View From a Height

Hedging's Limits

The Wall Stree Journal reports this morning that airlines are getting hit extra-hard by rising oil prices:

With crude-oil prices soaring, refiners are taking advantage of tight supplies to fatten the margins that they earn from turning oil into jet fuel. And cash-strapped airlines are picking up the mounting tab.

The widening gaps between the price of crude oil and various types of fuel -- known in the industry as crack spreads -- are dealing a one-two punch to an industry that can ill afford it, where fuel is the second-biggest expense after labor. The average crack spread for jet fuel topped $11 per barrel in the first half of this year. That is up from an average $2.59 per barrel in 2002...

The bottom line: About one-fifth of the increase in jet fuel prices is coming from a widening crack spread, while the other four-fifths reflect higher oil prices.

...

Blame diesel cars in part for the widening crack spread. Jet fuel and diesel fuel have similar components, and soaring demand for diesel-powered vehicles, particularly in Europe, is pushing up prices for both fuels. Greater industrial demand for diesel in China also has played a role. Airline executives complain that refiners, which in the past decade came off a long period of weak profit margins, have been slow to add new refining capacity, which is contributing to the high prices.

...

A few carriers, including Southwest Airlines and America West Holdings' America West, have partially insulated themselves from higher prices with fuel hedges. The hedges, executed before prices surged, effectively locked in lower prices. But most airlines have little or no hedges in place, and now it is too late and costly to find attractive prices.

A couple of points. First, as I've mentioned before, when your second-largest operating expense is one of the most volatile, politically-sensitive commodities available for sale, you might think a little about hedging your risk.

I don't have much sympathy for airlines who let unions in on the Great Barbecue of their own finances, create long-term obligations that their highly-cyclical business model can't possibly meet, and then fail to consider that maybe, just maybe, the world isn't fated to have $10-a-barrel oil for the rest of our lives.

Apparently there's no liquid market (so to speak) directly in diesel, so the airline probably hedge with oil futures. MarkWest did a similar thing with natural gas, modeling the change in gas prices as oil moved. But if jet fuel moves more than the model predicts, the hedge won't give as much cover as anticipated. So even those airlines that hedged may have some problems.

That said, while it's too late for United and American to avoid $60-a-barrel oil, it's never too late to hedge. "Attractive prices" are always relative. Even if China's thirst really is slowing down (and the commodities section of the latest ISM report suggests that it is), and oil prices may not be headed up anytime soon, the risk to the airlines is on the upside.

The airlines need to hedge their risk anyway, possibly through futures options. If the options expire unused, they'll have to add that as a cost of doing business. But you'd think they'd have learned the lesson of not having them around when they need them.