How does Hedging Jet Fuel Prices help U.S. Airlines Survive in Times of Oil Price Volatility - Coursework Example

Topic: How does Hedging Jet Fuel Prices help U.S. Airlines Survive in Times of Oil Price Volatility? Samuel Widjaja (0545267) FI 314 Dave Kurrasch Introduction: In recent years, quite a lot of hype has been created over Southwest Airline’s dramatic hedging policies and its dramatic improvement in profits in the face of an industry-wide crisis. As jet fuel costs make up almost 14% (Carter, D. A., Rogers, D. A., and Simkins, B. J., 2006) of the total operating costs to airlines in the U.S. and as much as 40% to airlines abroad, the rapid increase in crude oil prices has led to many airlines over the world shutting down. With the backdrop of this scenario and of countless other crises faced by the airline industry in recent years including the labor issues of the 9/11 aftermath, Southwest has managed to maintain 34 years of consecutive profits. The dramatic figures produced by Southwest have attracted the attention of many analysts as well as people from other industries who take lessons from Southwest’s success. Even the government, in recent years, has been planning to hedge for oil prices for its defense department in order to smooth its budget and improve cash management in its departments (Spinetta, L., 2006). What is hedging? Hedging is a contract between two parties to buy or sell a commodity at a specific price and quantity in the future. Companies make investments to reduce the risk of adverse price movements. Hedging is used in the purchase of nearly all commodities including food products and metals but it has been most successful in the case of crude oil. Oil price hedging can also be defined as ‘investments that increase in value as oil prices go up’ (Bond, D., May 2005). Generally, there are four types of hedging instruments: forward contract, futures contact, swap contract and option contracts. The most common instruments used by airlines in hedging are swaps, futures, call options, average price options, and collars (Spinetta, L., 2006). Such contracts allow the company to fix the price at which a commodity can be bought in the future and protect itself against unforeseen events that might cause erratic movements in the commodity price. Hedging allows for more accurate planning and budgeting. ‘Policymakers would know the true cost of their budget decisions because stabilized prices would match actual cost,’ says Lawrence Spinetta (2006). Hedging also improves a company’s cash flows by ensuring that ‘necessary funds are available to meet broader corporate objectives.’ Therefore, it can partly or completely smooth out the fluctuations in cash flows caused by price changes, which might actually require funding from outside sources. Therefore, hedging reduces the financing needs of a company. Hedging even leads to a reduction in taxes. An external view of hedging would lead to the conclusion that hedging would actually lead to higher taxes as it increases the profitability of a firm. However, according to Stulz (1996), hedging leads to a reduction in the volatility of reported income and the progressivity of most of the world’s tax codes. ‘By reducing fluctuations in taxable income, risk management can lead to lower tax payments by ensuring that, over a complete business cycle, the largest possible proportion of corporate income falls within this optimal range of tax rates,’ claims Stulz (1996). As Stulz (1996) explains, smart risk management practices can be used to alter both a company’s capital structure and its ownership structure. ‘By reducing the probability of financial trouble, (hedging) has the potential both to increase debt capacity and to facilitate larger equity stakes for management’ (Stulz, R. M., 1996). In that it also makes a company overall stable and allows it to concentrate on other more important factors like improving labor relations and customer service. Oil price fluctuations will not interfere with other activities of the organization. There are conflicting views on whether hedging can lead to increased firm value or not. Jin and Jorion have proven through their research into some oil and gas producing companies that hedging does not, indeed, lead to increased firm value. They claim that hedging often stems from the management’s incentives to improve their ‘personal utility functions’ and that it contributes nothing to what investors view as the true worth of the firm. In addition, they say that hedging indicates to outside parties how competitive the managers really are. In any case, it does not affect the investor’s opinions. However, they do quote an empirical research that found that ‘MV of firms using foreign currency derivatives is 5% higher on average than for nonusers’ (Jin, Y., and Jorion, P., Apr 2006). This shows a paradox in their study. A possible reason why they found hedging to not be positively correlated with firm value is that Jin and Jorion researched oil and gas producers whose income was dependant on the volatile prices of fuel. As prices of fuel were going up anyway, hedging stabilized firm value but did not lead to an increase in it. On the other hand, Carter, Rogers and Simkins (2006) found that changes in hedging are positively correlated with changes in firm value. They used the example of the airline industry to prove their hypothesis, which is actually the most prominent success story of the hedging theory. Hedging has managed to stabilize the income of airline companies and to protect them against potential loss from sporadic and unpredictable changes in oil prices. The study claims that a one standard deviation change in jet fuel price represents approximately a 25% change from the mean price – which can be translated into significant movement in the stock prices. It claims that for the airline industry on average, a one standard deviation movement in jet fuel price results in a 2.75% change (monthly) in stock prices. Carter, Rogers and Simkins (2006) have also measured the sensitivity of the cash flows to price risk. By hedging just 24% of their next year’s fuel requirement, firms can generate cash flows amounting to 21.7% of capital expenditures in the event of an extreme price move. Hedging has led to massive savings in costs for companies in the airline industry who have been prompt in foreseeing oil price changes and adopting the policy, but it is expensive. It requires cash up-front – in 2005, it was reported that Southwest’s investment in hedging contracts represented 26.5% of what would otherwise have been Southwests liquid assets (Bond, D., 2007). In addition, the company must pay margins and fees to the commodity clearing house. Herbst (2008) explains how this works: ‘To purchase options, investors need to pay a commodities clearing house a margin of about 10%. For example, a contract for 1,000 barrels of crude oil at $123 per barrel would be worth $123,000. To hedge at that price, the investor would need to pay about $12,300 and ultimately be prepared to pay the balance. Generally speaking, an option written one year ago, in a $65-per-barrel environment, was roughly half the cost of an equivalent option placed today.’ Besides this, investors must also pay a transaction cost for each hedge, called a ‘bid-ask spread’. All these costs have to be paid at the time of the contract and require the company to have cash up-front. This is the reason why many airlines have been unable to reap the benefits of hedging. As they already face very high energy prices and billions of dollars worth of debt, they do not have money left to invest in the future. (Herbst, M., 2008). Hedging can also mean losses at times when the prices may decline. The classic cases of unsuccessful hedging are Metallgesellschaft in 1993 and Diamler-Benz in 1995. The inability to predict oil prices and exchange rates at any cost for sure led to the downfall of these two companies (Stulz, R. M., 1996). Such mistakes have even been seen in the airline industry and have lead to airlines being stuck in long and hefty debts. In October 2006, it was reported that ‘Alaska Air Group recorded a third-quarter loss of $17.4 million, partly due to losses tied to fuel-hedging contracts. Similarly, U.S Airways got dipped for $88 million when it was forced to take a charge in order to reduce the book value of some outstanding fuel hedging contracts.’ This reminds us that no matter how unpredictable the future prices might be, investment in the future is still a ‘gamble’. (Calabro, L., Dec 2006). Not only do these bankruptcies lead to high legal costs but also cause a decline in investor confidence, eventually leading to an actual decline in the market value of the firm. Risk management is an important function of financial advisors within a company. A smart strategy on part of financial advisors in a company facing risks would be to hedge incidental risks – risks that are beyond the control of the organization – and to retain core risks – risks that can be influenced by the organization. The price of oil is most definitely an incidental risk, as it is influenced by world events that one company has no control over and recent events have shown companies and governments that hedging against oil can be very fruitful. (Spinetta, L., 2006). Basically, the goal of a company’s risk management department should be the elimination of costly lower-tail outcomes, to ‘reduce the expected costs of financial trouble while preserving a company’s ability to exploit any comparative advantage in risk-bearing it may have’ (Stulz, R. M., 1996). The Airline Industry – Structure of the Industry and Challenges Faced: Airline industry in the United States has an oligopolistic structure – with the United Air Lines Inc., American, Northwest, Continental Air Lines Inc., Delta and US Airways Group Inc. referred to as the ‘big six’ legacy carriers. IBISWorld (2008) reveals that the top four industry players in this industry hold a combined market share of around 55.5% in 2008. There are other airlines including AirTran Airways (Air Tran), Alaska Airlines (Alaska), ATA Airlines, Frontier Airlines, JetBlue Airways (JetBlue), Southwest Airlines (Southwest), Virgin America Airlines and their affiliated regional carriers, some of whom are giving the legacy carriers a tough time. In fact, according to the Form 10-K of Delta Airlines (2008), ‘the growth of low-cost carriers, including Southwest, AirTran and JetBlue, in the U.S. has placed significant competitive pressure on (Delta) and other network carriers in the domestic market’. Airline industry analysts agree that there is need for consolidation in this industry. There are too many airlines in the industry and too few carriers to cater to a limited number of routes. For an industry that can enjoy the benefits of strategic and technological economies of scale, such a fragmented industry structure is not at all a healthy sign. However, the complications involved in the consolidation process as well as the interests of several big fish in merger deals have prevented takeover deals from making any significant progress. The local competition is stifling enough but now the U.S. airlines will have to face competition from international competitors as well. The free trade fad has crept into the airline industry as well and the ‘US domestic airlines will have to manage the start of the open skies US-European Union agreement that promises to bring in international competitors’(O’Leary, C., 2007). This will mean the end of the limited protection that the local airlines had and will have to compete with foreign airlines on their level on service quality and prices. This will also mean that the local firms will have to improve their standards as well as their price competitiveness in order to maintain its current clientele. If they fail to maintain the standards, the European airlines – some of which like SWISS, Air France and Lufthansa are often voted as the best airlines in the world (SkyTrax, 2007) – could take over their market share in the U.S. The impact of international competition on the local industry is yet to be seen but the domestic industry itself in no way presents a level-playing ground. There are high barriers to entry in the industry, including financial, technological and legal barriers. Investments in aircraft, plant, technology, labor and equipment is the major barrier to entry (IBISWorld, 2006), as the aircraft technology is very expensive. At times, however, aircrafts can be leased, but this affects the value of the assets that the firm can show on its balance sheet. Moreover, the longer a company has been in the industry, the more economies of scale they will experience. ‘Having a network alliance, a wide network of industry contacts, a proven safety record and the evidenced ability to deliver projects on time and on budget are essential,’ says the IBISWorld report of 2008. These time-based economies are not available to new entrants and may present an unfair competitive situation for them. Regulations and government interference are other major barriers to entry. Some airlines are on maintenance holidays while others are subsidized. Though the industry was completely deregulated in 1978, the strategic importance of this industry as part of the transport sector makes it impossible for government interference to be completely non-existent. Environmental, security, safety and health regulations are all strictly enforced on all airlines. Their customer service practices are also closely monitored by the government. Besides that, the airlines have to adhere to the basic business practice laws to remain in business. The airline is free to operate its flights between any two points in the United States, provided it earns its approval from the Department of Transportation (DOT). Other restrictions on the industry’s members are laid out well in the Form 10-K of Southwest Airlines held by the SEC: ‘Airlines are permitted to establish their own domestic fares without governmental regulation. The DOT maintains authority over certain international fares, rates and charges, but applies this authority on a limited basis.  In addition, international fares and rates are sometimes subject to the jurisdiction of the governments of the foreign countries which the Company serves.  While air carriers are required to file and adhere to international fare and rate tariffs, substantial commissions, fare overrides and discounts to travel agents, brokers and wholesalers characterize many international markets.’ (Form 10-K Southwest, SEC, 2008). Technology is a rapidly changing factor in the industry. The dynamics of air travel have made the technology of the old aircrafts obsolete. Airlines are unable to keep up with the fast pace of technology change and are stuck with outdated on their hands that are costly to run. ‘Northwests fleet is estimated to have an average age of 20 years, and Deltas fleet is on average more than a decade old — which means they run a host of fuel-guzzling planes that also require costly, regular maintenance.’ (O’Leary, C., 2007). Therefore, these old planes are not only outdated and unreliable but they also eat up more fuel than the new, advanced carriers. Labor issues have touched this industry as much as any other in the United States. The airlines face a conundrum – according to O’Leary (2007), ‘the better their financial outlook, the more labor is going to fight for increased benefits and wage hikes when its time for contract negotiations’. Firms have to be careful and must link the labor rewards to company profits. Labor is not a barrier to entry in this market, as labor is very transient. The nature of the industry encourages movement between companies. The industry is labor-intensive and labor is quite expensive in the industry with labor costs making up as much as 35% of the total operating costs (Form 10-K Southwest, SEC, 2008). According to IBISWorld (2008), ‘expenditure on wages account for a larger proportion of revenue than does capital, with a typical firm in the industry using approximately 3.4 units of labor for each unit of capital’. Labor arrangements are inflexible as the employees have to have a strict pre-determined schedule. Unionization is common in the industry and about 17% of the labor force is unionized (Form 10-K Delta Airlines, SEC, 2008). This makes it difficult for the firms to maintain the good relations with their employees that are essential to the success of their businesses. Fuel prices make up the major chunk of the operating costs of the airline companies. The volatility of crude oil prices the world over has had adverse effects on the profitability of airlines. It was reported in 2004 that for every $1 increase in fuel, the airlines face an additional cost of $425 million. An analysis of the fuel cost information in the Form 10-K of Delta Airlines (2008) shows that it has suffered an extra cost over the year 2005 of around $897 million because of the increase in fuel costs in the year 2007. Local and world economic events have always had drastic consequences for the airlines. The consumer spending in this particular industry is tightly linked with the domestic GDP. The industry is ‘always at the mercy of external events like economic downturns, and the threat of an economic slowdown has becomes more pronounced amid the US housing industrys woes, which have already eaten away at consumer confidence and spending’ (O’Leary, C., 2007). Consumers lost confidence in air travel following the incidence of 9/11 and this severely affected the profits of airlines. Fortunately, this decline in air travel was only temporary and passengers soon got over their fear of air transportation. The level of international trade also impacts the level of international freight carriage. In addition, foreign exchange rates affect the income of airlines which are operating internationally, as they are receiving payments from customers abroad. Therefore, the international airlines are affected by the change in the world GDP and income levels in other countries as well. Furthermore, terrorist events and unforeseen political issues severely affect the industry. Most airlines are running a high leverage, which makes them volatile to interest rate changes. This has also been one of the major obstacles to mergers and takeovers in the airline industry. The cost of money is going up and this means that ‘while an airline may successfully woo a rival (into a consolidation deal), financing the purchase has become tougher and borrowing the money has become more costly. "The fact is that credit market tightness is going to make it difficult for any big financings to get done," Bill Warlick (an industry analyst) says.’ (O’Leary, C., 2007). However, the airlines have one advantage over other companies – they can secure their fleet against loans which means that they can avail credit much more easily than companies in other industries. This indicates the sheer value of the assets of an airline. However, since most assets are leased nowadays, it is not possible to obtain loans against them. An analysis of Delta Airlines financial information shows that nearly 38% of its aircrafts are leased (Form 10-K Delta Airlines, SEC, 2008). Even so, the interest rates are not as volatile as jet fuel prices, which remain the major concern for airlines. Airlines face a severe crisis in the face of international competition, worldwide depression, increasing wages, rising cost of money and changing technology. These factors have made the U.S. airlines uncompetitive and unprofitable but none of these factors is as pronounced a threat as the worldwide energy crisis that has potential to make the airlines lose all their profits. Unfortunately, it appears that the oil prices will continue to hike and the airlines will have a major dilemma on their hands. How does Hedging Jet Fuel Prices help U.S. Airlines Survive in times of Oil Price Volatility? According to Carter, Rogers and Simkins (2006), the jet fuel price volatility is approximately 27% (averaged over the period 1992-2003). The world crude oil prices information obtained from Energy Information Administration shows that the price of oil increased by almost 13% in a mere period of 4 weeks (between the months of June and July). Carter, Rogers and Simkins (2006) also explain that jet fuel prices can make up as much as nearly 19% of the total operating costs of an airline, while the Form 10-K report of Southwest Airlines (2008) shows that fuel costs have made up almost 28% of the operating expenses of the company at the prices of 2007. This can lead to significant losses in case the risk is not foreseen and managed properly. It was reported that ‘the six largest U.S. network carriers posted a $4.7-billion operating loss for the 12 months ended September 2005’ (Lott, S. and Taylor, A., 2006), owing to the dramatic increases in oil prices. If airlines can obtain fuel at an average cost of $60 per barrel instead of the regular market rate of $120 per barrel, as occurred with Southwest, this will lead to significant reductions in operating cost for an airline. As shall be seen, Southwest encountered significant savings in its operating costs over the period in which it had obtained lower jet fuel prices for its aircrafts. Airlines have had major cash flow issues as well in recent years. The unpredictability of the economic environment has made airlines very cautious and following the aftermath of September 11, airlines started conserving cash for a rainy day. Unfortunately, paying for the costly jet fuel ate into much of their funds and they were back to being broke and in debt. David Bond (2007) reports that four of the six network carriers went through reorganizations in bankruptcy protection following the 9/11 events. If firms had been able to foresee the oil price surges, they would have invested in the future rather than conserving the cash and would have saved greatly. Furthermore, they would have been able to predict their cash flows and plan strategically as a result. Cash flow has also been a major barrier to takeovers. Oil price surges may actually allow the consolidation deals because airlines that are on the brink of bankruptcy will have to sell their assets in order to improve their cash flow position and cope with the increased operating expenses. Stronger firms who have managed to hedge their oil price risks will be able to acquire these assets. Analysts hope that the critical position of several airlines will actually speed up merger deals between airlines. A merger deal between Delta Airlines and Jetblue Airlines seems to be on the verge of succeeding. Though firms need to be financially sound in order to hedge, hedging pays back in the long run – especially if firms hedge a huge chunk of their costs such as jet fuel for airlines. The example of Southwest Airlines will clarify this situation as Southwest has been the most aggressive risk managing company in this industry and has reaped the benefits of its approach. Southwest’s Proactive Approach: Southwest has secured itself against the hefty oil price increases, and has managed to hedge as much as 80% of its next year’s fuel requirements (D. A. Carter, D. A. Rogers and B. J. Simkins, 2006). According to Moira Herbst (Business Week Online, May 2008), 70% of its fuel needs are hedged at $51 a barrel for the year 2008. This means that ‘while competitors have to contend with spot prices hovering around $120 a barrel, Southwest can buy oil at less than half that.’ Such timely action by the company has made it the most competitive airline in the United States. For 2009, the company is ‘covered about 55% at $51 a barrel; for 2010, 30% at $53 per barrel; and for 2011 and 2012, at more than 15% at $64 and $63 per barrel, respectively.’ As hedging for oil requires massive funds and idle cash, Southwest is one of the few airlines which can do that. Even then, they can only hedge oil for a few years, depending on their current cash availability. Southwest is a rather traditional company with a conservative corporate culture but it has secured a market share of 12.2% for itself (IBISWorld, 2006). Their concentration has been on cutting costs and maintaining the confidence of their employees. They managed to go without lay-offs in the 9/11 aftermath and foreseeing future oil price surges, invested in future jet fuel in 2001. At the time Southwest adopted this policy, there was severe criticism against what they called ‘financial madness’ (Churchill, D., Mar 2006). But time has shown that hedging has borne great fruits for Southwest while its competitors have been struggling just to break-even. The third-quarter results of 2005 for the airline companies showed that Southwest had topped once again in its profits. While Continental turned in a profit of $61 million to make up for its losses during the past year, Southwest turned in a profit four times its profit the previous year during the same time - $227 million. (Bond, D., Oct 2005). Other evidence has come forth since then as to the advantages enjoyed by Southwest due to its hedging policies: ‘During the four years between Apr. 1, 2003, and Mar. 31, 2007, Southwest reported a total of $2.8 billion in operating profits. Of this amount, $2.2 billion came from gains in fuel hedging. The rest, about $600 million, came from operating the airline. In effect, 78% of Southwests operating profit during this period resulted from activities that had nothing to do with running an airline business. In six of the 16 fiscal quarters since April 2003, Southwest would have reported operating losses if it werent for hedging. Three of these quarters were in 2005, when Southwest turned in an $819-million operating profit for the full year. Without hedging gains, Southwest would have recorded an $85-million full-year operating loss. During the 16 quarters, hedging accounted for more than half of Southwests operating profit 12 times. The most recent period in which airline operations brought in more than hedging was the second quarter of 2004. In the third quarter of 2005, when Southwests hedging gains hit their peak at $295 million, the six big U.S. network airlines combined for a $165-million operating loss. Apart from hedging, Southwests operations during that quarter were $22 million in the red.’ (Bond, D., May 2007). Southwest estimated that hedging improved its quarterly results by $295 million for the third quarter of 2005, which is 8% more than its operating profit (besides hedging). The company’s hedging benefits may wear off, but only gradually: ‘Southwest is about 85% hedged for its estimated fourth-quarter fuel consumption with crude oil capped at $26 per barrel; more than 70% for full-year 2006 at $36; more than 55% for 2007 at $37; about 35% for 2008 at $37, and about 30% for 2009 at $39. Hedging "has bought us five years to be prepared" for the new world of high fuel costs, says CEO Gary Kelly.’ (Bond, D., Oct 2005). On the other hand, other airlines have resorted to creeping increases in the prices of airline tickets, and disciplinary actions within their organizations to reorganize their companies in order to remain competitive. American Airlines cut its domestic flights by 3% and increase its international flights by 7% during the year 2006. It hopes to cut costs through reorganization, while it is hedged very less (around 4% for the next year) against oil price increases. They are also exploring options to reduce the consumption of fuel by carriers. For instance, Southwest and Continental are fitting a large number of planes with "winglets," fin-like structures that reduce fuel consumption by as much as 5%’ (O’Leary, C., 2007). Southwest’s success with hedging lies with its perfect timing. It also lies in its availability of cash and its management’s skills in investing its funds in the right place at the right time. The company executives foresaw the rise in prices and managed to secure contracts that ensured that the company would not face the huge increases in costs that its competitors would face. However, their ability to hedge is limited by the availability of funds and the firm will soon be paying $120 for oil that its rivals are paying. Conclusion: The important thing is, however, that Southwest used its management’s expertise and skills to remain competitive at a time when the entire industry was in a severe crisis. The example of Southwest shows us that hedging can bring great benefits for those who use the tool sensibly and with skill. The important thing is to be able to predict the future and since no one can do that with precision, hedging remains a gamble. It is up to the company’s management to decide whether it is worth the risk to invest in the future. 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