Eddington’s statement that ‘a lot is said about hedging strategy, most

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of it well wide of the mark. I don’t think any sensible airline believes that by hedging it

saves on its fuel bills. You just flatten out the bumps and remove the spikes’.

Rao (1999) takes a different approach by estimating how much better off an airline

would be if it had bought different heating oil futures at different periods of time. He

concluded that quarterly income volatility would have declined by 23% on the basis of

following his assumed hedging policy. The author admits that the use of

a fictional airline may have inflated the advantage of hedging. He also assumes that the

purchase of futures is costless and the marking to market requirement of some

accounting requirements ignored.

Marking to market means accounting for gains or losses in any outstanding unrealised

derivatives position at the end of each financial reporting period (quarter). This may

introduce a new source of volatility in earnings. The latest accounting standards

recommend making these value adjustments only on the balance sheet, where the

hedge is expected to be effective throughout its life. Where it is not and its price

movements are not perfectly correlated with jet fuel prices, adjustments will have to be

made to reported profits.

Much research has been undertaken in examining the relationship between oil price

movements (and shocks) and both economic activity and corporate profitability (and

stock prices). Indirectly, this becomes an exploration of whether oil futures have a beta,

as discussed in section 6. Contrasting results were reported for the impact on stock

prices: Jones and Kaul (1996) found that oil prices do have an effect on aggregate stock

returns, while Huang et al. (1996) found no evidence of any correlation between oil price

future returns and aggregate stock returns. Sadorsky (1999) found that positive shocks

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to oil prices tend to depress real stock returns, which in turn effect interest rates and

industrial production (and thus economic growth). J P Morgan (2001) found ‘little

correlation between the price of jet fuel and airlines’ relative performance on the stock

market’.

3. Case study – Southwest airline use of oil futures

3.1 Southwest airlines – introduction

Southwest Airlines, is the third largest airline in the world as well as in America in terms

of passenger aircraft among all of the world's commercial airlines. It operates more than

540 Boeing 737 aircraft today between 67 cities in the U.S.A. Today, Southwest

operates approximately 3,300 flights daily and boasts of being the only major airline to

post profits every year for the last thirty-six years. It justifiably claims to be United

States’ most successful low-fare, high frequency, point-to-point carrier.

Profits in an airline industry come from passenger revenue, hence all stratagems must

be customer centric. In this current scenario with all the mergers and acquisitions,

airlines competing with each other, one way of attracting passengers is to keep the cost

of flying low. Southwest’s business model is the best low cost model yielding

considerable profit, while providing value for money. The main expenses for an airline

are the operating and fuel cost, expenses must be tightly controlled to reach and stay at

the lowest possible level. Certain expenses are unavoidable; however, one variable that

can be kept low through decisive planning and foresight is the cost of fuel. Fuel prices

are extremely volatile. A good way to achieve this is by hedging fuel, which is a

complex, but rewarding process as Southwest Airlines proves beyond doubt.

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3.2 Case background

On June 12, 2001 and Scott Topping, the Director of Corporate Finance for Southwest

Airlines (hereafter referred to as “Southwest”), is concerned about the cost of fuel for

Southwest. High jet fuel prices in the past 18 months have caused havoc in the airline

industry. Scott knows that since deregulation in the industry in 1978, airline profitability

and survival depends on controlling costs. After labor cost, jet fuel is the second largest

operating expense for airlines after labor. If airlines can control the cost of fuel, they can

more accurately estimate budgets and forecast earnings.

It is Scott’s job to hedge fuel costs and as anyone in his position realizes, jet fuel prices

are largely unpredictable (see Figure 1).

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

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whopping increase of 255 % in the spot price since the low in 1998. Yesterday’s spot

price for Gulf Coast jet fuel closed at a price of 79.45 cents/gallon. While this price is

lower than the highest level, Scott knows that future jet fuel prices are very uncertain.

Senior management asked Scott to propose Southwest’s 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.

Southwest’s average fuel cost per gallon in 2000 was $0.7869, which was the highest

annual average fuel cost per gallon experienced by the company since 1984. As

discussed previously, 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.

Although Scott thought the price of jet fuel would decrease over the next year, he

cannot be sure energy prices are notoriously hard to predict. Any political instability in

the Middle East could cause energy prices to rise dramatically without much warning.

If the cost of jet fuel continued to rise, the cost of fuel for Southwest would rise

accordingly without hedging. On the other hand, if the cost of jet fuel declines, the cost

of fuel would drop if Southwest were un-hedged.

To deal with these risks, Scott identified the following 5 alternatives. Scott estimated

Southwest’s jet fuel usage to be approximately 1,100 million gallons for next year:

1. Do nothing.

2. Hedge using a plain vanilla jet fuel or heating oil swap.

3. Hedging using options.

4. Hedge using a zero-cost collar strategy.

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5. Hedge using a crude oil or heating oil futures contract.

3.3 Southwest airlines hedge using a crude oil or heating oil futures contract

Jet fuel futures contracts do not exist in the United States, so futures on crude or

heating oil must be used instead to hedge jet fuel purchases

Table 1 gives the Fuel Cost per Gallon for the past 7 years. The fuel price rise in year

1999 & 2000 wreaked havoc and had increased the total fuel costs to the airline by a

considerable amount. The airline has no control over the volatility of fuel prices and

hence makes it difficult to control fuel costs and total costs.

Year Fuel Cost per Gallon in $

2000 0.7869

1999 0.53

1998 0.4567

1997 0.6246

1996 0.6547

1995 0.5522

1994 0.5392

Table 1

In order to offset fuel price rise and control fuel costs, keeping it constant to a level

acceptable, Southwest Airlines have to choose the best option among the following

alternatives based on two possible scenarios: 1) Fuel price decline and 2) Fuel price

rise.

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Table 2 below gives the list of variables and prices considered or assumed in each

scenario and for the hedging strategies.

NOTE: All Fuel and Total costs are indicated in $ millions.

3.3.1 Hedging using a Heating Oil Futures contract

A futures contract is an agreement to buy or sell a specified quantity and quality of a

commodity for a certain price at a designated time in the future. The airline, which is the

buyer, has a long position to offset against the fuel price rise. There is a daily settlement

to minimize the chance of default. In this case, in order to hedge, the airline buys

heating oil futures contract from the NYMEX. The heating oil Future Price on June 11th,

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2001 was $0.7002 per gallon and the estimated spot price (June 2002), for scenario 1 is

$ 0.388 per gallon.

The estimated spot price (June 2002), for scenario 2 is $ 1.186 per gallon. In scenario

1, due to the price decline in Heating Oil, the loss from the hedge is the difference

between the future price and the spot price of $ 0.388 per gallon. In scenario 2, due to

the price rise in Heating Oil, the profit from the hedge is the difference between the

future price and the spot price of $ 1.186 per gallon. The contract size is 42000 gallons

and the amount of fuel used is 1100 million gallons.

The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel

hedge. The profits or losses made by this strategy will offset the profit or loss made by

the jet fuel price. In scenario 1, the basis loss is 8.93 cents/gallon and in scenario 2,

there is a basis loss of 8 cents per gallon.

Table 3A: Heating Oil Price decline: Heating Oil Futures Contract

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Table 3B: Heating Oil Price rise: Heating Oil Futures Contract

3.3.2 Hedging using a Crude Oil Futures contract

This is similar to the Heating Oil Futures Contract. The Crude Oil futures contract traded

from NYMEX is a long position for the airline. The Crude oil Future Price on June 11th,

2001 was $26.39 per gallon and the estimated spot price (June 2002), for scenario 1 is

$ 14.10 per gallon.

The estimated spot price (June 2002), for scenario 2 is $ 40 per gallon. In scenario 1,

due to the price decline in Crude Oil, the loss from the hedge is the difference between

the future price and the spot price of $ 14.10 per gallon. In scenario 2, due to the price

rise in Crude Oil, the profit from the hedge is the difference between the future price and

the spot price of $ 40 per gallon. The contract size is 1000 barrels and the amount of

fuel used is 26.19 million barrels. The two fuel hedging ratios analyzed in this case are

the full hedge and 50% fuel hedge. The profits or losses made by this strategy will offset

the profit or loss made by the jet fuel price. In scenario 1, the basis gain is $11.89 per

gallon and in scenario 2, there is a basis loss of $13.21 per gallon.

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Table 4A: Crude Oil Price decline: Crude Oil Futures Contract

Table 4B: Crude Oil Price rise: Crude Oil Futures Contract

3.3 The effectiveness of Hedging with Futures and/or Forward

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 are the total fuel cost incurred by

the airline. In scenario 1, the total fuel cost is $432.3 million and $1315.6 million in

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scenario 2. The average of these two costs ($873.95 million) is used as benchmark to

compute the variance of the fuel costs in each strategy.

Figures 2 shows the Total Fuel costs of each strategy in Scenario 2. The purple bars

show the total costs when hedged fully and the maroon bars show the total costs when

50% hedging takes place. As discussed earlier, the 100% hedged strategy with Heating

Oil Futures contract has the minimum fuel cost.

Figure 2

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Figure 3

Figure 7 shows the Average Fuel costs considering equal occurrence of scenario 1 and

2. As we see, 100% hedge of heating oil futures options have the minimum fuel cost

than do nothing or un-hedged.

4. Conclusion

The report shows an overview about futures and forward market in fuel industry. Roles

of futures and forward contracts, and how to use it to hedging risk in airline fuel industry.

The literature review about derivatives tools, the studies is research by economists.

Applying those theories in specific case – Southwest. After all analysis above, we see

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that the cost is minimized by using derivatives tools to hedging risk of rising fuel cost (

Futures and forward contracts) than do nothing or unhedged. However, futures contract

is a win-lose contract (or zero profit contract) so we should carefully when predict the

trend of price in the futures or having another strategies that help company to hedging

risk.

5. References AFX News, May 17, 2004; BA says fuel requirements 45% hedged in current year,

www.afxnews.com. Carter, Rogers, and Simkins, September 16, 2002; Does Fuel Hedging Make

Economic Sense? The Case of the US Airline Industry. Oklahoma State University. CNN/Money article, May 25, 2004; Major airline closings seen,

www.money.cnn.com. CNN/Money article, May 26, 2004; United raises surcharge, www.money.cnn.com. DerivativesStrategy.com, 1997; Energy Hedging Lesson of 1996.

www.derivativesstrategy.com. Ernst & Young, LLP, December, 2001; Financial Reporting Developments:

Accounting for Derivative Instruments and Hedging Activities. Greene, William March 8, 2004; Reducing Estimates Across the Board due to Fuel,

Morgan Stanley. Hull, John C, Options, 2000; Futures, and Other Derivatives, Prentice-Hall. Jones, Key, March 10, 2003; Strategic Risk Management. BP Presentation at 5th

Annual Armbrust Conference. Levin, Doron, March 18, 2004; Hedging helps low-cost airlines hold down price of

aviation fuel, The Detroit Business News. McDonald, Robert L., 2003; Derivative Markets, Pearson Education, Inc. Reflector.com, May 7, 2004; Southwest Air Hedges Bet on Oil Prices,

www.reflector.com. Southwest Airlines Co., April 29, 2003; Fuel Hedging. Presentation at Oklahoma

State University. Trottman, Melanie, January 16, 2001; Southwest Airlines. Big Fuel-Hedging Call Is

Paying Off. Carrier Was Able to Protect Itself Against Soaring Energy Prices in Second Half. Wall Street Journal.

Wharton School of Business, 2004; Fare Wars: The .Friendly Skies. Are More Cutthroat Than Ever, http://knowledge.wharton.upenn.edu/index.cfm?fa=viewArticle&id=992

Zea, Michael, 2002; Is Airline Risk Unmanageable? Mercer on Travel and

Transport.

individual_assignment_chinhntv_fb00405_derivatives.pdf

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