canyonblue
Everyone loves Southwest
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The discount carrier is flying high, thanks to savvy jet-fuel hedges that are helping keep its costs earthbound
With its highly productive workers, efficient use of aircraft, and easy-to-use Web site, Southwest Airlines is as famous for its low costs as for its low fares. Recently, though, the discount king has been winning kudos for another kind of cost-cutting tactic: savvy fuel-hedging that has saved the airline millions of dollars as oil prices have hit records. Indeed, without its hedges, Southwest would have lost money in the first quarters of 2003 and 2004. Instead, with its recent third-quarter proft, including $73 million in net hedging gains, it's bragging about 54 consecutive quarters of earnings -- while many rivals are drowning in red ink.if (!window.adOb) document.write('');
Certainly, Southwest is feeling the squeeze of higher jet-fuel prices. With crude now at about $55 a barrel, its fuel costs per gallon rose 10% in the latest quarter. But thanks to the airline industry's most aggressive hedging program, Southwest can better afford to keep fares down even as oil prices rise.
And that's adding to the pain felt by higher-cost competitors, which are struggling to compete with rapidly growing low-cost carriers like Southwest. Analyst Vaughn Cordle of AirlineForecasts says most major carriers face the real possibility of bankruptcy, with fuel being the "key variable" in terms of the timing.
STAYING THE COURSE. It's not that Southwest was better than rivals at predicting where fuel prices were headed. Instead, with its rock-solid credit rating and strong cash position, it could afford to buy hedges in the past few years when the financially ailing legacy carriers couldn't. With their weak credit ratings, they faced not only higher costs but demands for cash collateral in some cases.
"You can't get enough money to buy [hedges], and you can't find anybody dumb enough to get on the other side of it," explains Continental Airlines CEO Gordon Bethune. Headed for bankruptcy and desperate for cash, Delta settled all of its fuel hedges in January for a gain of $82 million.
Solid Southwest can afford to stay the hedging course. It already has hedged more than 80% of its fuel needs for next year with prices capped at the equivalent of $25 per barrel of crude, 60% in 2006 at $31 a barrel, and over 40% in 2007 at $30 a barrel. That's far below where the market is betting that oil prices will be.
LOCK-IN RIGHT. Compare that to American Airlines, which is 4% hedged in the fourth quarter at $30 a barrel and is virtually unhedged for 2005 -- much like most of the legacy carriers. Even low-cost players such as JetBlue and AirTran are far less hedged than Southwest.
Southwest uses a combination of hedging instruments, including call options, collars, and fixed-rate swaps. Some are more expensive than others but less risky, while others give the airline a bigger advantage if oil prices fall. These instruments work in different ways, but Southwest essentially pays for the right to lock in fuel at a particular price or price range in a future period.
In some cases, if the real price is lower, Southwest is simply out the cost of the hedge. If it's higher, the airline is paid the difference. In other instances, Southwest might have to pay a counterparty the difference between the actual and the agreed-upon price if oil falls below where it's betting.
"INSURANCE." Is Southwest simply gambling, albeit successfully, on oil prices? The company insists that it's following a disciplined hedging program to smooth out volatility in a critical component of its costs. Fuel comprised 17% of its costs in the latest quarter, its second-biggest expense after wages and benefits.
"We don't know what's going to happen to energy prices," says Southwest Chief Financial Officer Laura Wright. The hedging effort, she says, is "really based on managing or fixing our costs" at a level at which Southwest can be profitable. Agrees airline expert Daniel Kasper of economics consultancy LECG: "I wouldn't call it speculation. I really think of it as insurance."
Southwest actually lagged behind its bigger rivals in hedging fuel costs until the late '90s. Analysts credit then-CFO Gary Kelly, now CEO, for focusing on the effort. Since 1999, after being hurt by a fuel-price spurt, Southwest has tried to hedge at least 50% of its fuel needs two years out, says Wright. The strategy helped it get a jump on rising oil prices this year.
NO CHANGE IN SIGHT. By the time some competitors were strong enough to jump back into the hedging market, it was too late for them to lock in lower prices. American, for instance, unwound its hedges in the spring of 2003 to conserve much-needed cash as it teetered on the brink of bankruptcy. When it began contemplating new hedges earlier this year, it didn't make sense to lock in dramatically higher fuel prices that analysts were predicting would come down, says a company spokesman. Now higher fuel prices are expected to add $1.2 billion to American's costs this year.
Two employees spend most of their time managing Southwest's hedges. Wright won't say what the hedging budget is. But with oil prices unlikely to plunge anytime soon, "we don't have anything that tells us we should change our strategy at all," she says. Chalk up one more advantage for the low-fare leader.
With its highly productive workers, efficient use of aircraft, and easy-to-use Web site, Southwest Airlines is as famous for its low costs as for its low fares. Recently, though, the discount king has been winning kudos for another kind of cost-cutting tactic: savvy fuel-hedging that has saved the airline millions of dollars as oil prices have hit records. Indeed, without its hedges, Southwest would have lost money in the first quarters of 2003 and 2004. Instead, with its recent third-quarter proft, including $73 million in net hedging gains, it's bragging about 54 consecutive quarters of earnings -- while many rivals are drowning in red ink.if (!window.adOb) document.write('');
Certainly, Southwest is feeling the squeeze of higher jet-fuel prices. With crude now at about $55 a barrel, its fuel costs per gallon rose 10% in the latest quarter. But thanks to the airline industry's most aggressive hedging program, Southwest can better afford to keep fares down even as oil prices rise.
And that's adding to the pain felt by higher-cost competitors, which are struggling to compete with rapidly growing low-cost carriers like Southwest. Analyst Vaughn Cordle of AirlineForecasts says most major carriers face the real possibility of bankruptcy, with fuel being the "key variable" in terms of the timing.
STAYING THE COURSE. It's not that Southwest was better than rivals at predicting where fuel prices were headed. Instead, with its rock-solid credit rating and strong cash position, it could afford to buy hedges in the past few years when the financially ailing legacy carriers couldn't. With their weak credit ratings, they faced not only higher costs but demands for cash collateral in some cases.
"You can't get enough money to buy [hedges], and you can't find anybody dumb enough to get on the other side of it," explains Continental Airlines CEO Gordon Bethune. Headed for bankruptcy and desperate for cash, Delta settled all of its fuel hedges in January for a gain of $82 million.
Solid Southwest can afford to stay the hedging course. It already has hedged more than 80% of its fuel needs for next year with prices capped at the equivalent of $25 per barrel of crude, 60% in 2006 at $31 a barrel, and over 40% in 2007 at $30 a barrel. That's far below where the market is betting that oil prices will be.
LOCK-IN RIGHT. Compare that to American Airlines, which is 4% hedged in the fourth quarter at $30 a barrel and is virtually unhedged for 2005 -- much like most of the legacy carriers. Even low-cost players such as JetBlue and AirTran are far less hedged than Southwest.
Southwest uses a combination of hedging instruments, including call options, collars, and fixed-rate swaps. Some are more expensive than others but less risky, while others give the airline a bigger advantage if oil prices fall. These instruments work in different ways, but Southwest essentially pays for the right to lock in fuel at a particular price or price range in a future period.
In some cases, if the real price is lower, Southwest is simply out the cost of the hedge. If it's higher, the airline is paid the difference. In other instances, Southwest might have to pay a counterparty the difference between the actual and the agreed-upon price if oil falls below where it's betting.
"INSURANCE." Is Southwest simply gambling, albeit successfully, on oil prices? The company insists that it's following a disciplined hedging program to smooth out volatility in a critical component of its costs. Fuel comprised 17% of its costs in the latest quarter, its second-biggest expense after wages and benefits.
"We don't know what's going to happen to energy prices," says Southwest Chief Financial Officer Laura Wright. The hedging effort, she says, is "really based on managing or fixing our costs" at a level at which Southwest can be profitable. Agrees airline expert Daniel Kasper of economics consultancy LECG: "I wouldn't call it speculation. I really think of it as insurance."
Southwest actually lagged behind its bigger rivals in hedging fuel costs until the late '90s. Analysts credit then-CFO Gary Kelly, now CEO, for focusing on the effort. Since 1999, after being hurt by a fuel-price spurt, Southwest has tried to hedge at least 50% of its fuel needs two years out, says Wright. The strategy helped it get a jump on rising oil prices this year.
NO CHANGE IN SIGHT. By the time some competitors were strong enough to jump back into the hedging market, it was too late for them to lock in lower prices. American, for instance, unwound its hedges in the spring of 2003 to conserve much-needed cash as it teetered on the brink of bankruptcy. When it began contemplating new hedges earlier this year, it didn't make sense to lock in dramatically higher fuel prices that analysts were predicting would come down, says a company spokesman. Now higher fuel prices are expected to add $1.2 billion to American's costs this year.
Two employees spend most of their time managing Southwest's hedges. Wright won't say what the hedging budget is. But with oil prices unlikely to plunge anytime soon, "we don't have anything that tells us we should change our strategy at all," she says. Chalk up one more advantage for the low-fare leader.
