Can fuel hedges keep Southwest in the money?

Southwest Airlines luv Thursday reports what almost certainly will be its 69th-consecutive quarterly profit, a string dating back to 1991.

It won't be the first time that the USA's leading discount carrier has earned money while a financial crisis threatened other carriers' survival.

What is its secret?

There are lots of factors, but easily the most important is that Southwest is the champion oil price hedger among airlines worldwide.

Using some simple and some complex investment strategies, Southwest has for a decade locked in the prices it pays for large amounts of jet fuel months and even years ahead of time. Its success at that has protected it from run-ups in crude oil prices and dramatically cut its fuel expenses. Since 1998, it has saved $3.5 billion over what it would have spent if it had paid the industry's average price for jet fuel. That's equal to about 83% of the company's profits over the last 9½ years.

On the spot market, jet fuel sold at an average price of $3.95 a gallon for the week ended Friday. A week earlier, the average price was $4.10. American Airlines paid an average $3.17 a gallon last quarter. Delta, $3.13. And Southwest? Its second-quarter average will be disclosed Thursday, but its recent estimate was about $2.35 a gallon.

That advantage will narrow, and perhaps disappear, as Southwest's $5 billion in fuel-hedging contracts expire over the next four years. With crude oil prices having fallen more than $20 a barrel the past two weeks to $124, the risk of a plunge in prices is higher, the odds of another steep, fast run-up more uncertain, and Southwest's hedging profits harder to sustain.

In fact, oil prices have been so high and have risen so fast that the airline hasn't bought a significant hedging contract in 15 months. Southwest Treasurer Scott Topping, who runs the airline's hedging program, says its successes have produced a crucial benefit: time to adapt its determinedly low-cost business model to paying full market price for jet fuel if necessary.

Southwest is no longer growing at double-digit rates as it has for decades, but the nation's leading domestic passenger carrier is the only big airline that's still growing. As other airlines burn through cash, slash their schedules and lay off employees by the thousands, Southwest is poised to gain market share.

And while other carriers seem to be raising fares somewhere almost every week, Southwest's fare increases have been less frequent and smaller. In national print and broadcast advertising, it's even flaunted its refusal to follow ailing competitors that have begun charging for checking bags, preferred seat assignments and other passenger services.

Southwest's hedging program "means that they'll still be there in a couple of years when you want to fly, even though some other carriers may not be," says Paul Stebbins, CEO of World Fuel Services, a Miami firm that sells fuel management services to transportation companies.

Managing risk

A hedge is a financial instrument that reduces risk. It can be a futures contract, an option to buy or sell a commodity or an agreement to trade commodities that's tied to specific dates or prices. For example, if a company anticipated jet fuel would increase to $4.50 a gallon next year, it could agree now to pay $4.25 a gallon for that fuel on specific dates next year. If the hedge works, it saves 25 cents a gallon on the average price next year. The oil producer selling the hedge would agree to sell at $4.25 as a hedge against a possible drop in prices next year.

Airlines assume some risk when they hedge jet fuel purchases. They sometimes end up paying more than the spot market price for contracted fuel. Had oil prices collapsed in the past year, Southwest's hedges could have cost it money.

However, Barry Siler, an oil and chemicals commodities trading consultant from Houston who first turned Southwest on to hedging 14 years ago, argues that the risks of not hedging are even higher.

"Being unhedged is the ultimate short position," he says. "You're betting every day that the price of fuel won't go up."

In fact, a 2006 study of airline hedging practices by professors at Oklahoma State University and Portland State University in Oregon found that although airlines sometimes lose money hedging, overall those that hedge have a 5% to 10% better financial performance than those that don't.

"Hedged airlines can make investments in their operations and equipment and make other important decisions that positively affect their firm's overall value," says David Carter, an associate professor of finance at Oklahoma State and one of the study's authors. "In bad periods, they tend to have more cash flow as a result of their hedging activity, and that gives them flexibility to continue to make good investments in their operation."

Ben Brockwell, director of data, pricing and information services at the Oil Price Information Service, puts it another way: "Hedging is about having an insurance policy against prices rising."

Siler adds that the real value of fuel hedging is that by locking in a price for its biggest operational cost item, a carrier is shielded from volatility. Managers, he says, can build a business plan with confidence about what the company's costs will be.

"When you know how much you'll be spending, you can know how much service you need to offer and what you need to charge for it," he says.

Slow-starting trend

Hedging in crude oil and distillates got its start in the late 1970s, but generally low prices and abundant supplies in the 1980s and early 1990s gave airlines little reason to get involved.

In 1994, Siler met with Gary Kelly, Southwest's chief executive now but CFO at the time. They started the carrier's jet-fuel-hedging program modestly at first, locking in prices for only 20% to 30% of Southwest's expected fuel needs three to six months in advance.

It was, Siler says, a simple, unsophisticated protection against the kind of big event — a refinery explosion, a terrorist act or an international incident — that could cause a brief price surge. Still, low prices for jet fuel made hedging seem unimportant.

That began to change in 1998. Kelly brought Southwest's fuel-management program in-house. He also enlisted the aid of Topping, then a young associate in Southwest's finance department.

"The timing happened to correspond with the Asian market meltdown," says Topping. "Simultaneously, OPEC was fighting for market share, so prices fell and hit $11-a-barrel for crude. Jet fuel was just 35 cents a gallon. It just made sense for us to go in and lock in some prices. It was just opportunistic, not some grand plan."

Even so, their timing was perfect. Crude oil jumped from $12.50 a barrel in January 1999, just before the carrier launched its big hedging program, to $26.10 in December, then climbed above $34 a barrel in November 2000. Wall Street analysts praised Southwest for its deft handling of what was then considered a fuel price crisis and chastised other airline managements for failing to show the same foresight and courage.

Value of good credit

The price of oil mostly fluctuated between the upper-$20s and the mid-$30s all the way through 2003, double, even triple what the price had been in 1998 and 1999.

Throughout that period, Southwest paid 25% or 35%, or in some cases even 40%, less for jet fuel than rivals with smaller hedges or no hedges at all. Not only did it hedge its fuel at lower prices, Southwest hedged a larger percentage of its fuel than did most all of its rivals. That's a big reason it remained profitable throughout the historic 2001-05 downturn, when the industry overall lost more than $35 billion.

The pattern continues. Southwest has 70% of its fuel needs for the rest of 2008 hedged at $51 a barrel. In contrast, American has 34% of its fuel needs for the year hedged at $82 a barrel. Delta has hedges for a little less than half of its remaining fuel needs this year, and at prices closer to American's than Southwest's.

Topping says Southwest's history of financial strength is one reason it's been able to hedge aggressively.

Southwest has been the most profitable carrier in the USA the past 20 years, and it's the only U.S. airline with an investment-grade credit rating from Standard & Poor's and other rating services. It has the cash and the access to lines of credit to pay the upfront premiums required to hedge. Its credit rating means the oil producers and financiers with which it makes those hedging deals don't worry about Southwest's ability to come up with more cash should a rapid change in market conditions trigger a margin call, a demand for additional funds.

A second factor in Southwest's hedging success, Topping says, is the carrier's philosophical commitment to hedging.

While airlines' finance departments typically are strong proponents of hedging, executives from other departments often argue that the money spent buying hedges would be better spent on new planes, an advertising campaign or the latest technology.

At Southwest, where keeping operating costs low has been the priority from its launch in the early 1970s, senior management bought into the idea that locking in a predictable fuel price would be key to maintaining the company's all-important cost advantage over its rivals.

"When oil got to $40 a barrel, we thought, 'Oh, wow! It's too late.' Then it went to $60, and to $80, and then to where we are now," Topping says. "At each step along the way, the question 'Is this something we should continue to do?' became more and more difficult to answer. But our overall philosophy led us to keep buying hedges. It's a matter of discipline."

That discipline is being tested now. Southwest hasn't done a significant number of new hedging contracts since the first quarter of 2007, when crude oil briefly dipped below $50.

"We've not made a decision to stay out of the market now. We just haven't seen a good buying opportunity come up in more than a year," Topping says.

Will such an opportunity arrive?

That's a big unknown, he says. "That's partly because you just don't know if (the price of oil) has reached a peak and will begin dropping, or if it's still climbing.

"For us to make the kind of gains in the future that we've made in the past on hedging implies the price of fuel would have to go much, much higher still," he says. "We don't know that that will happen, and frankly, we hope it doesn't.

"But we do have time, a cushion that our competitors don't have, to find new sources of revenue to make up the difference."