Tuesday, September 06, 2005

Katrina and the Airlines

Mark Tatge and Phyllis Berman pose the question, "Will Katrina Ground Airlines for Good?" in last week's article in Forbes. They argue that Delta is likely to be hit twice--by rising fuel costs and by its dependence on traffic in the affected areas. They judge Northwest to be near the brink, too. The second paragraph below tells us almost everything we need to know about the industry:

Now, the situation is at a breaking point. Not just for Delta, but for the entire industry. Katrina should reduce total refining output by 43 million barrels over the next two months, according to Lehman Brothers. That translates to about a 10% to 15% reduction in the supply of jet fuel. Oil prices, despite falling back slightly in the past day, are expected to stay above $70 per barrel until at least the end of the year.

Both Delta and Northwest have no hedges against exposure to rising fuel prices. AMR's American Airlines and Continental Airlines, although in better financial shape, have no hedges in place either. The only airline with significant hedging is Southwest Airlines, which holds hedges for 65% of its 2006 fuel needs--most of it at $32 per barrel, according to Lehman Brothers.

Checking the stock ticker, Southwest has a market capitalization of $10.9 billion. American is at $2 billion, and the total of Continental, Delta, Northwest, and United is no more than $1.5 billion. Given the thrust of the article, these relative magnitudes should come as little surprise.

10 comments:

Anonymous said...

All these "Katrina and" things sound like bad band names.

Anonymous said...

http://tinyurl.com/7sj7t

Jack Miller said...

The total revenues of AMR, CAL, NWAC, and the others dwarf the revenues of LUV. The hedges may prove to be nothing but added cost. Traffic is up, while costs are down. A deal with the unions and moderating fuel prices may turn big losses into big profits.

Anonymous said...

Insurance is an option. You exercise it when you need it. Big risks that can knock you out of business and that have a pretty decent chance of happening should be hedged.

Why wouldn't an airline have some sort of hedge for oil? Southwest was not "lucky". They were doing what was reasonable. Big carriers were basically negligent and incompetent. If you pay for insurance and never need it, consider yourself fortunate and blessed.

Lots of companies have interest rate swaps to manage interest rate risk. Should this practice be eliminated because shareholders can diversify away interest rate risk?

I've heard the shareholder argument about diversifying away risk and not needing managers to purchase insurance. Anecdotally I hear this from traders and from very young and green finance professors with no signficant work experience.

I've also heard extremely successful business people turned elder professors say "self insurance= no insurance"

See the theory of the fat tails-

Anonymous said...

I am not 100% certain that Southwest is the only airline that has used fuel hedges. I will do more digging later-

http://uk.biz.yahoo.com/050818/323/fpzji.html

Insurance is cheaper if you (eg, Southwest) buy it when you don't have a pre-existing condition-

Anonymous said...

one more:

If Southwest got in financial trouble, the govt would let them go under and they would not get bailed out by the govt. This is because of Southwest's size and the nature of SW's operation (serves smaller, underserved airports and tends to have more non-business-class and lower income people on the plane).

Big airlines expected a bail out. They had no incentive to avoid disaster so they did not.

What we have seen has been logical given the incentives provided by govt.

Anonymous said...

i am not sure i said "wrong". to tell you the truth, i am somewhat confused on this. maybe Prof Samwick can point us in some direction.

if you are a good driver, you may purchase insurance with a higher deductible and take the savings in premiums billed from lower deductible and invest it in an index fund.

i also think for some people who buy health insurance, it may make sense to get buy with a policy with a very high deductible and pay for small stuff out-of-pocket.

why it might be wrong? carry it to an extreme. what if no publicly traded corporations bought any insurance of any kind because investors can diversify it away and the company can self-insure? would this be a good thing? dunno.

insurance companies have lots of money set aside to provide stability in emergencies. there are externalities to stability, and people (society) may be willing to invest more given stability. insurance companies also have econ of scale and efficiency from specialization in dealing with certain types of emergencies. corporations benefit when they pool and allow this econ of scale and efficiency to develop at insurance companies (eg, car claim centers).

there are ways to hedge oil that do not include futures. some of this might be swaps based on some notional amount. people could get creative.

in derivatives, counterparty risk is a big thing. no one wants to be a counterparty to a weak party.

Anonymous said...

katrina may have been good for airlines (assuming no more shocks in near future).

the govt relaxed a bunch of regulations. the world is tapping reserves. oil prices (per barrel in US) have come down.

Andrew said...

Jack: To measure size by revenue, without considering that when the non-Southwest carriers earn that revenue, they incur even more costs, is to miss the point. Why put planes in the air if doing so doesn't earn profits? I hope you are right that the so-called major airlines will get their act together, but it's hard to be optimistic. On the ed/Anonymous discussion about why firms hedge, I'll post more in a bit.

Anonymous said...

"I believe oil futures prices are the same for everybody. (On the other hand, if you need to borrow to buy the futures, this may cost more for some than for others.)"

The *initial* cost of entering into a futures contract is zero for most futures. Of course, down the road, the contract might produce positive or negative cashflows, so some amount of margin is typically required by the broker. However, the margin is very small in case of futures contracts.

Southwest did not purchase insurance against rising oil prices. An option would do that. A futures contract exposes the holder to price movements in both directions. Had oil sank to 16 (from the future-specified price of 32), Southwest would effectively be buying oil at 32, when everybody would have been buying at 16.