Wednesday, January 21, 2009

Airlines "Hedging" Fuel Prices

During a lull at work, I was skimming the financial headlines and came across an opinion piece with this provocative headline: "The perils of plunging oil prices: UAL's effort to fight fuel costs backfires". The piece goes on to talk about how airlines' heading strategies are backfiring now that oil prices have dropped, so they're suffering financial losses and having to lay people off.

What's odd here is that hedging shouldn't backfire. Hedging is a method of reducing risk, kind of like insurance, but if you're a clever airline on a tight budget you can often do it for no out of pocket cost. For instance, an airline might decide it can afford jet fuel when oil's $100 per barrel but no more, so it might sign a forward contract, a contract with a supplier to pay that price for jet fuel--no more and no less--for the next two years. True, if oil drops below $100, the airline may be upset that it's locked into the $100 price, not the lower market price, but those are losses it's already figured into its business model. At least theoretically. Or if it wants to to limit the range of fuel prices, it could set up a collar (or, more accurately, a costless collar): pay someone for the right to buy fuel from them at the $110/barrel price (buy a "call" option), and finance it by selling someone else the right to sell fuel to the airline at the $90/barrel price (sell a "put" option). If oil goes above $110/barrel, the airline's covered, and it oil goes below $90/barrel, the airline has to buy it at $90, so the airline's locked into the $90-110 price range.

A look at United Airlines' quarterly report for the quarter that ended September 30, 2008 reveals a somewhat different story:

Aircraft Fuel Hedges. We have a risk management strategy to hedge a portion of our price risk related to projected jet fuel requirements primarily through collar options. The collars involve the simultaneous purchase and sale of call and put options with identical expiration dates. In order for the Company to obtain more favorable terms for a portion of its hedge positions, the Company also entered into collars with additional features. These hedge positions include extendable collars, referred to above, and collars that include twice the amount of put volume as call volume. Gains and losses derived from the Company’s hedge positions are not accounted for as cash flow or fair value hedges under SFAS 133. The Company’s hedges that are classified either in Mainline fuel expense or nonoperating income (expense), based on the nature of the hedge instruments.
(emphasis added) This looks more like speculation than hedging. Twice as many "put" options as "call" options? No wonder they're getting hit. Using the collar example above, for each person they've paid for the right to buy fuel at the higher price, they've sold two people the right to sell them fuel at the lower price. And the price of oil dropped way below that lower price. (In reality, probably no fuel is changing hands. Instead, they just settle up the amount of money each party would have gained or lost if it had traded fuel. Financially, the net result should be pretty close, give or take some taxes.)

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