Fuel Hedging in the Airline Industry Essay

Fuel Hedging in the Airline Industry: The Case of Southwest Airlines By Dave Carter a, Dan Rogers b, and Betty Simkins c a College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-5104, Email: [email protected] edu b School of Business Administration, Portland State University, Portland, OR 97207-0751, Phone: (503) 725-3790, Email: [email protected] pdx. edu c CONTACT AUTHOR: College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-8625, Fax: (405) 744-5180, Email: [email protected] edu Review copy for use of the Case Research Journal.

Not for reproduction or distribution. Fuel Hedging in the Airline Industry: The Case of Southwest Airlines By Dave Carter, Dan Rogers, and Betty Simkins “If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk. ” Scott Topping, Director of Corporate Finance for Southwest Airlines June 12, 2001: Scott Topping, the Director of Corporate Finance for Southwest Airlines (hereafter referred to as “Southwest”), 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. 1 After labor, jet fuel is the second largest operating expense for airlines. If airlines can control the cost of fuel, they can more accurately estimate budgets and forecast earnings. It was Scott’s job to hedge fuel costs, however, he knows 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 day’s (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. Figure 2 illustrates the high volatility of jet fuel prices. As shown, historical daily volatility over a recent 25-day period for Gulf Coast has averaged 58. 7 percent. 2 Clearly, fuel price risk is an important concern for airlines. One of the most important events in the history of the airline industry was the Deregulation Act passed by U. S. Congress in 1978. This act removed all government controls over fares and domestic routes for the first time and gave airlines the opportunity to operate as true businesses. For example, at the price of 79. 45 cents/gallon for jet fuel, there is a 68% probability that the price will change by as much as +/-46. 63 cents/gallon (i. e. 79. 45 x 0. 587). This means that there is a 68 percent probability that the price will range from 32. 8 to 126. 0 cents/gallon.

Using a recent 10-week average volatility of 30. 5% (data not shown), 2 1 Review copy for use of the Case Research Journal. Not for reproduction or distribution. As a result of fuel price increases during the later half of 1999 and throughout 2000, Southwest’s fuel and oil expense per available seat-mile (ASM) for the year 2000 increased 44. 1 percent over that for 1999. 3 As shown in Table 1, Southwest’s average price per gallon of jet fuel in 2000 was $0. 7869 compared to $0. 5271 in 1999. 4 About Southwest Airlines Southwest was formed in 1971 by Rollin King and Herb Kelleher and the airline began with hree Boeing 737 aircraft serving the Texas cities — Dallas, Houston, and San Antonio. The airline began with one simple strategy: “If you get your passengers to their destinations when they want to get there, on time, at the lowest possible fares, and make darn sure they have a good time doing it, people will fly your airline. ”5 This strategy has been the key to Southwest’s success. The airline realized early on that air travel would become a commodity business. In May 1988, Southwest became the first airline to win the coveted Triple Crown for a month – Best On-time Record, Best Baggage Handling, and Fewest Customer Complaints.

Since then, the airline has won five annual Triple Crowns: 1992, 1993, 1994, 1995, and 1996. In addition to being a top quality airline, Southwest was also innovative. They were the first airline with a frequent flyer program to give credit for the number of trips taken and not the number of miles flown. Additionally, they pioneered senior discounts, same-day airfreight delivery service, ticketless travel, and many other unique programs. By the year 2000, the small Texas airline had evolved to become the 4th largest U. S. carrier based on domestic passengers boarded and the largest U. S. carrier based on scheduled domestic departures.

At year-end 2000, Southwest operated 344 Boeing 737 aircraft and provided service to 58 airports in 57 cities in 29 states throughout the U. S. In 2000, Southwest commenced service to Albany and Buffalo, New York, and in January 2001, to West Palm Beach, Florida. Tables 2 and 3 provide Southwest Airlines’ consolidated statement of income and consolidated balance sheet, respectively, for the years 1999 and 2000. Historically, Southwest has experienced some seasonality in their business. For example, quarterly operating income and, to a lesser extent, revenues tend to be lower in the first quarter.

In 2000, quarterly operating income represented 22 percent of annual operating income. Fuel Hedging in the Airline Industry there is a 68% probability that the price will change by as much as 24. 23 cents/gallon. Given that Southwest spent $484. 7 million on jet fuel in the year 2000, there is a 68 % change that jet fuel can fluctuate by as much as $ 147. 8 million using the 10 week volatility average (i. e. 0. 303 x $484. 7 million). 3 See the appendix for a glossary of airline terms. 4 These prices are net of the following gains from hedging — approximately $113. million in 2000 and $14. 8 million in 1999. 5 Refer to “We Weren’t Just Airborne Yesterday”, Southwest Airlines – A Brief History, http://www. southwest. com/. 2 Review copy for use of the Case Research Journal. Not for reproduction or distribution. Airlines executives know that it is often impossible to pass higher fuel prices on to passengers by raising ticket prices due to the highly competitive nature of the industry. Because large airlines compete with one another on most of the routes they serve, they have little power to raise prices in response to higher fuel costs.

For example, Continental Airlines rescinded a fare hike after trying a number of times to boost overall fares. The airline said the airfare increases were due to high fuel costs, but intense airline competition has left the firm unable to pass along fuel costs to customers. 6 Table 4 provides information on competition in the airline industry for both passenger airlines (Panel A) and airfreight carriers (Panel B). As shown in Panel A, Southwest Airlines holds a 5. 51% market share based on total available seat miles flown over the period 1994-2000.

Over the same period, Southwest holds a much smaller share of the freight market (see Panel B). By 2000, Southwest was the fourth largest carrier in the US based on passengers flown and the largest based on departures (see previous section). Obviously, competition is a top concern for Southwest. With air travel becoming a commodity business, being competitive on price is the key to survival and success. As Warren Buffett states: “You cannot be the high-cost producer in a commodity business. Sometimes it’s not even any good to be the low-cost producer. ” (McCartney, Michaels, and Rogers, 2002).

Airlines that want to prevent huge swings in operating expenses and bottom line profitability choose to hedge fuel prices. In fact, Raymond Neidl (see Neidl and Chiprich, 2001) points out that “the carriers that produced an adequate return, especially in the second half of 2000, tended to be those that had good fuel hedge positions in place. ” Airlines without hedges in place had disappointing earnings or losses. For example, in the fourth quarter 2000, US Airways, which was unhedged, estimated that its $88 million net loss would have been a profit of $38 million if their fuel costs had not increased.

Airlines are different from most commodity users or producers in that it usually the airline company’s treasury department (rather than the fuel purchasers) that handles fuel hedging. Fuel price risk management techniques were adopted by airlines around 1989 (Clubley, 1999). Airlines use derivative instruments based on crude oil, heating oil, or jet fuel to hedge their fuel cost risk. The majority of airlines rely on plain vanilla instruments to hedge their jet fuel costs, including swaps, futures, call options (including average price options which are a type of call option), and collars (including zero-cost collars).

There are two main reasons why several fuels other than jet fuel are used in jet fuel hedging by airlines. The first reason requires a brief explanation of refining. When refiners process crude oil, the main products are gasoline, middle distillates (heating oil, diesel fuel, and jet kerosene) and residual fuel oil. Refiners often refer to these products as top, middle, or bottom of the barrel, respectively. Products from the same part of the barrel share similar characteristics, and as a result, the prices are highly correlated. Hence, heating oil, which shares similar 6 See “Continental Raises Domestic Fares, Cites Fuel Costs” (Reuters, February 27, 2004) and “Continental Airlines Resends Latest Fare Hike” (Reuters, June 7, 2004). 7 Jet fuel is a essentially pure kerosene with some additives. Two products from the barrel not mentioned above are the gas liquids like butane at the very top and asphalt at the very bottom. 3 Review copy for use of the Case Research Journal. Not for reproduction or distribution. characteristics to jet fuel, is frequently used in hedging by airlines.

Also, since jet fuel is refined from crude oil, crude oil is also used in hedging by airlines due to high price correlation. The second reason why airlines use several fuels in hedging is because jet fuel is not a sufficiently liquid market to warrant a futures contract or other type of exchanged-traded contract. As a result, derivative contracts for jet fuel must be arranged on the over-the-counter (OTC) markets. However, there are active and liquid markets for exchange-traded contracts on crude oil and heating oil in New York (the New York Mercantile Exchange, NYMEX) and for gasoil in London (the International Petroleum Exchange, IPE). While exchange-traded products offer high liquidity and low credit risk, typically these contracts are standardized and inflexible, meaning that users often face large basis risk. The term “basis risk” is used to describe the risk that the value of the commodity being hedged may not change in tandem with the value of the derivative contract used to hedge the price risk. While crude oil, heating oil, and jet fuel prices are highly correlated, significant basis risk can emerge if the relationship between the commodities breaks down.

In an ideal hedge, the hedge would match the underlying position in every respect, removing any change of basis risk. However, in actuality, basis risk is a high concern, even if the derivatives contract is for the exact same commodity being hedge. More specifically, in the futures markets, basis is defined as the differential between the cash price of a given commodity and the price of the nearest futures contract for the same, or a related commodity. 9 Hence, basis risk when hedging using futures contracts refers to the risk of the differential changing over the life of the hedge. Why does basis risk occur?

The following three basis risks occur frequently in hedging: product basis risk, time basis risk, and locational basis risk. Product basis risk occurs when there is a mismatch in the quality, consistency, weight, or underlying product. For example, airlines frequently use crude oil contacts to hedge jet fuel, but obviously crude oil and jet fuel are two different commodities and hence have large product basis risk. Even within the same commodity category, such as crude oil, product basis risk occurs because there are many types of crude oil varying in viscosity (such as heavy versus light crude) and sulfur content (sweet versus sour crude).

Time basis risk occurs when there is a mismatch in the time of the hedge. For example, if a hedger wishes to hedge long-term but only has short dated contracts available, time basis risk is very significant. 10 Locational basis risk, one of the most common types of basis risk, 8 9 Gas oil is the European designation for No. 2 heating oil and diesel fuel. Refer to “A Guide to Energy Hedging” published by the New York Mercantile Exchange. 10 For one of the most famous examples of time basis risk, refer o Metallgesellschaft Refining and Marketing (MGRM), which was an American subsidiary of Metallgesellschaft (MG), an international trading, engineering, and chemicals conglomerate. In 1992, MGRM implemented what it believed to be a profitable marketing strategy. The company agreed to sell specified amounts of petroleum products every month, for up to ten years, at fixed prices that were higher than the current market price. MGRM then purchased short-term energy futures to hedge the long-term commitments – a “stack” hedging strategy. This timing mismatch caused MGRM to go bankrupt.

The MGRM hedge also illustrates another type of hedging risk: “funding risk” – the risk that positions which may be profitable in the long run can bankrupt a company in the short run if negative cash flows are mismatched with positive cash flows. For a short summary of the MGRM hedging disaster, refer to http://www. erisk. com/Learning/CaseStudies/ref_case_mg. asp. 4 Review copy for use of the Case Research Journal. Not for reproduction or distribution. occurs when there is a mismatch in the price of the product from one location to another, a mismatch in the delivery point for the derivatives contract, among others.

While such extreme breakdowns in correlations are rare, hedgers should be aware of basis risk. Julian Barrowcliffe, director of global commodity swaps at Merrill Lynch (Schap, 1993) stated: “Some of the largest hedging losses have resulted from the assumption that heating oil and jet kerosene were essentially the same product and heating oil futures could hedge jet. At times, they haven’t tracked each other at all. ” For example, in late 1990 when Iraq invaded Kuwait (which precipitated the first Gulf War), the differential between European jet fuel and heating oil quickly increased to more than five times the usual margin.

As shown in Figure 3, the spread between jet fuel and heating oil for the Gulf Coast location increased to 28. 5 cents per gallon. This is 8. 1 times the average spread of 3. 5 cents per gallon and represents a 714% increase relative to the average spread (i. e. (28. 5 – 3. 5)/ 3. 5). It is important to note that since this period of time, basis risk fundamentals between jet fuel and heating oil or crude oil have improved. This is due primarily to the fact that there is significantly more storage of jet fuel in the Middle East now, which places less price pressure on jet fuel in periods of higher demand due to military conflict.

Frequently Used Fuel Hedging Instruments by Airlines This section describes the most commonly used hedging contracts by airlines: swap contracts (including plain vanilla, differential, and basis swaps), call options (including caps), collars (including zero-cost and premium collars), futures contracts and forwards contracts. Plain Vanilla Swap The plain vanilla energy swap (called this because it is simple and basic when compared to more exotic swap contracts) is an agreement whereby a floating price is exchanged for a fixed price over a certain period of time.

It is an off-balance-sheet financial arrangement, which involves no transfer of the physical item. Both parties settle their contractual obligations by means of a transfer of cash. In a fuel swap, the swap contract specifies the volume of fuel, the duration (i. e. , the maturity of the swap), and the fixed and floating prices for fuel. The differences between fixed and floating prices are settled in cash for specific periods (usually monthly, but sometimes quarterly, semi-annually, or annually). Figure 4 illustrates fuel hedging using two types of swap contracts.

Example 1 in the figure describes how a plain vanilla jet fuel swap arranged in the OTC market is used. Example 2 illustrates fuel hedging on the organized exchanges using a highly liquid contract — the NYMEX New York Heating Oil Calendar Swap contract. In all swap contracts, the airline is usually the fixed-price payer, thus allowing the airline to hedge fuel price risk. For more information on these contracts, refer to the NYMEX website at http://www. NYMEX. com. Differential Swaps and Basis Risk 5 Review copy for use of the Case Research Journal. Not for reproduction or distribution.

While a plain vanilla swap is based on the difference between the fixed and floating prices for the same commodity, a differential swap is based on the difference between a fixed differential for two different commodities and their actual differential over time. Differential swaps can be used by companies to manage the basis risk from other hedging activities. For instance, assume an airline prefers to hedge its jet fuel exposure using a heating oil plain vanilla swap. The airline can used an additional swap contract, the differential swap for jet fuel versus heating oil, to hedge basis risk assumed from the heating oil swap.

The net result is that the airline can eliminate the risk that jet fuel prices will increase more than heating oil prices. Basis risk can be an important concern for cross-hedges of this type. For more information on differential swaps, refer to Chapter 1 of Falloon and Turner (1999). Call Options (Caps) A call option is the right to buy a particular asset at a predetermined fixed price (the strike) at a time up until the maturity date. OTC options in the oil industry are usually cash settled while exchange-traded oil options on the NYMEX are exercised into futures contracts.

OTC option settlement is normally based on the average price for a period, commonly a calendar month. Airlines like settlement against average prices because an airline usually refuels its aircraft several times a day. Since the airline is effectively paying an average price over the month, they typically prefer to settle hedges against an average price (called average price options). In the energy industry, options are often used to hedge cross-market risks, especially when market liquidity is a concern. For example, an airline might buy an option on heating oil as a cross-market hedge against a rise in the price of jet fuel.

Of course, cross-market hedges should only be used if the prices are highly correlated. Airlines such as Southwest value the flexibility that energy options provide, but energy options can be seen as expensive relative to other options. The reason is the high volatility of energy commodities, which causes the option to have a higher premium. For this reason, zero-cost collars (discussed next) are often used. Figure 5 provides a conceptual illustration for hedging gains or losses using swaps, call options, and premium collars when locking into a 60-cent/gallon price of jet fuel.

Collars, Including Zero-Cost and Premium Collars A collar is a combination of a put option and a call option. For a hedger planning to purchase a commodity, a collar is created by selling a put option with a strike price below the current commodity price and purchasing a call option with a strike price above the current commodity price. The purchase of a call option provides protection during the life of the option against upward commodity price movements above the call strike price. The premium received from selling the put option helps offset the cost of the call option. By stablishing a collar strategy, a minimum and maximum commodity price is created around a hedger’s position until the expiration of the options. Figure 6 provides an example of the net cost of jet fuel in $/gallon using a collar where a call option is purchased with a $0. 80 strike price and a put option is sold with $0. 60 strike price. As shown, the airline will never pay more than $0. 80 for jet fuel no matter how high prices rise, yet will never pay less than $0. 60 regardless of how low jet fuel 6 Review copy for use of the Case Research Journal. Not for reproduction or distribution. rices drop. A collar can be structured so that the premium received from the sale of the put option completely offsets the purchase price of the call option. This type of collar is called a “zero cost collar. ” If more protection against upward price movements is desired (i. e. , having a lower call option strike price) or more benefit from declining prices is desired (i. e. , selling a put with a lower strike price), a premium collar is used. With a premium collar, the cost of the call option is only partially offset by the premium received from selling a put option.

Refer to Figure 5 for a conceptual illustration of the premium collar strategy. Using a zero-cost collar or premium collar may appear to be a reasonable hedging strategy for an airline since it involves no upfront cost (or low upfront cost) and involves no speculative return. However, if jet fuel prices fall significantly, as illustrated in Figure 6, the airline may pay more for jet fuel than its competitors who did not employ the collar strategy. Competitors may lower their airfares aggressively as a result. Accordingly, the zero-cost collar should be more accurately called a “zero-upfront cost” collar.

Futures and Forward Contracts 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 buyer has a long position, which means he/she agrees to make delivery of the commodity (i. e. , purchase the commodity). The seller has a short position, which means he/she agrees to make delivery of the commodity (i. e. , sell the commodity). Futures contracts are traded on an exchange, which specifies standard terms for the contracts (e. g. , quantity, quality, delivery, etc. ) and guarantees their erformance (removing counterparty risk). Only a small percentage of futures contracts traded result in delivery of the commodity (less than one percent in the case of energy contract). Instead, buyers and sellers of futures contracts generally offset their position. A forward contract is the same as a futures contract except for two important distinctions: (1) Futures contracts are standardized and traded on organized exchanges, whereas forward contracts are typically customized and not traded on an exchange; and (2) Futures contracts are marked to market daily, whereas forward contracts are settled at maturity only.

For the futures contract, this means that each day during the life of the contract, there is a daily cash settlement depending on the current value of the commodity being hedged. The NYMEX exchange trades futures on crude oil, heating oil, and gasoline (among other commodities). Table 5 illustrates how a fuel hedger can use the NYMEX heating oil futures contract to hedge jet fuel price risk. As shown, the hedger purchases a futures contract at 66. 28 cents per gallon (futures contract size is 42,000 gallons) in January. On the same day, the New York jet fuel spot price is 80. 8 cents per gallon. If the hedger closes out this futures contract for 42,000 gallons on August 29, 2000 at 98. 59 cents per gallon, he/she has made a profit of 32. 31 cents per gallon (98. 59 minus 66. 28). The spot price of NY jet fuel on August 29th is 103. 6 cents per gallon. (Note: If the hedger had not hedged, he would have paid 23. 32 cents/gallon more for the fuel. ) However, by using the futures contract and purchasing jet fuel in the spot market, the gain of 32. 31 on the futures more than offsets the 23. 32 increase in jet fuel prices. In essence, the 7

Review copy for use of the Case Research Journal. Not for reproduction or distribution. hedger’s net cost of jet fuel is 71. 29 cents per gallon (i. e. , 103. 6 spot price in August minus the futures hedging gain of 32. 31 cents/gallon). Accounting for Derivatives According to SFAS 133 The Financial Accounting Standards Board (FASB) issued Statement 133 to make a company’s exposure to its derivative positions more transparent. Prior to SFAS 133, most derivatives were carried off-balance sheet and reported only in footnotes to the financial statements. Under SFAS 133, depending on the eason for holding the derivative position and the derivative’s effectiveness in hedging, changes in the derivatives’ fair value is recorded either in the income statement or in a component of equity known as other comprehensive income. Table 6 summarizes the balance sheet and income statement impacts of cash flow hedges, fair value hedges, and speculative transactions under SFAS 133. Under SFAS 133, managers such as Scott Topping that want their hedge to receive hedge accounting treatment, must be certain their hedge will pass the effectiveness measure.

To qualify, the manager must measure the effectiveness of the hedge at least each reporting period for the entire duration of the hedge. Any ineffective portion or excluded portion of the change in derivative value must be reported directly to earnings. According to the FASB, hedge effectiveness should take into account both historical performance (retrospective test) and anticipated future performance (prospective test). The FASB has provided only broad guidelines for testing hedge effectiveness. The FASB has two suggested approaches to measure historical performance: the “80-125 rule” and the correlation method.

According to the “80-125 rule” (also referred to as the dollar-value-offset method), a hedge is deemed effective if the ratio of the change in value of the derivative to the change in value of the hedged item falls between 80 % and 125%. Shown in equation form: Effectiveness measure = ? ni=2(? PH)i ? ? ni=2(? PD)i Where: (? PH)i = (PH)i – (PH)i-1 (? PD)i = (PD)i – (PD)i-1 PH = the daily price of the hedged item PD = the daily price of the derivative i = trading day i n = total number of trading days in the period

According to the correlation measure, a hedge is deemed effective if the correlation between the changes in the value of the hedged item and the derivative is high. In other words, a hedge should be considered effective if the R-squared of the regression of this relation is around 80 percent. Furthermore, the slope of the regression line should be close to 1. 0 (but this is not explicitly referred to in SFAS 133). For more information on measuring hedge effectiveness, refer to Kalotay and Abreo (2001), Risk Books (1999), and Energy Information Administration (2002), among others. Review copy for use of the Case Research Journal. Not for reproduction or distribution. June 12, 2001 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. Table 7 provides Southwest’s hedging practices at year-end 2000 as discussed in their annual report. 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. 869, 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. (Refer to Table 1: The average price per gallon of jet fuel in 2000 was $0. 7869 compared to $0. 5271 in 1999. ) 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. Scott knew that: “Predicting is very difficult, especially as it concerns the future” (Chinese Proverb).

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 unhedged. 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. 2. 3. 4. 5. 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. Appendix 2 contains information on NYMEX futures contracts and futures options contracts, both for crude oil and heating oil. For alternative 2 above (i. e. hedging using a plain vanilla crude oil or heating oil swap), there were two different possibilities: 11 (1) Enron offered Scott an over-the-counter plain vanilla jet fuel swap with a 1-year maturity. The offer stipulated a fixed rate for Southwest Airlines of 76 cents/gallon.

The variable rate was based on the monthly average price for Gulf Coast jet fuel. Contract payments would be made monthly during the life of the contract. The size of the swap contract was one million gallons and for simplicity, assume that Enron was willing to For the swap contract, use 1/12th of the hedge volume since the contracts are settled monthly over the one-year period. In other words, for the 100% hedging, use swap contracts for a total of 1,100 million gallons divided by 12 = 91. 67 swap contracts (or round to 92 contracts). 11 9 Review copy for use of the Case Research Journal.

Not for reproduction or distribution. enter into as many of these swap contracts as Southwest Airlines wanted. This swap was similar to that explained in Example 1 of Figure 4. (2) Scott also considered a NYMEX New York Heating Oil Calendar Swap (1-year duration). The contract size was 42,000 gallons. The contract guaranteed a fixed rate for Southwest Airlines of 73 cents/gallon for heating oil. The variable rate was based (per NYMEX regulations) on the arithmetic average of the NYMEX New York Harbor heating oil futures nearby month settle price for each business day during the month.

Contract payments would be made monthly during the life of the contract. This is similar to Figure 4 (see Example 2). Appendix 3 (see the first figure) contains information on the relation between jet fuel costs and airline stock prices (11 major airlines). Note the negative correlation between the two lines. Appendix 4 illustrates monthly load factors for U. S. domestic flights. As shown, demand varies significantly by month and demand is highest in the summer months. The Excel file (Jet Fuel Hedging Case Excel Data for Students. ls) contains historical prices for jet fuel (spot), heating oil (spot and futures), and crude oil (spot and futures). 10 Review copy for use of the Case Research Journal. Not for reproduction or distribution. Case Questions 1. 2. 3. Why do firms like Southwest hedge? What are the benefits of hedging? (Suggestion: refer to Carter, Rogers, and Simkins (2004) for assistance in answering this question. ) Does heating oil or crude oil more closely follow the price of jet fuel? To answer this question, use the information in the Excel spreadsheet. (a) Evaluate each of the five proposed hedging strategies.

What are the benefits of each hedge based on two fuel price scenarios in one year? In other words, assume in June 2002 that one of these scenarios occurs. Calculate your net cost of jet fuel under each scenario incorporating the hedging strategies used. (Note: you can analyze the hedges under as many price scenarios as you wish, but be certain to include the following two scenarios. ) For both scenarios, consider full hedging and a 50% hedge strategy. SCENARIO 1: 39. 3 cents/gallon spot price for jet fuel; 38. 8 cents/gallon spot price for heating oil, or $14. 10 per barrel spot price for crude oil, and SCENARIO 2: 119. cents/gallon spot price for jet fuel; 118. 6 cents/gallon spot price for heating oil, and $40,00 per barrel spot price for crude oil. (b) Discuss the pros and cons of each hedging strategy. (c) Describe how a combination of the hedging strategies can be used. 4. What are the risks of being unhedged? Totally hedged? (Note: the February 24, 2004 Wall Street Journal article titled “Outside Audit: Jet-Fuel Bets Are Risky Business” by Melanie Trottman may be useful. ) (a) What is basis risk and how is it different from price risk? (b) What are the implications of a changing basis? c) Does basis risk exist for Southwest Airlines in their fuel hedging program? (a) What is FAS 133 and how does it impact a firm’s hedging strategy? (b) Using the effectiveness measure on page 6, calculate the effectiveness of hedges using heating oil futures and crude oil futures for the period 2000-2001 (up until the time of the case). How does the effectiveness measure impact a firm’s hedging decision. Describe how a market in backwardation or contango (i. e. shape of the forward curve) might impact hedging strategies. Are current crude oil markets in backwardation or contango? Note: Backwardation is the market situation when futures prices are progressively lower in the distant delivery months when compared to the nearest (prompt) month. Contango, the opposite of backwardation, is a market situation in which prices in later delivery months are progressively higher than in the nearest delivery (prompt) month. ) What do you recommend to Scott Topping? Why? 5. 6. 7. 8. 11 Review copy for use of the Case Research Journal. Not for reproduction or distribution.