Southwest Airlines Flies to $14 Unless Hedging Losses Eat Profits

Southwest Airlines (NYSE:LUV) was the largest domestic carrier by total passengers in 2010, but in the airline industry its best known for being consistently profitable over the last 38 years – a feat unmatched in the commercial aviation history. While its point to point service and low-cost, low-fare contributed to the company’s past success, its intensive fuel hedging programs is also largely responsible for these past profits. In fact hedging alone saved Southwest Airlines over $3.5 billion and made up almost 83% of the company’s total profits between 1998-2008. ^{[1] [2]} Given this success why aren’t other competing airlines like Delta Airlines (NYSE:DAL) and American Airlines (NYSE:AMR) more aggressively pursuing hedging programs? We highlight the risks of depending too heavily on hedging programs below.

We have a $14 price estimate for Southwest Airlines, which is around 30% ahead of the market price.

How does hedging fuel prices work?

Hedging is basically a way of locking in a price range for the airlines’ future fuel needs through options, futures and forward contracts and works as insurance against unexpected swings in crude oil prices. If the price of the fuel rises beyond the contractually agreed-upon price, the airline reaps the benefits. If however, the price declines or stays below what the airlines hedged to buy it at, at the time of the contract’s expiry, the airline ends up paying a higher price than the market.

Hedging merely allows an airline to estimate with some certainty the actual fuel cost, which makes up almost a third of the overall operating expenses for most airlines. This predictability on a significant portion of total costs could help an airline better plan the remaining operating costs such as employee compensation, fleet size and new routes… but it comes at a price.

Since the fuel prices have been very volatile in the recent past fluctuating between over $140 in mid 2008 to less than $40 in the same year, it costs much more to hedge now and can cost as much as 10% more than the market price since volatility makes option pricing more expensive. Even at current crude prices hovering at around $90 per barrel, it costs anywhere between $6 and $8 to hedge a barrel of fuel. ^[3] This would require fuel prices to rise exceptionally for the hedges to bear meaningful returns.

The case of Southwest Airlines

While hedging seems to have broadly worked in Southwest Airlines’ favor, it by no means guarantees that this will work in the future as well. Southwest has incurred considerable losses on account of hedging in the past.

For instance, the company hedged over 70% of its fuel requirements in 2008 at $51 per barrel when the price had shot up to over $125 by mid 2008. However, amid rising fuel costs Southwest continued hedging at higher prices throughout 2008. With the result, in the fourth quarter of the same year, Southwest Airlines reported hedging losses to the tune of $117 million when the fuel prices crashed to levels below what the airline had effectively paid for fuel.

So in general it seems that hedging works best as fuel prices rise steadily. However, since fuel prices have been falling lately and quite volatile, could a lingering hedging loss again surprise investors?

See our full analysis of Southwest Airlines

1. Can fuel hedges keep Southwest in the money?, USA Today, July 24’ 2008 [↩]
2. Airlines hedge against soaring fuel costs, MSN, June 30’ 2008 [↩]
3. Should carriers rethink fuel hedges?, philly.com, February 06’ 2011 [↩]