[Rhodes22-list] Energy Policy - Oops!

[Roger Pihlaja]

Ed & Brad,

Interesting article!  However, I am left with one question.  Given the huge
amounts of jet fuel and money being exchanged in these hedge contracts and
the long term trend of crude oil price ever upwards, who is willing to sell
anyone a contract that locks in the price of jet fuel at the equivalent of
$26/barrel of crude oil?  Is the investment income from the time value of
money which must be paid up front to purchase the hedge contract sufficient
to offset the disastrous effect of a doubling of the price of crude oil?
Given the currently low interest rates and poor performance of the stock
market, that seems hard to believe.  Are there some commodity exchange
brokers that have been bankrupted by having to make good on some of these
hedge contracts when oil prices went up?

I realize the oil companies are in a box because they must sell all the
products that come from their refineries.  By that I mean, they can only
catalytically crack and reform a small amount of the jet fuel fraction into
other products and they have limited storage capacity.  If they don't sell
the rest of the jet fuel fraction as fast as it is produced; then, they will
run out of storage capacity and the refinery would have to shut down.   In
effect, are the oil companies willing to take a loss on jet fuel at a time
when airline travel is down in order to sell as much gasoline and diesel
fuel as they can produce at a huge profit.  Is this what drives these hedge
contracts?

Roger Pihlaja
S/V Dynamic Equilibrium

----- Original Message -----
From: "brad haslett" <flybrad at yahoo.com>
To: <rhodes22-list at rhodes22.org>
Sent: Monday, February 21, 2005 6:48 AM
Subject: [Rhodes22-list] Energy Policy - Oops!


> Ed, forgot you couldn't attach MS Word documents.
> Here's a cut and paste version.  Brad
>
>
> ______________________________________________________
>
>
>
>
>
>
> Passenger Airline Profitability in the Post 9/11
> Environment - How Southwest has Controlled Fuel Costs
> by Hedging and Why Other Airlines Should Hedge Fuel
> Purchases
>
>
>
>
>
> Brad Haslett
> Managerial Finance BA-518
> Embry-Riddle Aeronautical University
> Winter 2004
>
>
> The Search for Profits Post 911
>
> The US passenger airline industry was in trouble in
> 2001 prior to 9/11. A slowing economy and the bursting
> dot-com bubble suggested substantially slowed economic
> growth. With a softening economy and a recent round of
> tough labor negotiations, most major airlines were
> facing a bleak profit outlook. However, industry cash
> reserves totaled $11 billion at the end of the first
> quarter of 2001 and operating revenues had been
> growing nearly 7 per cent annually since 1995.  The
> 9/11 terrorist attacks eliminated any hopes for a 2001
> profit for all but a handful of carriers, and three
> years later, only a rare few have achieved positive
> financial results.  One key to the success of those
> that have not only survived, but also prospered, is
> keeping fuel costs under control. Every one-cent
> increase in the cost of a gallon of jet fuel costs the
> industry $180 million per year. This paper will
> examine the history of airline fuel costs, what
> techniques are available to control and predict jet
> fuel prices, and what the most successful in the
> industry, primarily Southwest Airlines, are doing to
> control fuel costs and maintain profits by using fuel
> hedging strategies.
>
> Oil is a commodity that has always had a volitale
> price history, however, prior to 1973, the inflation
> adjusted price tended to hover around $25 per barrel.
> The rise to power of the OPEC oil producing nations in
> 1973 changed the dynamics and the volitality of crude
> oil prices. OPEC mandated cutbacks in production in
> 1973 and 1979 created substantial rises in worldwide
> crude oil prices.  Airlines suffered substantially as
> a result but the industry was still regulated in 1973
> and de-regulation was in its infancy in 1979.  Crude
> oil prices reached their highest point in nearly two
> decades in 2004. The sudden rise in crude oil was due
> to a complex set of factors including uncertainty
> about the stability of production from the Middle
> East, but few in the oil industry predicted it.
> Almost no US air carriers were financially prepared
> for it. US based airlines were already suffering
> heavily from the post 9/11 environment. The 2003
> industry debt level stood at $100 billion while the
> value of all the outstanding stock of passenger
> airlines was only $3.2 billion. The sudden rise in oil
> prices eliminated all hope for an industry profit for
> the remainder of 2004 and perhaps for the next several
> years for all but a few.  Those carriers that have
> remained profitable, namely Southwest Airlines, have
> done so largely because thay have controlled fuel
> expense through a sophisticated system of hedging jet
> fuel costs.  We will examine why Southwest has been so
> successful and why the other competiters haven't
> followed their example.
>
> Most major air carriers have retired their older, less
> fuel efficient jet fleets for aircraft that burn less
> fuel. Today's jet fleet is nearly three times more
> fuel-efficient than the fleet that was operating at
> the time of the first OPEC fuel crisis. However, fleet
> modernization requires major outlays in capital and
> heavily affects profits when passenger traffic
> declines.  Despite improving fuel requirements, jet
> fuel expenses still account for 12 to 18 per cent of
> operating costs, second only to labor expense.  Fuel
> costs nearly doubled in 2004 and unlike other
> industries, the airline industry was unable to pass
> the expense to the consumer.  Cargo airlines such as
> FedEx and UPS tacked on fuel surcharges to customer
> invoices and consumers accepted the price increases
> for services.  When Contential and United airlines
> tried to add fuel surchages to ticket prices, airline
> passengers sought other carriers without the
> surcharges and both airlines quickly recinded the
> charges.  The US passenger market remains extremely
> price sensitive and fuel surchages of as little as $10
> per ticket have led to mass defection of travelers to
> other carriers.  Purchasing jet fuel at the lowest
> cost has become one of the most important factors to
> remaining competitive.
>
> FUEL HEDGING AT SOUTHWEST VERSUS OTHER CARRIERS
>
> SouthWest Airlines locked in 80% of their 2004 fuel
> costs based on a $26 per barrel of crude oil while
> other carriers paid as much as $55 per barrel on the
> spot market.  Southwest has already hedged much of
> their 2005 fuel costs at $32 per barrel and 45% of
> their 2006 fuel deliveries at $28 per barrel.  United
> and US Airways are prevented by law from hedging
> because they are operating under bankruptcy court
> supervision.  Delta had hedged nearly 40% of their
> 2004 fuel costs but were forced to sell their hedge
> positions for $82 million because they were strapped
> for cash.  This short- sighted strategy forced them to
> buy fuel on the spot market.  Other carriers hedged
> fuel costs to a much smaller degree than Southwest but
> were unprepared when oil prices peaked in mid-year
> 2004.  While hedging has proven extremely successful
> for Southwest, it is not without its risks.  Hedging
> requires substantial up-front cash and few airlines
> have sufficient cash post 9/11 to take hedge
> positions.  Most of the surviving legacy carriers have
> needed all available cash to avoid bankruptcy.  By not
> hedging, airlines are taking on the risk of rising
> commodity prices into their business model.  This
> would be acceptable if no airlines hedged.  But when
> carriers such as Southwest are successful at keeping
> fuel costs (at times nearly half of their competiters)
> so much lower than their rivals, other competiters
> must match fares and absorb the rising fuel expense.
> Were crude oil prices to fall in the $20 per barrel
> range, Southwest would be at a decided disadvantage.
> Few in the oil industry or the airline industry expect
> oil prices to retreat to that range in the near
> future.  It's not that Southwest was better than
> rivals at predicting where fuel prices were headed.
> Instead, with its rock-solid credit rating and strong
> cash position, it could afford to buy hedges in the
> past few years when the financially ailing carriers
> couldn't.  With their weak credit ratings, they faced
> not only higher costs but demands for cash collateral
> in some cases.  The weak position of rival airlines
> was summed up by Continential Airlines CEO Gordon
> Bethune, "you can't get enough money to buy hedges,
> and you can't find anybody dumb enough to get on the
> other side of it".  American Airlines CEO Gerard Arpy
> stated much the same sentiment, "we couldn't enter
> into swaps, which were our traditional mechanism for
> hedging fuel, so as a consequence, we're not as hedged
> as we've been historically, its's frustrating".  Fuel
> costs will be the deciding factor for many airlines in
> 2005 as to whether they can postpone bankruptcy.
>
> Southwest uses a combination of hedging instruments,
> including call options, collars, and fixed-rate swaps.
>  Some are more expensive than others but less risky,
> while others give the airline a bigger advantage if
> oil prices fall.  These instruments work in different
> ways, but Southwest essentially pays for the right to
> lock in fuel at a particular price or price range in a
> future period.
>
> OTHER ADVANTAGES OF HEDGING
>
> The financial results of the US Airline industry for
> 2004 and the positive gains achieved by Southwest
> Airlines aggressive fuel hedging strategy have
> demonstrated the benefits of hedging. Those airlines
> that have chosen a non-hedging strategy because of
> bankruptcy or policy have paid dearly.  John Armbrust,
> a jet fuel contract consultant, talking about the
> majority of the airline industry, other than Southwest
> and JetBlue, states "don't underestimate the ability
> of the airlines to walk off a cliff together.  Almost
> all of them are pretty vulnerable right now".  This
> herd mentality exists primarily among the legacy
> carriers.  The low-cost carriers such as Southwest
> have departed from this line of thinking, and by doing
> so have achieved financial success while the rest of
> the industry is on the verge of bankruptcy. But other
> financial issues facing airlines benefit from hedging
> as well.  There are two major ways in which hedging
> can assist in an airlines ability to invest.  First,
> new aircraft purchases must be planned years in
> advance, and purchase orders submitted to the aircraft
> manufacturer.  Hedging preserves internal cash flow to
> meet future commitments to purchase aircraft.  Second,
> during periods of economic downturn, weak airlines
> often have to sell assets to survive.  Financially
> stronger airlines may be in a position to buy these
> assets at prices below fair market value.  If hedging
> improves a carriers cash position during economic
> downturns, the hedged airline may rely less on
> external sources of funds to make capital
> expenditures.  External finance is increasingly
> expensive when the hedgeable risk factor (jet fuel)
> negatively affects cash flow.  By hedging its fuel
> costs, Southwest has been able to meet financial
> objectives and has taken advantage of its superior
> cash position to buy gates from other financially
> troubled airlines.  Even though hedging requires
> substantial up-front cash, Southwest can predict its
> budgetary needs and avoid unexpected rises in
> operating costs that have forced others into
> bankruptcy and "fire sales" of assets.  High jet fuel
> prices coincide with low industry cash flows, and
> industry investment is directly related to the level
> of jet fuel cost.  Studies have shown investors are
> willing to pay a "hedging premium" for companies that
> reduce their exposure to commodity risk.  The hedging
> premium can be attributed to the benefits an airline
> reaps by generating more consistent, stable cash
> flows.  Hedging airlines are able to better predict
> future cash flows, and earnings, and make investments
> during the high stages of the price cycle, both of
> which are positively valued by investors.  Investors
> in general do not trust airlines' earnings consistency
> and heavily discount the sector's stock.  Airline P/E
> ratios are generally half or a third of the market
> average, a fact often lamented by airline CEO's.  By
> hedging jet fuel purchases, airlines are better able
> to predict future expensed and earnings, which would
> help increase the confidence of financial markets.
>
> HEDGING STRATEGIES AVAILABLE
>
> A properly designed hedging strategy should optimize
> the use of an airlines' capital and minimize the
> volatility of earnings.  Hedging may occasionally lose
> money, but the carrier as a whole benefits.
> Well-designed hedging programs secure or limits the
> loss on key financial ratios by allowing the carrier
> to spend capital on core activities.  One of the
> reasons hedging activities have historically come
> under so much scrutiny is that all hedging
> transactions have a "loser".  Warren Buffet described
> derivitive contracts (related to hedging strategies)
> as "weapons of financial mass destruction".  If
> airlines entered into hedging contracts solely as
> speculative investments, Mr. Buffet's observation
> would perhaps be correct.  But airlines must purchase
> vast quantities of fuel to operate and hedging allows
> them to smooth out expenditures, keep costs within a
> certain range, and avoid suffering from sudden and
> swift rises in operating expenses.  Derivitave
> contract operations are a very specialized field and
> most airlines that utilize hedging operations use a
> combination of internal employees and outside
> consulting firms.  Southwest for example, has three
> full time fuel risk management employees who handle
> fuel risk operations.
>
> There is no specific market that trades in jet fuel
> hedging contracts so airlines use contracts in
> existing markets for products that are closely related
> in kind or whose price is closely correlated to jet
> fuel prices.  Crude oil is actively traded on several
> markets with the New York Merchantile Exchange (NYMEX)
> being the most active.  Jet fuel is a direct product
> of crude oil but does not precisely follow the price
> trends in crude.  Home heating oil is very simular to
> jet fuel and is actively traded on several markets
> including futures markets.  Additionally, home heating
> oil demand is seasonal and competes with jet fuel
> refining capacity so it correlates well with jet fuel
> spot market prices.  Successful jet fuel hedging
> operations spread risk over different time frames and
> several crude oil related product markets.  Some
> contracts extend as far as eight years in advance but
> the bulk of hedging operations are for contracts of
> one year or less.  Generally, the farther in advance
> an airline hedges the more expensive the up-front
> costs while shorter range hedging, though cheaper,
> exposes fuel expenditures to more risk.  Successful
> strategies use a variety of products over a variable
> time frame.  Derivatives are traded directly between
> airlines and investment banks and are usually traded
> with several different banks and investment firms to
> diversify risks and to get the best pricing.
>
> Hedging instruments are either over-the-counter (OTC)
> products or exchange-traded futures.  The most
> commonly used hedges in the airline industry are are
> OTC swaps, collars, futures and forward contracts.
> Collectively these are known as symmetric hedges.
> While reducing earnings volatility by eliminating the
> exposure to downside risks, they give away all or part
> of the carriers participation in the upside (falling
> oil prices).  A symmetric hedge is nothing more than a
> portfolio of an option purchased (a long position) and
> an option sold (a short position).  The long-option
> position insures the operator against the downside,
> but the short-option position gives away the upside
> participation.  The premium from the short-option
> position finances the creation of a long-option
> position.
>
>  Swaps, also known as Contracts-for-Differences
> (CFD's) are used to lock in a fixed price for a
> predetermined but not necessairly constant quantity.
> The first airline swap contract was traded in 1986
> when Chase Manhattan Bank acted as counterparty to
> Cathay Pacific Airways and Kock Industries in an
> oil-indexed price swap.  Swaps are further delineated
> into vanilla swaps, variable volume swaps,
> differential swaps, margin or crack swaps,
> participation swaps, double-up swaps, and extendable
> swaps.   The vanilla swap is an agreement in which the
> counterparties exchange a floating energy price for a
> fixed energy price, that is, one party pays a fixed
> price and recieves the floating price either by
> receiving the cash value of the spot energy or the
> spot energy itself.  The other party, the swap
> provider recieves the fixed prices and either supplies
> the spot energy or its cash equivilent.  The contract
> defines the fixed volume or quantity over a specified
> period of time.  The variable volume swap contract is
> identical to a vanilla swap except that the quantity
> is not known in advance.  A differential swap is
> simular to a vanilla swap except that the
> counterparties exchange the difference between two
> different floating prices for a fixed price
> differential.  The crack spread or margin is the price
> differenetial between crude oil and jet fuel.  Because
> jet fuel competes with other refined products, crack
> spread swaps can protect against rising fuel costs due
> to refinery capacity swings.  Participation swaps are
> simular to vanilla swaps except the airline may
> participate in a certain percentage of the savings if
> prices fall.  Double-up swaps allow the airline to get
> a better swap price but the provider has the option of
> doubling the volume of product delivered.  Extendable
> swaps are simular to double-up swaps except the swap
> provider has the option to extend the period of the
> swap for a predetermined period.
>
> Caps, floors, and collars are also CFD's used in
> hedging.  Caps provide price protection for the buyer
> above a predetermined level, the cap price, for a
> specified period of time.  A floor guarantees the
> minimum price that will be paid or received at a
> predetermined level.  A collar is a combination of a
> long position in a cap and a short position in a
> floor.  Caps, floors and collars are for predetermined
> quantities and are usually settled at regular
> intervals over the period of the contract.
>
> Exchang-traded futures are also use by airlines to
> hedge fuel costs.  Jet fuel futures contracts do not
> exist in the United States, so futures on crude or
> heating oil is used instead to hedge jet fuel purches.
>  Because these futures contracts are based on an
> underlying commodity other than jet fuel, they
> introduce basis risk because they are not perfectly
> correlated.  Basis is generally defined as:
>      Basis = spot price of hedged item - futures of
> selected contract.
> Basis risk is a result of the relationship between the
> spot price and futures price not remaining constant
> throughout the life of the hedge, thus generating
> ineffectiveness.  At the onset of the hedging
> relationship, the optimal hedge ratio will take into
> account the current basis, as well as the difference
> in volatilities of and the correlation between the
> spot commodity and the futures contract.  In the case
> of the airline industry, they are always short jet
> fuel and must go long futures.
>
> To implement a dynamic hedging strategy, an airline
> needs to vary the hedging products over the oil price
> cycle.  When oil is at the low point in the cycle,
> receive-fixed swaps are used because the likelihood of
> further price declines is not considered as probable
> as price increases, and the swap contract allows the
> airline to lock in the relatively low price.  In the
> mid-range of the cycle, collars are used to lock in a
> specified range of prices, giving up potential savings
> from price depreciation while hedging against further
> increases.  When oil prices are at the top of the
> price cycle, caps are used to prevent losses from
> further appreaciation while allowing the company to
> take advantage of price decreases.  This sophisticated
> strategy requires a substantial amount of monitoring,
> but it has been rather successful for Southwest
> Airlines: their fuel costs are currently locked in at
> prices well below their competition.  Southwest
> prefers OTC derivatives to exchange traded futures
> because they are more customizable.  The ability to
> customize these contracts greatly facilitates the
> implementation of a dynamic hedging strategy.  This
> strategy is based on the presumption that the oil
> price cycle is a mean-reverting process, or that it
> moves in cycles rather than consistently in one
> direction.  Given this characteristic, it is possible
> to implement a hedging strategy that enables airlines
> to lock in prices at the low point in the cycle while
> capping prices at the high end to take advantage of
> eventual price declines.  To implement a dynamic
> hedging strategy, a firm needs to vary the products
> over the oil price cycle.  When oil is at the low
> point in the cycle, receive-fixed swaps are used
> because the likelihood of further price declines is
> not considered as probable as price increases, and the
> swap contract allows the airline to lock in the
> relatively low price.  In the mid-range of the cycle,
> collars are used to lock in a specified range of
> prices, giving up potential savings from price
> depreciation while hedging against further increases.
> When oil prices are at the top of the price cycle,
> caps are used to prevent losses from further
> appreciation while allowing the company to take
> advantage of price decreases.
>
> ACCOUNTING ISSUES ASSOCIATED WITH HEDGING
> Accounting for jet fuel hedges is an important issue
> for airline managers because poorly structured hedging
> strategies can adversely affect earnings statements.
> Some airline CEO's and managers are reluctant to enter
> into hedging agreements that they don't completely
> understand and accounting rules can sometimes make
> losses on hedging appear as a management failure when
> if fact, hedging makes sense for the airline.  It is
> essential that trades are structured and tested in a
> way that will enable the firm to receive the
> preferable accounting treatment, otherwise earnings
> volatility will be increased rather than decreased.
> Trading desks play a crucial role in ensuring that
> both the internal and external accountants have the
> information they need, so an intimate knowledge of the
> relevant accounting standards is necessary by all
> parties involved.
> Jet fuel consumers are short jet fuel and must
> purchase the commodity in the future as it is needed
> for consumption.  This type of hedging strategy is
> defined as a "cash flow hedge of a forcasted
> transaction" by the Statement of Financial Accounting
> Standards Number 133.  The accounting guidance for
> such a transaction specifies that the derivative must
> be marked-to-market on the balance sheet.  The
> offsetting journal entry, however, is not booked to
> earnings but rather to Other Comprehensive Income
> (OCI).  Entries to the OCI account are booked directly
> to Retained Earnings, bypassing the income statement.
> Then, when the forcasted transaction impacts the
> income statement, the amounts booked to OCI are
> "released" to the income statement, offsetting the
> earnings fluctuations from the price of jet fuel.  The
> net result is that the derivatives are carried at the
> market value on the balance sheet, but there is no
> volatility introduced to the income statement.
>
> The accounting rules have an important implication for
> hedging strategy.  If, for example, an airline
> forcasts that it will burn 100,000 gallons of jet fuel
> in a given month, hedges 100% of this usage, and then
> uses only 80,000 gallons, the portion of the
> derivative hedging the other 20,000 forcasted gallons
> must be released from OCI to the income statement
> immediately upon the determination that it is no
> longer probabable that the full 100,000 gallons will
> be used.  This will increase income statement
> volatility and also call into question the company's
> ability to forcast.  If the company repeatedly
> demonstrates an inability to forcast their usage and
> thus overhedges, that may be precluded from using cash
> flow hedging strategies in the future.  Therefore, it
> is a common practice for firms to hedge up to the
> level they are certain to use, and remain unhedged for
> any additional consumption.
>
> OIL COMPANY HEDGING OPERATIONS
> Airlines are naturally short on fuel while oil
> production companies are naturally long on crude oil.
> It is useful to monitor oil company hedging operations
> as a predictor of the direction oil prices are
> heading.  The largest companies in the oil industry do
> not hedge because they have several large projects
> spread over numerous time frames and simply choose to
> ride out the price cycle.  Smaller companies with less
> diverse production and less vertical integration often
> hedge their production to smooth out earnings swings.
> The latest run-up in crude oil prices was not as
> lucrative for some mid-level producers as one would
> think because many companies hedged their production
> at price levels far below the eventual high mark of
> $55 per barrel. This should encourage airlines in the
> short run because oil producers do not think the
> current prices will remain at their present level.
> The longer-term forcast is not as comforting. Oil
> price forcasting is a tricky and often an elusive
> pursuit, however, observing how oil companies have
> responded to the most recent upturn in prices should
> give airline managers some insight to how the
> suppliers of the second most expensive input to
> airline operations think the market will behave.
> While oil companies are currently enjoying substantial
> profits from the rise in crude oil prices, few have
> stepped up discovery budgets far beyond what was
> previously budgeted.  This would indicate that they
> think the current situation is temporary and prices
> will return to "normal" in the near future. The bulk
> of both large and small production companies have used
> the excess cash from earnings associated with high oil
> prices to pay down debt, buy back stock, and reward
> shareholders with increased dividends rather than step
> up exploration.  While this should encourage airline
> managers that fuel prices are falling, the longer-
> term outlook in the oil industry should be cause for
> alarm.
>
> The concept of  "peak oil", that is the eventual high
> point of worldwide oil production, has been discussed
> since Colonial Drake's first oil well.  A Shell Oil
> geologist and later professor emeritis of geology at
> Princeton University, L. King Hubbert, wrote a
> scientific paper in 1956 which was derided by his
> employer and peers and became known as "Hubberts
> Peak".  Hubbert theorized that oil production lags oil
> discovery by roughly forty years.  Since discovery
> peaked in the US in the thirties, he predicted that
> production would peak in the early 1970's. US domestic
> oil production did in fact peak in 1970.  His later
> prediction was that since world oil discovery peaked
> in the sixties, world oil production would peak
> shortly after the turn of the century.  While it is
> still too early to tell with certainty, there is much
> evidence to indicate that his second prediction is
> eerily accurate as well.  As production peaks, crude
> oil prices will rise with a constant demand.  With the
> rapid modernization of China, and to a lesser degree
> India, world oil demand is rising rapidly at the same
> time production capacity is falling.  The history of
> oil prices has been one of a fairly stable trend line
> with wild but short lived swings away from the mean.
> If Hubbert's Peak prediction holds true, we may see a
> shift away from the fundamental futures forcasting
> models and a substantial rise in the baseline price
> range for crude oil.  This should give pause to
> airline executives and further encourage them to adopt
> hedging operations to smooth fuel cost fluctuations
> and earnings swings.  A majority of oil industry
> analysts believe that there is a fundamental paradigm
> shift in oil price trends.  Where in the past,
> volatility was due primarily to geo-politics; future
> price swings will be more a function of geology.  This
> new paradigm can be seen by looking at the reserve
> life index (RLI) of global oil reserves, a
> simple-to-calculate metric: total reserves divided by
> total production.  Simply put, the higher the RLI, the
> greater the oil market's long-term growth potential.
> The current situation does not look encouraging.  In
> the past 30 years, RLI has dropped from 119 years in
> 1970 to 47 years in 2004.  This trend is not reversing
> but in fact seems to be accelerating with some
> estimates that RLI will only be 20 years by 2020.
> This has a very ominous meaning for airline
> executives.  Where in the past oil prices have been
> determined by short-term political and economic
> factors, future prices will be a result of market
> recognition of the structural imbalance between demand
> and supply.  Detractors from this theory will point to
> "un-discovered" oil fields as the weakness in the
> Hubbert's Peak argument but the oil industry's
> reluctance to substantially increase discovery efforts
> during a period of high oil prices should give little
> comfort.  Most of the large and medium sized oil
> companies have chosen growth through merger and
> acquisition rather than the drill bit.
>
> The rising world demand for crude oil with a flat or
> declining supply of the raw product will have serious
> impacts across a broad spectrum of industries but
> perhaps none more so than airlines.  While many
> industries can switch to other sources of energy and
> raw materials, there is no substitute for crude oil
> derived jet fuel and no alternative fuels are expected
> for decades.  Prudent airline managers would be wise
> to closely follow investment and performance of oil
> companies to guage what direction long-term jet fuel
> prices are heading.  While no amount of hedging will
> stop this long term trend, the volitility of oil
> prices will most likely increase with more aggressive
> market speculation by traders as the spector of
> increasing demand along with falling supply develops.
>
> CONCLUSIONS
>
> The small number of airlines that produced stable
> earnings in 2004, including Southwest Airline,
> aggressively hedged their fuel budget.  Those airlines
> that chose to "ride the market" for fuel or were
> prevented from hedging by weak cash positions or
> bankruptcy saw their potential for profit decimated by
> the sudden run-up in crude oil prices.  Unless
> passenger airlines are able to pass fuel cost
> increases on to consumers, something no airline has
> been successful at to date, smoothing fuel price
> fluctuations through hedging would appear to be the
> industry "best practice".  Making the case against
> hedging, one foreign airline CEO, Rod Eddington, the
> CEO of British Airways, commented: "a lot is said
> about hedging strategy, most of it is well wide of the
> mark.  I don't think any sensible airline believes
> that by hedging it saves on its fuel bills.  You just
> flatten out the bumps and remove the spikes.  When you
> hedge all you do is bet against the experts of the oil
> market and pay the middle man, so you can't save
> yourself any money long term.  You can run from high
> fuel prices briefly through hedging but you can't run
> for very long".  Perhaps so, but the "bumps and
> spikes" of the 2004 crude oil market has nearly ruined
> several air carriers in the United States. The point
> that Eddington misses and the bulk of the US based
> legacy carriers missed in 2004, is this: hedging may
> not save money, in fact it may cost money, but it
> allows you to stay on budget and avoid suprises. At
> least two may face liquidation in 2005.  Investor's
> have shown a preference and are willing to pay a
> premium to purchase shares in airlines and other
> industries that protect earnings through hedging.
> Airline executives testified before members of the US
> Congressional House Transportation and Infrasturcture
> subcommittee in June 2004, outlining the airline
> industry's struggle for survival and pleaded for more
> government bailouts.  They were flatly denied any help
> and were heavily critisized by subcomittee members for
> their handling of fuel costs and the failure to hedge.
> It does not appear than any more government help is
> forthcoming. Those airlines that chose not to hedge
> have paid a terrible price and some may not survive
> because of their error in judgement.
>
>
>
>
>
>
>
> References
> Air Transport Association of America, Inc., 2003,
> "Airlines in Crisis: The Perfect Economic Storm",
> www.airlines.org
>
> Air Transport Association of America, Inc., May 20,
> 2004, "Recent Trends in Crude Oil and the Strategic
> Petroleum Reserve", www.airlines.org
>
> Carter, Rogers, and Simkins, 2002, "Does Fuel Hedging
> Make Economic Sense? The Case of the US Airline
> Industry, Oklahoma State University
>
> DeMarzo, P. and D. Duffie. 1995 Corporate incentives
> for hedging and hedge accounting.  Review of Financial
> Studies 8:  743-772
>
> Ernst & Young, LLP, December, 2001; Financial
> Reporting Developments: Accounting for Derivative
> Instruments and Hedging Activities
>
> Financial Accounting Standards Board. 1998. Statement
> of Financial Accounting Standards No. 133, Accounting
> for Derivative Instruments and Hedging Activities.
>
> Gecy, C., B. Minton, and C. Schrand. 1997 Why firms
> use currency derivatives. The Journal Finance 52:
> 1323-1354
>
> Haigh, Michael S., and Matthew T. Holt, "Crack Spread
> Hedging: Accounting for Time-Varying Volatility
> Spillovers in the Energy Futures Markets," Journal of
> Applied Econometrics, 2002, 17, 269 289
>
> Heinberg, R., 2003, "The Party's Over: Oil, War and
> the Fate of Industrial Societies," New Society Press
>
> Herbert, John H., "Trading Volume, Maturity and
> Natural Gas Futures Price Volatility," Energy
> Economics, October 1995, 17,293 299
>
> Haushalter, G.D. 2000. Financing policy, basis risk,
> and corporate hedging: Evidence from oil and gas
> producers. The Journal of Finance
>
>
> Kiodex, Inc., October 2001, "The Effective Energy Risk
> Management Program - Design and Implementation,
> www.kiodex.com
>
> Kim, E.H., Singal, V., 1993 "Mergers and market power:
> Evidence from the airline industry," American Economic
> Review, 83,549-569
>
> Litzenberger, Robert H, and Nir Rabinoqitz,
> "Backwardation in Oil Futures Markets: Theory and
> Empirical Evidence," Journal of Finance, 1995, 50,
> 1517 1545
>
> Marshal, Adkins, November 22, 2004, "Why Are Oil
> Fundamentals Different This Time?," Equity Research,
> Raymond James & Associates
>
> Mian, S. 1996. Evidence on corporate hedging policy.
> Journal of Financial and Quantitive Analysis 31:
> 419-439
>
> Mahul, Oliver, 2002. "Hedging in Futures and Options
> Markets with Basis Risk", The Journal of Futures
> Markets, 22:1, 59-72
>
> Pindyck, Robert S., "Inventories and the Short-Run
> Dynamics of Commodity Prices," The RAND Journal of
> Economics, Spring 1994, 25, 141 159
>
> Pindyck, Robert S., "Volatility and Commodity Price
> Dynamics," The Journal of Futures Markets, 2002
>
> Pulvino, T.C., "Do asset fire sales exist? An
> empirical investigation of commercial aircraft
> transactions," Journal of Finance, 53, 939-978
>
> Rahgozar, Reza, 2002, "Application of Futures
> Contracts and Analyzes of Hedging Effectiveness in
> Managing Crude Oil Price Risk", Review of the Academy
> of Finance, 2, 96-107
>
> Smith, C. and R. Stulz 1985. The determinants of firms
> hedging policies. Journal of Financial and
> Quantitative Analysis 20: 391-405
>
> Southwest Airlines, July/August 2004, "Hedge Your
> Jets", The Southwest Wing,  www.swatakeoff.com
>
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