Saturday, September 10, 2005

Should Airlines Hedge Fuel Costs?

A discussion about corporate hedging developed in the comments to an earlier post on the impact of Hurricane Katrina. It seemed like a useful topic to follow up in a new post. The issue at hand is why Southwest seems to be the only major airline that hedges a large part of its fuel costs. It could be that they are just speculating in the fuel market and got insanely lucky here, but I doubt that. Southwest's management is extremely shrewd--if they were making a bet, they knew what they were doing.

An economic approach to the issue would be to start by identifying the conditions under which hedging would be irrelevant. If trading is costless and markets are completely efficient, then hedging wouldn't add value. Under these assumptions, any transaction that the firm does can be undone by the shareholders outside of the firm at the same relative prices. So we look for market imperfections of one sort or another to explain hedging.

In most cases, the market imperfection is the cost associated with financial distress or bankruptcy. If unexpectedly high operating costs need to be covered by borrowing, and if borrowing is costly when done on short notice, then it makes sense to smooth out the variation in operating costs. Hedging--in this case, locking in a forward price of a key input to production--allows that to happen. This theory cannot explain why Southwest hedges its fuel costs and the other airlines don't, because it is in the best financial shape.

Perhaps we can tweak it a bit (as was being done in the comments) to suggest that Southwest is one of the few airlines mentioned where the stockholders are actually the residual claimants. The other companies are much closer to bankruptcy, when the equity holders get essentially nothing and any assets get assigned to the debtholders. Refusing to hedge in this case is a form of risk-shifting onto a financially weak firm's creditors. It may also be that the weak financial position of the other airlines doesn't allow them to enter into the long-term contracts involved with hedging next year's fuel costs.

Another possibility is that Southwest has a very unusual business model and is a $10 billion company because it rigorously applies that business model and looks for ways to improve it. If they lock in the price of their fuel, then fluctuations in the price of fuel won't interfere with their ability to figure out what routes are profitable, what schedules improve efficiency, or what the next city on their route map should be. Variation in performance month-to-month will better reflect choices they made rather than fluctuations they couldn't control.

But maybe this is overthinking the problem. Two months ago, David Grossman wrote in USA Today:

Southwest reported a profit of $235 million and saved approximately $351 million during the first six months of this year. If Southwest hadn't hedged, that profit would have been a $116 million loss and the first time in 57 consecutive quarters that the company did not report a profit.

Maybe they hedge to keep the streak alive.

This topic comes up any time fuel costs increase. About a year ago, Jim Garven noted most of these points and provided links to empirical and case studies of fuel hedging. Some other good discussions are here and here at the Conglomerate blog.


Anonymous said...

The Cost of Financial Distress (CFD) argument is appealing to me. There are probably a lot of intangible CFD in addition to higher borrowing cost and transaction fees. These costs strike me as possibly non-linear --> they can start increasing quickly as a company gets in financial trouble.

The Unknown Professor said...

The financial distress argument has merit, but I see what's going on in another (somewhat related) way. The airline industry is definitely nowhere near perfectly competitive. So, hedging allows the hedger competitive advantage during times like this -- they have cash when non-hedging competitors don't.

In case you (or your readers)are interested, Adams, Dasgupta, and Titman have a paper on the SSRN (Financial Constraints, Competition, and Hedging In Industry Equilibrium) and that looks at this issue (caution - it's got a fair bit of mathematical modeling, so "non-nerds" might find it a bit of rough sledding.

Anonymous said...

I believe the answer is more likely that the other airlines aren't managed particularly well.

Anonymous said...

The Unknown Professor writes:

"they have cash when non-hedging competitors don't."

this might be an intangible cost of CFD - competitors "shark" on a bleeding company. they sense blood and move in foor a kill.

other intangible costs are adverse selection with employees and customers (people avoid companies that lack cash and may be at a higher risk to go under), damage to brand (company loses its "position" in customer minds) -prevention (hedging) costs less than fixing the brand after the CFD

Robert Schwartz said...

Why should hedging, like any other form of leverage, make any difference to firm value? Cann't investors perform the same hedges and save the company the trouble and trading costs?

Anonymous said...

i've been at cash-starved companies that even fed ex starts to cut-off. is the inability to ship things via fed ex a CFD? seriously, what reasonable person with other options wants to work under such conditions. companies start to lose employees when they have no cash and have to borrow money at junk bond and usurous rates.

ed said...

Interesting post.

I see in the Grossman article he writes: "In the interim, hedging will keep airfares low."

Basic, standard economic theory would predict that there is no reason hedging should keep airfares doesn't do anything to reduce the opportunity cost of costs of operating the airline, and opportunity costs should be what matters. (Of course adding things like taxes and transaction costs might change this conclusion a bit, but I doubt that's what Grossman had in mind. More likely he just doesn't understand basic economic theory.)

Interestingly, it says that Grossman is a former airline industry exectutive.

hedging rules said...

One question: why would hedging be irrelevant under zero transaction cost markets? One would also have to assume that shareholders outside the firm would have the same information as the insiders with regards to the airline's fuel consumption. In all practicality, outsiders would not have this information in the timely manner required for say dynamic hedging in a volatile asset. Also I can't see typical mutual funds getting into buying airlines and hedging the fuel risk (even though probably most of the equity vol comes from fuel cost vol).

Another idea: there are not only Bankruptcy costs to consider (while going without a hedge) but there is a 'utility' of staying in business. Why mess around, when you can focus on what you're good at? Being short something with 60 vol is a major distraction to the core business and it's hard to plan around this volatility.

Second order reason, given that fuel cost vol is just so large vs other business risk, financing should be a lot cheaper than if you did not hedge. Even if you were a financially weaker airline I think your financing cost should still be lower in lieu with a hedge than without. Fuel cost vol seems to be a large determinant of credit worthiness. (Nothing to back this claim but intuition.)

Toon said...

All very interesting, does anybody know any good papers written on this subject. I am currently writing my dissertation on airline companies fuel hedging strategies an how it impacts their financial performance. Thanks