Energy: Hedging Their Costs

A few years ago, before the Iraq war, even before 9/11, Southwest's analysts looked at fuel prices and saw all arrows pointing north. Guided by then chief financial officer Gary Kelly, the airline assembled a strategy to gird against potentially calamitous surges in oil prices. Two full-time oil specialists at Southwest's Dallas headquarters spent most of their time just watching oil markets and crunching numbers. By the time financial disaster struck the industry, Southwest had signed contracts guaranteeing the airline a certain price for fuel in the future, no matter how high the market climbs.

It's no coincidence that Kelly is now Southwest's CEO. While oil prices are currently bobbing around $55 per bbl., this year Southwest is paying just $26 per bbl. for 85% of its oil, thanks to the aggressive hedging strategy he put in place several years ago. The industry overall lost about $4 billion as a result of higher oil prices last year; in contrast, Southwest's hedging reduced its energy costs by $455 million, helping bump its 2004 earnings to $313 million. According to Vaughn Cordle of Airline Forecasts, oil would have to shoot past an average of $65.30 per bbl. this year to affect Southwest's bottom line--not a likely scenario. "You have to have foresight, wisdom and some courage to hedge," says Tammy Romo, Southwest's treasurer.

In this age of soaring oil prices, hedging has become a crucial part of business for the most successful airlines--the smaller, upstart carriers that aren't burdened by the legacy costs of the old majors. Since energy is usually an airline's second highest cost (after labor), any tweaks in fuel costs or use can turn into big savings. All the major airlines have hedged fuel prices since the 1980s, but as the major carriers have run into financial difficulties in recent years, they have no longer had the cash--or the creditworthiness--to play the oil-futures market. Last year Delta held positions but was forced to sell them in a short-term cash crunch. Those hedges would have protected about a third of its fuel needs. Continental has no hedges in oil-futures contracts this year. United Airlines, which filed for bankruptcy protection in December 2002, has 30% of its fuel hedged at $45 per bbl.

The major airlines aren't commenting on why they don't have more aggressive hedging positions--or any positions at all in some cases. But there is no question that higher energy prices are crippling the industry, which will spend $6.8 billion more on jet fuel this year than last year's $21.4 billion. Since 2001, prices have increased 91%. "Without the doubling of oil prices over the last three years, the industry would not be in the economic crisis we find ourselves," Air Transport Association president James May told Congress last month. "And the future doesn't look any brighter."