Southwest's fuel gamble: Hedges keeps fares in check

DETROIT -- 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.

But even with hedging, Southwest customers have seen fare increases. The airline has boosted fares about 7% to 14% since the summer of 2007, said Rick Seaney, chief executive of farecompare.com. But that's about one-third of the increase seen from legacy carriers like Northwest, American and United.

Southwest will likely keep fares lower despite having less fuel hedged in the coming years, Seaney said. Its strong financial position could allow it to continue to lock in fuel prices, analysts say. For 2012, Southwest only has around 15% of its jet fuel locked in based on $63 a barrel.

At Metro, Southwest is just behind Spirit in the number of passengers carried so far this year. But Spirit has told the Wayne County Airport Authority that it expects its number of passengers to fall 30% in fiscal 2009. Southwest predicts a decline of just 0.2%. Southwest has three gates in the North Terminal and Spirit has two.

Klaskin said it's unlikely that Southwest would take over all of the business Spirit may drop. But filling in the gaps in Detroit wouldn't be out of the question, especially if Delta cuts capacity after it merges with Northwest, he said. "They know how to cherry-pick the good stuff," Klaskin said about Southwest.

The airline has already done this in Denver. Southwest has added flights there as United and Frontier have pulled back. By Nov. 2, Southwest plans to have 115 daily flights out of Denver, a ninefold increase from mid-2007.

At Metro, Southwest wants more business travelers and those fliers might be more interested if Northwest drops flights. Southwest also has a new alliance with WestJet, a Canadian low-cost carrier. That might spur more interest in Detroit.

"Detroit is a nice logical place to connect out of Canada," Seaney said.

However, this isn't the most likely time to see significant growth in the industry, even at Southwest, Seaney said.

"At $120 oil, nobody is in a position to grow very much ... the likelihood of anything growing is slim," he said.

The Detroit Free Press is owned by Gannett, parent company of USA TODAY.