Hedging helps airlines deflect higher jet fuel costs
Mary Clair Austin -- Purchasing, 8/17/2004 2:00:00 AM
Sky-high jet fuel prices are pinching bottom lines of the major airlines so much that many carriers have expanded hedging of energy purchases. The goal is to control energy costs, maintain the low airfares that consumers increasingly favor and not impose the jet fuel surcharges being applied on rates by airfreight companies.
Most airlines hedge their fuel costs somewhat, but 2004 has shown a surge in hedging activity after three years of relative inactivity. Reason: High jet-fuel bills have wreaked havoc on the airline industry, forcing bankruptcy by some start-up carriers, lowering earnings at major airlines and widening losses at others. Jet fuel prices have shot up to an average $1.05/gal for the first six months of this year, almost twice the cost of the kerosene-based fuel at the start of 2002, according to the U.S. Energy Department, when jet fuel went for about 58¢/gal.
"Higher fuel costs are consistent with lower cash flow," says Dan Rogers, professor of finance at Portland State University in Oregon. "Given that jet fuel costs can be hedged, airlines with a desire to conserve cash have found value in hedging future purchases of jet fuel."
Since jet fuel prices equal 16% of an airline's costs, the latest prices are creating fiscal headaches for carriers, all of which have tight operating margins and still are trying to shake the effects of the 2001 terrorist attacks and the 2000-2003 economic recession.
"High energy prices are a concern for us, and we continue to monitor the trend," says Derek Kerr, America West Airlines' chief financial officer. "The negative impact of jet fuel hikes on air carriers has dimmed financial outlooks for us and other major carriers."
In fact, kerosene-based jet fuel prices on the spot market of $1.145/gal in June soared 49% from the 77¢ of last June, and the Air Transport Association (ATA), an industry trade group, says each 1¢ rise in price adds $180 million to the industry's annual costs. This is because high crude oil prices are dogging the economy. West Texas Intermediate crude oil prices averaged $37/barrel in the first half and entered the third quarter trading at $38/barrel on the New York Mercantile Exchange.
America West of Tempe, Ariz., hedged 40% of its first-quarter fuel needs at $32 per barrel (crude oil), but only 5% has been bought up front for the second quarter and none for the latter half of the year. "We are kind of naked from the second through the fourth quarters," admits Kerr. But that's not the case at Southwest Airlines, which appears to be in the best position of major carriers when it comes to dealing with the fuel issue. In fact, Dallas-based Southwest has 80% of its fuel supplies for 2004 under $24/barrel and 70%-80% for 2005 purchased in advance, or hedged, at $24-$25/barrel.
Today, Southwest calls oil futures contracts, or hedges, its "insurance policy" against higher fuel prices. Like the other airlines that hedge, they lock in the prices they will pay for oil products months or even years in advance by buying contracts on the open market.
"Our customers do not want to pay for the additional fuel costs so our ability to pass that through is limited," says Tammy Romo, senior director of investor relations at Southwest, adding that hedging allowed the airline to save $63 million on fuel and oil expenditures in the first quarter even though expanded operations forced it to spend $22 million more on fuel and oil than in the same quarter in 2003.
Even though traffic has been strong, earnings growth remains a problem for such large carriers as American, United, Delta, America West, Alaska and others. To combat the rise in fuel expenses, Houston-based Continental Airlines is 100% hedged in the fourth quarter. Still, in the current weak fare environment, the company expects to post a loss in the second quarter and a significant loss for 2004. Reason: In March 2003, when Continental originally planned for break-even results in 2004, it expected jet fuel prices to average approximately 68¢/gal for the year. At early July's prices of approximately $1.13/gal, Continental faces an additional $700 million in annual operating expenses.
In the second quarter Continental hedged 80% of their jet fuel volume at $40/barrel. In the third and fourth quarters, 45% of the volume will be hedged around $36/barrel. Both prices are below the current $44/barrel cost of jet fuel at the close of June. "Continental has done price hedging on fuel for a long time and employs it depending on market conditions," says a spokesman. "In 2003, Continental did not explore any fuel hedges, but in the first quarter of 2004 we began taking on some new hedging positions to protect against certain upward price moves."
What Continental expected to be a break-even year in 2004 is going to turn out differently as a result of the recent fuel price spike and Continental is just one of several airlines who have not been successful at passing on additional costs to its customers. "We have tried to raise prices with only limited success," says the spokesman. "There is excess seat capacity in the market and this is preventing fares from moving meaningfully higher." That's why Continental in June dropped a proposed $40/round trip fare increase when other carriers declined to follow. The higher prices would have covered about 20% of the airline's added fuel costs.
Meanwhile, efforts to return United Airlines, the nation's number two carrier, to profitability continue to be complicated by jet fuel costs. The airline is undergoing cost-reduction initiatives and revenue-generating efforts. "We are going to have to maintain a relentless focus on cost improvement," says Glenn Tilton, chief executive of the Chicago-based carrier in a statement.
Now Playing: 