Southwest Airlines Fuel Hedge Program. Why Southwest Hedged Fuel Research Paper

Southwest Airlines Fuel Hedge Program. Why Southwest Hedged Fuel - Research Paper Example US Airline Industry Background An overview of the US airline sector reveals an industry setting with numerous considerations where heightened competition and fuel costs are key determinants of performance. Global fuel prices are highly volatile, a trend which has been observed over the last two decades (Carter, Rogers and Simskin 1). Fuel costs greatly impact an airline’s operations since they constitute about 17% of total costs, second to labor costs only. Moreover, ticket prices usually reflect fuel prices, hence, determining profit margins, financial outlooks and forecasts. The competitiveness in the US airline industry translates into a situation where the rising fuel costs cannot be passed to the service consumer. Southwest Airlines, as a major player in the US industry, among other things, specializing in short-haul, provides high-frequency and low fare point-to-point services which in the long run can be largely impacted by such volatilities in the fuel prices (Morrell and Swan 713-714). The inability to pass on fuel costs to consumers forces airlines to consider other strategies for surviving fuel prices fluctuation. Hedging is one of such strategies considered by airlines, such as Southwest, as a solution to the fuel price volatility problem. Hedging: Fuel Price Risk Management: Drastic changes in fuel prices are some of the major risks that may cripple airlines. For instance, political volatility in the Middle East- a major source of crude oil- disrupts global oil prices in two ways. First, war increases the local demand for fuel, hence, lesser exports. Secondly, normal extraction of oil may be disrupted during military operations. Carter et al. (4-5) provide an example of such a situation using the Gulf War, where the average spread rose by 8.1 times, from 3.5 cents to 28.5 cents per gallon. Trempski (1) offers another point of view concerning the jet fuel price volatility stating that a barrel of crude oil price rise from $10.82 in 1996 to $6 9.91 in 2005, had a negative impact on the heavily oil-dependent industry. Control of global fuel prices is not within the power of airlines such as Southwest; hence, there is a need for alternative strategies. Airlines use several instruments to hedge their fuel including over-the-counter (OTC) swaps, future contracts that are exchange traded, exchange traded or OTC call options and OTC or exchange traded collars (Carter et al. 4). Hedging in the airline industry, however, follows a unique format, where risk management is done on fuels other than jet fuels. The first reason for this is based on the refining process; products from the same distillation step share similar characteristics and highly correlated prices and future commercial outlooks. Hence, heating oil can be used to hedge jet fuel prices owing to the fact that their price changes and future contract price changes are highly correlated. Jet fuel is refined from crude oil, thus, crude oil is also heavily applied in hedgi ng jet fuel. The second reason is based on the nature of the jet fuel market which is not sufficiently liquid to warrant future contracts. Derivative contracts on jet fuel have to be based on OTC trading. On the other hand, exchange traded contracts for crude oil and heating oil are active and liquid enough, accompanied by low credit risks. Therefore, airlines interested in hedging traditionally use crude oil or heating oil