The grounding of Silverjet brings to mind a question George Anders asked the other day in the Wall Street Journal: why doesn't the airline industry do more to hedge its oil exposure? Without appropriate hedging, airlines are pretty much always speculating on the price of oil.
With oil near $130 a barrel, why does Southwest Airlines stand alone in the airline industry in its aggressive use of hedging to keep fuel costs under control? Southwest has locked in more than 70% of its jet-fuel requirements this year at a price equivalent to $51 a barrel for crude oil. By contrast, other big carriers have hedged 30% or less of their fuel needs this year. Those carriers generally expect to pay the equivalent of $85 to $100 per barrel of oil under their hedging programs.
Anders' column suggest the answer might be frequent management changes in the industry. With such regular turnover in the top ranks, the airlines just lack management experience to deal with price changes. Law professor Larry Ribstein has some even more complicated explanations, including the possibility that airline management are concerned about putting complex hedges into their disclosures for fear of triggering memories of Enron. Worse, management may run the risk of Sarbanes-Oxley legal liability if they inadequately disclose their hedges. Perhaps its safer not to hedge.
Why Rivals Don't Copy Southwest's Hedging [Wall Street Journal]
Posted by Anal_yst , May 30, 2008 12:33PM
This is nonsense. Back in school we did a simple study of the hedging programs of most major airlines. Now my memory is a bit hazy, but sarbox compliance (or other bs like that) is very unlikely to explain the lack of/poor hedging by every airline other than southwest.
Again, if memory serves, what it appeared was that management was not comfortable with even conservative hedging strategies like collars, and even more averse to more aggressive directionally-biased approaches.
There were at least a few situations where prior airlines had gotten burned by (poorly conceived/executed) hedges, further causing executives to shun such strategies, as the viewpoint is that its easier to explain away poor operating results due to rising input costs than it is to explain a major hit due to bad financial alchemy.
Posted by guest , May 30, 2008 12:36PM
Oh, I get it, but for the fear of memories of Enron, we'd all be running to buy airline stock. Touche, airline industry.
Posted by BSD , May 30, 2008 12:38PM
...and once again you have incentives of the brain-dead management completely misaligned with those of the shareholders and customers. Airlines is an industry run by people who wouldn't be fit to ride a tricycle in a room covered with foam walls.
Posted by guest , May 30, 2008 12:39PM
Unless the management of the airline has a controlling stake in the company (ie ownership), then it is not efficient for them to engage in hedging. Shareholders can own shares in the company and hedge exposure to changes in oil prices independently. Management of an airline should focus on running airlines, not managing the volatility of oil prices.
Posted by guest , May 30, 2008 12:40PM
Unless the management of the airline has a controlling stake in the company (ie ownership), then it is not efficient for them to engage in hedging. Shareholders can own shares in the company and hedge exposure to changes in oil prices independently. Management of an airline should focus on running airlines, not managing the volatility of oil prices.
Posted by Anal_yst , May 30, 2008 12:42PM
@ 12:40
You went to the University of Chicago, didn't you?
Heaven forbid management takes conservative, reasonable measures to control input costs, right? Investors can just do all of that on their own, duh!
Posted by guest , May 30, 2008 12:45PM
@ 12:40. That is ridiculous. Part of managing a company is keeping costs down. Effective hedging of oil prices in the airline industry is an important way of keeping costs down.
Posted by guest , May 30, 2008 12:50PM
Buffett said it best about airlines.
Posted by guest , May 30, 2008 12:50PM
No others have the cash
Posted by guest , May 30, 2008 12:54PM
12:40 did not go to any Univ but is some douche who is probably trying to clear CFA level 1 and thinks he understands all about diversification.
Oh and he doesn't understand agent-principal issues either. Come to think of it, the whole double-posting was crap. Damn, I just wasted my time pointing out crap to be crap.
Posted by Riskybusiness , May 30, 2008 1:00PM
Anal_st - More likely South West Texas Mechanical and Animal Husbandry College. I hear they have a magnificent insemination management program.
Posted by Riskybusiness , May 30, 2008 1:00PM
Anal_st - @ 12:40 More likely went to South West Texas Mechanical and Animal Husbandry College. I hear they have a magnificent insemination management program.
Posted by guest , May 30, 2008 1:04PM
same reason everyone that exposure to oil doesnt hedge.. its expensive and only seems like a good idea in retrospect (given the current oil prices).
Why dont airline companies engage in oil exploration and mining?
Posted by Random Banker , May 30, 2008 1:05PM
Its too late to hedge now, geniuses. The time to hedge was when Oil was at $10 a barrel. The real problem is that there is too much competition in the industry so they can't pass through the costs to their customers effectively. That should be the real question you're asking: why are there still so many airlines? The answer is that the government and AIG and GE keep bailing them out with cheap airline leases and subsidies. The government because, they're retarded, and AIG and GE because they make a mint by charging high financing fees to customers with few other options.
Posted by guest , May 30, 2008 1:06PM
Doesn't the whole headline knock down the Enron and SOX arguments? If the legal and PR issues are so bad, how come Southwest is able to do it? I'll second the idea that most airlines are run by people you wouldn't trust to pick their noses.
Maybe they figure it's better not to hedge since they have much more experience with the bankruptcy process than they do with hedging. Go with what you know.
Posted by AJ , May 30, 2008 1:08PM
Part of the problem is the call to hedge always comes too late. Southwest has a consistent hedging program but the other airlines don't really. There seems to always be a call for them to start hedging but it's always near peaks. No manager wants to hedge 70% of their jet fuel when oil's at $130. If it goes to $150, sure they look like geniuses, but if it falls to $100, they lose their job. They really only want to take the risk to hedge when oil isn't a problem, but at those times, it doesn't even come across their radar.
Posted by guest , May 30, 2008 1:12PM
I always wondered this, and have discussed it with colleagues. The best answer was that the airlines did hedge, but that they could only hedge so much exposure (say, locking in the price at $50, but anything above $90, the airline would be responsible for). This sounds reasonable.
Posted by guest , May 30, 2008 1:12PM
I always wondered this, and have discussed it with colleagues. The best answer was that the airlines did hedge, but that they could only hedge so much exposure (say, locking in the price at $50, but anything above $90, the airline would be responsible for). This sounds reasonable.
Posted by guest , May 30, 2008 1:12PM
I always wondered this, and have discussed it with colleagues. The best answer was that the airlines did hedge, but that they could only hedge so much exposure (say, locking in the price at $50, but anything above $90, the airline would be responsible for). This sounds reasonable.
Posted by guest , May 30, 2008 1:12PM
I am a huge proponent of hedging and see this with customers (mostly O&G) all the time. Managment idiots, and the investing idiots that drive them, are much more worried about leaving a few bucks on the table than insuring business continuity and locking in cash flow.
It's also much easier for execs who generally don't understand derivatives to rationalize their lack of protection by throwing out the Buffet quote relating derivatives to WMDs. Ignorance is bliss I guess.
-Nominate me
Posted by guest , May 30, 2008 1:15PM
Gotta trim the hedges. BAZING!
Posted by Anal_yst , May 30, 2008 1:20PM
Sadly a handful of comments provides far more insight than any of the articles I've seen written, lets see:
+ Airline execs have no/poor incentives to attempt to hedge
+ Airline execs don't understand hedging
+ Hedging often seems like a great idea in hindsight (easy/poor excuse though)
+ Structure of the airline industry is not conducive to increasing service, efficiency, profitability
+ For real, someone get me a job running an airline. I'll take 1/2 the pay and f' it up in 1/2 the time.
Posted by diablo , May 30, 2008 1:23PM
I'm glad that most commentators here are smarter than the WSJ, Ribstein and Carney regarding hedging by airlines.
AJ @ 1:08 PM hit the nail on the head.
Posted by guest , May 30, 2008 1:24PM
viva la milton friedman!
Posted by Master of None , May 30, 2008 1:27PM
In theory, if the underlying business is unprofitable at a given spot rate, and the spot rate of inputs seems sustainable, shareholder returns would be maximized by ceasing operations and cashing in on the hedge.
So, if airlines are going to hedge, that's fine, but as an owner I would still want to own the hedge, not the airline.
Said another way, if you're running a hedged airline, you can see quite clearly that the business is unsustainable when the hedge expires. At the minimum, you're planning to shut down the business when the hedge expires, but to truly maximize cashflow you should cease operation ASAP and close out the hedge.
Posted by guest , May 30, 2008 1:28PM
I don't like airlines. Lousy unions.
Posted by guest , May 30, 2008 1:33PM
@ Anal
What's even worse, I remember sitting in university case studies discussing this same topic. The consensus when all was said and done was that hedging fuel costs and passing on the p/l via ticket prices was absolutely the way to go. (A few other things went into it, but that was the idea for this discussion)
Was this hindsite? It was 2001-2, and every college student since about 1995 has done this same exercise and come to the same conclusion. These airline clowns seem like a bunch of braindead, bureacratic zombies.
One airline that I think will be interesting is the new Neeleman (of JetBlue fame) project based out of Brazil.
-Nominate me
Posted by Master of None , May 30, 2008 1:37PM
The argument that there is too much competition is flawed; the reason airlines can't pass along higher input costs is because of the small number of hedged competitors that keep prices down.
This is especially true of Southwest, which passes all the profit from its hedges along to its customers. To me, it seems perverse to give away the only profitable part of the business... oh well, guess that's why I'm not running an airline.
Posted by guest , May 30, 2008 1:37PM
Random banker and AJ got ti right.
Hedging is not free- in fact in a market with 50% vol a 5 year hedge is crippillingly expensive. So you have to be sure that it is necessary. In addition there is the game theory component- if no one else is hedging and you all face higher oil costs in the future you are all in the same boat.
If you are the only guy who hedged and oil is trading below you forward all in hedging cost you have a more expensive cost structure in a business with paper thin margings.
Add to this and no one expected oil here- aside from T. Boon Pickens.
Look the best advice anyone can give you when it comes to investing in Airlines was Richard Branson's answer to the question, "how do you become a millionaire?"
His answer- start as a billionaire and buy and airline
"My2Cents"
Posted by Anal_yst , May 30, 2008 1:38PM
@ Nominate me
I did the study at the same time, obviously same sort of conclusions (in addition to what i mentioned in the 1st comment).
The question to me is, besides the index-component, why the hell would you buy an airline stock if you're a fund manager? Just give me the #, i'll kick you in the nuts, and you can be on your merry way, that much wiser.
Posted by guest , May 30, 2008 1:40PM
@1:28
Is that you GG?
Posted by guest , May 30, 2008 1:49PM
@ Anal
Domestic airlines and auto companies, take that money and invest it in a racehorse fund or vineyard. The prospective returns are probably equal, but the horses and grapes would be a lot more fun.
What is your going rate? I pay good $ to have people step on my cubes.
btw: bberg just showed that Big Brown was purchased for $190k.
-Nominate me
Posted by guest , May 30, 2008 1:55PM
Incidentally, dont be surprised to see the other airlines peeing blood a couple of years from now when oil prices come down. Look at the oil futures. There has been tremendous upward movement on the backend over the part month. The main players on the backend tend to be producers / large consumers and the steep rise there tends to indicate that many consumers have given in to the fact that oil prices will remain high.
I will not be surprised if some of those folks are these very airlines - and if their move ends up looking ridiculous a few years from now.
Oh, and Southwest managing fuel prices is a part and parcel of their job. Yes, if they got into the job oil trading then that would be diversification and something that the investor could do themselves. But managing costs of raw inputs in essential for their business! Should General Mills not care about managing the cost of grains, should Honda not hedge the cost of rolled sheets and should US Steel not hedge the cost of ore?
Posted by guest , May 30, 2008 2:08PM
c'mon anal... your biggest concern today is that the "friday night girls" you're going to wheel at happy hour are "hedge-free".
--Calgary Schmooze
Posted by guest , May 30, 2008 2:10PM
This is a great example of the Prisoner’s Dilemma.
It is virtually impossible for an airline to pass through “business specific” higher costs. – This is why the industry accepts unions- as they are, more or less, all exposed to the same wage costs.
To put on a meaningful hedge it should run for 5 – 10 years. Otherwise you are better off making some projections for 7 or 8 quarters, adding 20% and set budgets accordingly.
In Contango markets hedging is not cheap. So, when spot crude was 20 bucks, a 5 year hedge would have been about 24 bucks and a 10 year closer to 30. Where fuel is at lest 50% plus of total costs, hedging increases total costs by 10%.
All the Airlines would LOVE to hedge if they could guarantee that they all decided to do it and start at the same time. They can't, so they move to the Nash Eq.
PS> Southwest doesn't pass through hedging costs. They control the other half of their costs i.e., wages are lower, and they put that money to work in a hedge program.
"Sometimes rational decisions aren't sensible" -Ian Stewart
Posted by guest , May 30, 2008 2:13PM
If the underlying is only going up over time the shape of the hedge looks like stairs anyway.
Posted by guest , May 30, 2008 2:14PM
@1:27, et al: Don't laugh. Aluminum producers did this very thing a few years back when that whole west coast electricity debacle was going on. Aluminium production uses godawful amounts of electricity and producers lock in long-term price commitments. For a while there, Alcoa could put the plant in maintenance mode, sell their long-term electricity commitments, and send the workers home to eat potato chips and watch SpikeTV at full pay while making MORE money than they did rolling Al. Then when it all eventually got fixed (along with a nice little bump in the price of Al due to the production cutbacks) they started making Al again.
Posted by guest , May 30, 2008 2:15PM
The reason Southwest is so well-hedged is that they started buying contracts in 1998, when oil had tanked. They've continued to add more because they have continued to make money, and have a significantly better credit rating than any other carrier.
Simply put, no other airline has had the cash flow and the credit to hedge as aggressively. What's more, some carriers that had bigger hedges had to sell them as they began the spiral into bankruptcy. See Delta, Northwest, et al.
The WSJ guy could have figured this out had he actually, you know, done some reporting.
Posted by Anal_yst , May 30, 2008 2:16PM
@ 2:10
I'll take most of what you said, but does the airline industry really qualify (as-is) as a nash equilibrium? Isn't that kind of just accepting defeat?
Posted by John Carney , May 30, 2008 2:20PM
I'm going to add my appreciation for these insightful comments. I've learned more about this question from reading this thread than I could have from anywhere else. Great work lads and lasses.
Posted by guest , May 30, 2008 2:22PM
I can't think of a better candidate for hedging than the airline companies. They're consistently unprofitable - how risky could hedging be?? especially if it's done w/out naked positions.
Should IPPs not hedge against coal and natural gas costs? You're saying that their shareholders should do that themselves? absolutely retarded.
Posted by guest , May 30, 2008 2:24PM
222 should read the preceding comments
Posted by guest , May 30, 2008 2:30PM
Anal_yst, 2:10 here,
Perhaps you are right, but I came about this opinion honestly. I was in the energy biz, trying to structure a fuel hedge for an airline, and was schooled by the client.
So, lessons learned, hedging works when the hedge cost can be passed through and sometimes the old codgers in rumpled suits know a thing or two.
Posted by Anal_yst , May 30, 2008 2:33PM
@ 2:30 (aka 2:10)
Sun even shines on a blind dog's ass once in a while (or whatever)
Posted by guest , May 30, 2008 2:35PM
The big take away is that the airlines need dance partners.
Posted by guest , May 30, 2008 2:36PM
Hedge and lose = fired
Hedge and win = keep job
Don't hedge and win = keep job
Don't hedge and lose = blame it on circumstances beyond your control and keep job.
So long as they all move together in lock step, everyone keeps their jobs.
Posted by onetwo , May 30, 2008 2:40PM
Thank you RB. While i know we don't always agree, i was hoping someone was going to be smart enough to point out the fact that it's too late.
LUV always had an aggressive hedging program in place, so they locked in their current prices year(s) ago. I'm pretty sure the airlines are nowhere near profitable at prices this high, so pretty much their only option is to be short oil. If they stay long (essentially what they're doing by hedging) then they're guaranteeing their own demise. It's a mild form of prospecting theory. Until they get anti-trust exemptions we are just going to see these airlines roll over time and time again because they can't raise prices unilaterally.
Also, because of the turnover in the airline industry, many of the airlines now haven't even been around long enough to have set up their operations and hedged when oil was "cheap".
Posted by miami , May 30, 2008 2:50PM
Most of the comments here are moronic.
'Random banker and AJ got ti right.
Hedging is not free- in fact in a market with 50% vol a 5 year hedge is cripplingly expensive.'
Yes, but MORE importantly, the I-banks you better BELIEVE demand cash collateral from the airlines upfront.
Most airlines do not have unencumbered cash. Those that have some can only afford to hedge a little.
Also, cash may be needed for the contemplated purchase of new routes/gates or for old ones from weak hands during downturns. A new SF-Tokyo gate/slot > slightly cheaper oil by miles.
~interned at Big Airline for former CFO. Got out fast.
Posted by Random Banker , May 30, 2008 3:26PM
Oh 1-2, you are as tender hearted as you are tender headed. No wonder girl loves you. Happy Friday!
Posted by Anal_yst , May 30, 2008 3:31PM
speaking of friday, anyone doing Happy hour?
Posted by guest , May 30, 2008 4:33PM
Sorry Miami- did not realise any of the comments here that were not yours were moronic.
Thanks for explaining counterparty credit exposure on derivatives hedging- i guess if you interned at an airline you would assume that people who worked in finance did not understand that.
Just make your comment and move on
Posted by guest , May 30, 2008 4:44PM
...shareholder returns would be maximized by ceasing operations and cashing in on the hedge.
I love that b-school crap about how management should just fire themselves because it'd be the best for the stockholders. Right after they give out ponies as a dividend.
Posted by Johnny , Jun 02, 2008 4:00PM
Well said, AJ @ 1:08...
In hindsight w/ $125+ oil, LUV look like geniuses. But we all know Gasbagarino would be squawking about how reckless they were with their hedging if oil were to plummet back down to $50-60.
Posted by guest , Sep 28, 2008 2:07PM
Only thing worse than the airline business is a bunch of ignorant people on a chat board talking out their rears.
the reason airlines dont hedge is that most are not financially fit enough to do so. A futures contract is a massive financial obligation (in the billions for a big 5 airlines) and the airlines are not creditworthy enough.
I worked in the airline biz for several years. Generally a much smarter, more resourceful group of execs that those surviving in other "country club" industries. I have personally seen many geniuses from the premium CPG companies, manufacturers (eg GE), and mgt consulting firms attempt to "show people the right way" only to watch them crash and burn.
Unfortunately the airline biz will not change much in our lifetimes. No control over the biggest factors impacting performance - fuel (now approaching 50% of expenses); airplanes (duoploy pricing & capital intensive); airport infrastructure (generally managed by politicians); and lastly organized labor.
Mate those expense realities to the fact the the product they manufacture is a near commodity sold with near perfect consumer price info(ie virtually no revenue premiums among carriers ), the financial results will always suck.
That is the reality of the airline biz.