Why Do Airlines Hedge Fuel Costs?
Most airlines in the U.S. today hedge fuel costs in a systematic fashion. Each quarter, they open new hedge positions in future quarters, with earlier periods tending to be more heavily hedged than periods further in the future.
If you asked airline executives why they hedge fuel, they would almost all say that since they sell most of their tickets several months in advance, they need to lock in some of their fuel costs in advance, too. However, most airlines hedge fuel one to two years out. Thus, they are hedging far beyond what is necessary to cover previously sold tickets. Most executives would probably claim that they do this in order to mitigate their risk, since it's difficult to pass fuel prices through to customers immediately.
This fuel-hedging strategy has questionable utility over the long term. Airlines that follow this practice are locking in some of their future fuel consumption each month, and so over time these companies' fuel costs are tied to the market price just as they would be if they did not hedge at all. The only difference is one of timing; hedging programs tend to smooth out the cost of fuel over time.
However, systematic hedging programs have very clear costs. Oil prices tend to be quite volatile, leading to high hedging premiums. Moreover, the relationship between oil prices and jet fuel is not constant, creating a risk that fuel hedges will be "ineffective". As a result, from a long-term investor's perspective, hedging fuel costs does not make very much sense. Over a typical economic cycle, hedging losses will tend to outweigh hedging gains.
Swimming against the tide
Alone among legacy carriers, US Airways abandoned its fuel-hedging program after the Great Recession. The company determined that the cost of hedging premiums was excessive.
Moreover, by locking in fuel prices through collars, swaps, forward price contracts, or similar hedging instruments, airlines lock in a minimum fuel price as well as a maximum price. In the event of a sudden economic shock -- something like the Great Recession -- the airline would face low demand, but fuel prices would be locked in at an above-market price by the hedges. In other words, hedges provide the least protection in the most dangerous economic environment.
The move away from fuel hedging has worked out well for US Airways -- despite the fact that oil prices have risen dramatically from 2009 to today. Since 2010, US Airways has paid a lower average fuel price compared to each of the four largest airlines in the country -- AMR , Delta Air Lines , Southwest Airlines , and United Continental -- all of which use fuel hedges extensively.
Airline yearly average fuel prices (2010-present):
In 2011, when fuel prices skyrocketed due to strong demand and fears about the Arab Spring, US Airways paid slightly more for fuel than most of its competitors. However, this has been balanced out by lower fuel bills in every other year, when competitors' hedge premiums went to waste.
Over the full period, US Airways has saved anywhere from $0.01 per gallon (compared to AMR), to $0.09 per gallon (compared to Southwest). In a declining fuel price environment, US Airways would have shown an even bigger advantage. Since the major airlines use billions of gallons of jet fuel each year, they are potentially losing tens or even hundreds of millions of dollars annually from hedging.
Back to square one
Over the past several years, US Airways has shown quite convincingly that the costs of fuel hedging outweigh the benefits. Even in a rising fuel price environment -- when hedging should offer the most benefits -- US Airways has still paid less than competitors for fuel, on average. So why do most of US Airways' competitors continue to hedge?
The real reason is most likely that executives want to increase the predictability of earnings. By hedging, airlines restrain their profit growth when fuel prices drop while mitigating the drag of fuel price increases. Airline executives look better to shareholders in the short-run if they can make earnings relatively predictable.
However, hedging costs are significant over time. For long-term investors, having a higher long-term earnings stream should be more important than artificially keeping earnings steady from year to year, as long as a company can maintain comfortable liquidity throughout the business cycle. (Major airlines tend to hold billions of dollars in cash, so this shouldn't be a major issue.) Unfortunately, only US Airways is really looking out for long-term investors' interests when it comes to fuel hedging.
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The article Why Do Airlines Hedge Fuel Costs? originally appeared on Fool.com.Adam Levine-Weinberg is short shares of United Continental Holdings and is long September 2013 $33 puts on United Continental Holdings. The Motley Fool recommends Southwest Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.