Airlines can't catch a break these days no matter how hard they try. Case in point -- United Airlines has announced it could lose as much as $544 million because of falling oil prices. Say what?
United has fallen victim to its own efforts to manage what's been a devastating rise in fuel costs. The airline, like just about everyone else in the business, has been buying jet fuel using a tactic called hedging. Ben Brockwell of the Oil Price Information Service calls it "an insurance policy against prices rising."
So long as prices are rising, it works. But if prices start falling, it can quickly become a fiscal disaster, as many airlines are discovering.
Here's a very simplified explanation of how fuel hedging works, using a hypothetical scenario: Let's say oil is selling for $130 and the price is expected to rise. An airline signs a deal with a supplier to buy, say, three months worth of fuel at $110 a barrel. That's called a fuel hedge. The price of oil rises to $140 a barrel, but since the airline is locked in at $110, it can sit back and laugh as its competitors pay more for fuel. Smart move.
But let's turn that scenario on its head and say the airline hedges at $110 but the price drops to $92. Oops. Now the airline is paying more for fuel than it costs on the open market, placing it at a competitive disadvantage. The balance sheet craters.
That's what's happened at United. The company has 51 percent of its 2008 fuel hedged at $111. Per-barrel prices closed under $98 yesterday. It's third-quarter ledger will include $72 million in hedging losses, although the airline warns it could lose another $472 million depending upon what happens with fuel costs. The airline's 2009 fuel hedges are based on a per-barrel price of $118.
Hedging is a big roll of the dice and no one's played the game better than Southwest Airlines. It has consistently hedged more fuel than its competitors, and with far more success. As of this summer, Southwest has 70 percent of its 2008 fuel hedged at $51 a barrel. Compare that with American Airlines, which has 34 percent hedged at $82 a barrel, and Northwest with its hedge at $108. Industry analysts estimate that since 1998 Southwest has paid $3.5 billion less for fuel than its competitors. That's equal to 83 percent of its profits over the last nine years. It's a big part of the reason the airline continues reporting profits while the rest of the industry bleeds red ink to the tune of $5.2 billion this year.
So why doesn't every carrier hedge as much as possible? Airlines entering into hedge contracts must pay a deposit or commission, which is set by the seller depending on perceived risk. This can be a significant outlay of cash, money that some execs gamble would be better spent on new airplanes or debt repayment. An airline has to believe that savings from hedging will exceed the costs of the contract. And, as this last month proves, no one can really predict which way the oil market will go. United Airlines is learning that the hard way.
United has fallen victim to its own efforts to manage what's been a devastating rise in fuel costs. The airline, like just about everyone else in the business, has been buying jet fuel using a tactic called hedging. Ben Brockwell of the Oil Price Information Service calls it "an insurance policy against prices rising."
So long as prices are rising, it works. But if prices start falling, it can quickly become a fiscal disaster, as many airlines are discovering.
Here's a very simplified explanation of how fuel hedging works, using a hypothetical scenario: Let's say oil is selling for $130 and the price is expected to rise. An airline signs a deal with a supplier to buy, say, three months worth of fuel at $110 a barrel. That's called a fuel hedge. The price of oil rises to $140 a barrel, but since the airline is locked in at $110, it can sit back and laugh as its competitors pay more for fuel. Smart move.
But let's turn that scenario on its head and say the airline hedges at $110 but the price drops to $92. Oops. Now the airline is paying more for fuel than it costs on the open market, placing it at a competitive disadvantage. The balance sheet craters.
That's what's happened at United. The company has 51 percent of its 2008 fuel hedged at $111. Per-barrel prices closed under $98 yesterday. It's third-quarter ledger will include $72 million in hedging losses, although the airline warns it could lose another $472 million depending upon what happens with fuel costs. The airline's 2009 fuel hedges are based on a per-barrel price of $118.
Hedging is a big roll of the dice and no one's played the game better than Southwest Airlines. It has consistently hedged more fuel than its competitors, and with far more success. As of this summer, Southwest has 70 percent of its 2008 fuel hedged at $51 a barrel. Compare that with American Airlines, which has 34 percent hedged at $82 a barrel, and Northwest with its hedge at $108. Industry analysts estimate that since 1998 Southwest has paid $3.5 billion less for fuel than its competitors. That's equal to 83 percent of its profits over the last nine years. It's a big part of the reason the airline continues reporting profits while the rest of the industry bleeds red ink to the tune of $5.2 billion this year.
So why doesn't every carrier hedge as much as possible? Airlines entering into hedge contracts must pay a deposit or commission, which is set by the seller depending on perceived risk. This can be a significant outlay of cash, money that some execs gamble would be better spent on new airplanes or debt repayment. An airline has to believe that savings from hedging will exceed the costs of the contract. And, as this last month proves, no one can really predict which way the oil market will go. United Airlines is learning that the hard way.
