Southwest's fuel gamble: Hedges keeps fares in check

As jet fuel prices sent airlines on a stomach-churning ride, spurring new fees and higher prices, Southwest Airlines customers have had a smoother trip.

Southwest, the second-biggest carrier at Detroit Metro's new North Terminal, took a gamble on fuel purchasing that has paid off for consumers. It's been able to keep fare increases much lower than those of most carriers because it locked in jet fuel prices before crude oil skyrocketed to almost $150 a barrel earlier this year.

That protection is likely to wear off a bit in 2009, but many analysts say the Dallas-based airline's strong financial position will allow it to remain one of the cheapest deals for travelers.

"Southwest is the price-setter in Detroit," said Tom Parsons, chief executive of bestfares.com. "They are still king of the low-cost carriers."

For instance, the airline advertises that a Friday to Sunday trip from Detroit to Chicago in late October can be as low as $160. Northwest matches that price, but charges for checked baggage. Prices for carriers like Delta Air Lines, Frontier Airlines and US Airways range from $240 to $330.

Southwest works hard to preserve its image, presenting itself as a fun, lower-cost alternative. There is no fee for the first two checked bags, no fee for aisle and window seats, and no fee for snacks. When its gates opened in the new North Terminal, Southwest employees handed out T-shirts and other trinkets to passengers and decorated its gates with balloon arches.

But the key to Southwest's success has been fuel hedging. With a hedge, the airline enters into a contract with a bank or other financial services firm. The airline bets oil prices will go up; the other side bets they will go down. The loser must pay the difference to the other party.

With oil hovering about around $100 a barrel, Southwest has come out on top. For 2008, it has locked in the price for about 70% of its jet fuel based on oil priced at $51 per barrel. For 2009, it has locked in 55% of its jet fuel based on that same price.

That makes Southwest, which flies 19 daily nonstops from Detroit, more protected than any other airline if oil prices remain around where they are now, said Stuart Klaskin, an aviation analyst at KKC Aviation Consulting in Coral Gables, Fla.

"No one else is positioned like that. No one else has the cash to hedge with," Klaskin said. "Southwest has the most sophisticated fuel-hedge operation of any airline ... they have top fuel traders who work for them."

Southwest officials declined to comment on the airline's strategy.

Darin Lee, a principal at LECG, said Southwest's hedges have been crucial to its ability to report profits in 2008.

"They probably would have lost money, had they not had the fuel hedges," said Lee, an analyst for the Cambridge, Mass.-based firm.

In the second quarter, Southwest reported net income of $321 million, nearly setting a record for its most profitable quarter. Most other airlines were reporting losses in the same period, including Northwest — Metro's largest carrier — which posted a net loss of $377 million.

Lee said jet fuel now accounts for nearly 30% of passenger carriers' costs, more than twice what it was in 2000. Crude oil prices have almost quadrupled since then, Lee said.

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