Fuel Hedging in the Airline Industry
Fuel Hedging in the Airline Industry: The Case of Southwest Airlines
By Dave Carter a, Dan Rogers b, and Betty Simkins c
a
College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-5104, Email: dcarter@okstate.edu b School of Business Administration, Portland State University, Portland, OR 97207-0751, Phone: (503) 725-3790, Email: danr@sba.pdx.edu c CONTACT AUTHOR: College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-8625, Fax: (405) 744-5180, Email: simkins@okstate.edu
Review copy for use of the Case Research Journal. Not for reproduction or distribution.
Fuel Hedging in the Airline Industry: The Case of Southwest Airlines
By Dave Carter, Dan Rogers, and Betty Simkins
“If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk.”
Scott Topping, Director of Corporate Finance for Southwest Airlines
June 12, 2001: Scott Topping, the Director of Corporate Finance for Southwest Airlines (hereafter referred to as “Southwest”), was concerned about the cost of fuel for Southwest. High jet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew that since the industry was deregulated in 1978, airline profitability and survival depended on controlling costs.1 After labor, jet fuel is the second largest operating expense for airlines. If airlines can control the cost of fuel, they can more accurately estimate budgets and forecast earnings. It was Scott’s job to hedge fuel costs, however, he knows that jet fuel prices are largely unpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overall upward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. On September 11, 2000, the Gulf Coast jet fuel spot price was 101.25 cents/gallon – a whopping increase of 255 % in the spot price since the low in 1998. The
By Dave Carter a, Dan Rogers b, and Betty Simkins c
a
College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-5104, Email: dcarter@okstate.edu b School of Business Administration, Portland State University, Portland, OR 97207-0751, Phone: (503) 725-3790, Email: danr@sba.pdx.edu c CONTACT AUTHOR: College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-8625, Fax: (405) 744-5180, Email: simkins@okstate.edu
Review copy for use of the Case Research Journal. Not for reproduction or distribution.
Fuel Hedging in the Airline Industry: The Case of Southwest Airlines
By Dave Carter, Dan Rogers, and Betty Simkins
“If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk.”
Scott Topping, Director of Corporate Finance for Southwest Airlines
June 12, 2001: Scott Topping, the Director of Corporate Finance for Southwest Airlines (hereafter referred to as “Southwest”), was concerned about the cost of fuel for Southwest. High jet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew that since the industry was deregulated in 1978, airline profitability and survival depended on controlling costs.1 After labor, jet fuel is the second largest operating expense for airlines. If airlines can control the cost of fuel, they can more accurately estimate budgets and forecast earnings. It was Scott’s job to hedge fuel costs, however, he knows that jet fuel prices are largely unpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overall upward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. On September 11, 2000, the Gulf Coast jet fuel spot price was 101.25 cents/gallon – a whopping increase of 255 % in the spot price since the low in 1998. The
References: Clubley, Sally, 1999, “An Early Take Off”, Risk (May), (see pg. 7 of Commodity Risk Special Report in the issue). Carter, David A., Dan Rogers, and Betty J. Simkins, 2004, “Does Fuel Hedging Make Economic Sense? The Case of the U.S. Airline Industry”, Oklahoma State University working paper. Energy Information Administration, 2002, Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries (October), U.S. Department of Energy. Falloon, William and David Turner, editors, 1999, Managing Energy Price Risk, Risk Publications (London). Kalotay, Andrew and Leslie Abreo, 2001, “Testing Hedge Effectiveness for FAS 133: The Volatility Reduction Measure”, Journal of Applied Corporate Finance Vol. 13 (No. 4), 93-99. McCartney, Scott, Daniel Michaels, and David Rogers, 2002, “Airlines Seek More Government Aid”, The Wall Street Journal, September 23, 2002, (pages A1, A10). Neidl, Raymond E. and Erik C. Chiprich, 2001, Major U.S. Carriers 2000 Results and 2001 Outlook, Global Research, Ing-Barings. Reuters, 2004, “Soaring Jet Fuel Prices Threaten Airlines’ Bottom Lines”, March 10. Schap, Keith, 1993, “Jet Fuel Swaps Ground Risk”, Futures (February), 44-46. Trottman, Melanie, 2004, “Outside Audit: Jet-Fuel Bets Are Risky Business”, Wall Street Journal, February 24, page C3. 12 Review copy for use of the Case Research Journal. Not for reproduction or distribution. Table 1 Fuel Usage and Hedging Data for Southwest Airlines Hedging variables Exposure variables Fiscal year ends 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec Fuel Hedge Used Fuel? (Million Fuel Cost Year Gallons) ($million) $ 2000 Yes 1022.2 804.4 $ 1999 Yes 939.1 495.0 $ 1998 Yes 850.3 388.3 $ 1997 Yes 792.4 495.0 $ 1996 Yes 740.3 484.7 $ 1995 Yes 662.2 365.7 $ 1994 Yes 592.6 319.6 Cost of Fuel ($ per gallon) $ 0.7869 $ 0.5271 $ 0.4567 $ 0.6246 $ 0.6547 $ 0.5522 $ 0.5392 Available Seat Miles (ASM) (millions) 59,910 52,855 47,544 44,487 40,727 36,180 32,124 $ $ $ $ $ $ $ Total Total Fuel as a Revenue Fuel Cost Expenses % of (% of ($ ($ Millions) Expenses Millions) Revenue) $ 4,628 $ 3,954 $ 3,480 $ 3,293 $ 3,055 $ 2,559 $ 2,275 10.5% 12.5% 11.2% 15.0% 15.9% 14.3% 14.0% $ 5,649 $ 4,736 $ 4,164 $ 3,817 $ 3,406 $ 2,873 $ 2,592 8.6% 10.5% 9.3% 13.0% 14.2% 12.7% 12.3% Longest % of Maturity Gallons Next of Hedged Year Hedges (millions) Hedged (yrs) N/A 126.10 290.00 not material not material 1.05 2.10 80.00% 86.00% 33.00% not material not material 2.00% 5.00% 3.00 >1 0.50 N/A N/A