Southwest Fuel Hedging Explained (hopefully)

[chase]

DERIVATIVE AND FINANCIAL INSTRUMENTS



Fuel contracts - Airline operators are inherently dependent upon energy to

operate and, therefore, are impacted by changes in jet fuel prices. Jet fuel

and oil consumed in 2004, 2003, and 2002 represented approximately 16.7

percent, 15.2 percent, and 14.9 percent of Southwest's operating expenses,

respectively. The Company endeavors to acquire jet fuel at the lowest possible

cost. Because jet fuel is not traded on an organized futures exchange,

liquidity for hedging is limited. However, the Company has found that crude

oil, heating oil, and unleaded gasoline contracts are effective commodities for

hedging jet fuel. The Company has financial derivative instruments in the form

of the types of hedges it utilizes to decrease its exposure to jet fuel price

increases. The Company does not purchase or hold any derivative financial

instruments for trading purposes.



The Company utilizes financial derivative instruments for both short-term and

long-term time frames when it appears the Company can take advantage of market

conditions. As of December 31, 2004, the Company had a mixture of

purchased call options, collar structures, and fixed price swap

agreements in place to
hedge its total anticipated jet fuel requirements, at crude oil equivalent

prices, for the following periods: 85 percent for 2005 at approximately $26 per

barrel, 65 percent for 2006 at approximately $32 per barrel, over 45 percent

for 2007 at approximately $31 per barrel, 30 percent in 2008 at approximately

$33 per barrel, and over 25 percent for 2009 at approximately $35 per barrel.

As of December 31, 2004, the majority of the Company's first quarter 2005

hedges are effectively heating oil-based positions in the form of option

contracts. For the remainder of 2005, the majority of the Company's hedge

positions are effectively in the form of unleaded gasoline-based and heating

oil-based option contracts. [Jet A fuel is not traded as a commodity but

these commodities are closest in price of Jet A fuel in a refined form] The

majority of the remaining hedge positions are crude oil-based positions.


Under the rules established by SFAS 133, the Company is required to record all

financial derivative instruments on its balance sheet at fair value; however,

not all instruments necessarily qualify for hedge accounting. Derivatives that

are not designated as hedges must be adjusted to fair value through income. If

a derivative is designated as a hedge, depending on the nature of the

hedge, changes in its fair value that are considered to be

effective, as defined, either offset the change in fair value of

the hedged assets, liabilities, or firm commitments through

earnings or are recorded in "Accumulated other comprehensive

income (loss)" until the hedged item is recorded in earnings. Any

portion of a change in a derivative's fair value that is

considered to be ineffective, as defined,
Any portion of a change in a derivative's fair

value that the Company elects to exclude from its measurement of

effectiveness is required to be recorded immediately in earnings.


The Company primarily uses financial derivative instruments to hedge its

exposure to jet fuel price increases and accounts for these derivatives as cash

flow hedges, as defined. In accordance with SFAS 133, the Company must

comply with detailed rules and strict documentation requirements prior to

beginning hedge accounting. As required by SFAS 133, the Company assesses

the effectiveness of each of its individual hedges on a quarterly basis. The
Company also examines the effectiveness of its entire hedging program on a

quarterly basis utilizing statistical analysis. This analysis involves

utilizing regression and other statistical analyses that compare changes in the

price of jet fuel to changes in the prices of the commodities used for hedging

purposes (crude oil, heating oil, and unleaded gasoline). If a derivative

instrument does not qualify for hedge accounting, as defined by SFAS 133, any

change in fair value of that derivative instrument is recorded immediatelly in

earnings.



During 2004, the Company recognized $13 million in additional expense in "Other

(gains) losses, net", related to the ineffectiveness of its hedges. During 2003

and 2002, the Company recognized $16 million and $5 million, in additional

income, respectively, in "Other (gains) losses, net", related to the

ineffectiveness of its hedges. During 2004, 2003, and 2002, the Company

recognized approximately $24 million, $29 million, and $26 million,

respectively, of net expense, related to amounts excluded from the Company's

measurements of hedge effectiveness, in "Other (gains) losses, net". Hedge

accounting, as administered according to SFAS 133, generally results in more

volatility in the Company's financial statements than prior to its adoption,

due to the changes in market values of derivative instruments and some

ineffectiveness that has been experienced in fuel hedges.



During 2004, 2003, and 2002, the Company recognized gains in "Fuel and oil"

expense of $455 million, $171 million, and $45 million, respectively, from

hedging activities. At December 31, 2004 and 2003, approximately $51 million

and $19 million, respectively, due from third parties from expired derivative

contracts, is included in "Accounts and other receivables" in the accompanying

Consolidated Balance Sheet. The fair value of the Company's financial

derivative instruments at December 31, 2004, was a net asset of approximately

$796 million. The current portion of these financial derivative instruments is

classified as "Fuel hedge contracts" and the long-term portion is classified as

"Other assets" in the Consolidated Balance Sheet. The fair value of the

derivative instruments, depending on the type of instrument, was determined by

the use of present value methods or standard option value models with

assumptions about commodity prices based on those observed in underlying

markets.



As of December 31, 2004, the Company had approximately $416 million in

unrealized gains, net of tax, in "Accumulated other comprehensive income

(loss)" related to fuel hedges. Included in this total are approximately $246

million in net unrealized gains that are expected to be realized in earnings

during 2005.
_____________

A lot of techno talk but hope that provides some insight into how SWA handles their fuel hedging. For those waiting for the results of the latest DB, good luck & keep the faith regardless of the outcome!!!!

​

 

[av8tortype]

The unfortunate thing is that companies in BK (Chptr 11) are not allowed to hedge fuel contracts and therefore are at a distinct disadvantage. They end up paying spot rates.

Might as well give the captain a gas card and let him buy some beef jerky at the next fuel stop while he's at it.

 

[English]

Not hedging is what got them into bankruptcy in the first place.

 

[av8tortype]

Not hedging is what got them into bankruptcy in the first place.

It's part of the equation, for sure. I was talking to a USAIR capt a couple months before they filed for Ch11 and he was telling me that the hub-spoke system is killing the majors. Inefficient, causes flow back-ups, so forth and so on. He felt the LCC's have the right model and the regionals are quickly moving in.

 

[DH2WN]

It's part of the equation, for sure. I was talking to a USAIR capt a couple months before they filed for Ch11 and he was telling me that the hub-spoke system is killing the majors. Inefficient, causes flow back-ups, so forth and so on. The LCC's have the right model and the regionals are moving in.

jetBlue is hub and spoke. Airtran is hub and spoke. There is alot more to the failures of the legacy carriers than the hub and spoke system.

 

[caseyd]

Not hedging is what got them into bankruptcy in the first place.

Truth is, hedging makes you look like a genius if prices move up. The investment results in savings. But like other insurance expenses, if prices remain stable (or you don't have a flood), the insurance premium (guaranteeing you fuel at X $/ gallon) insured against an event (rising prices) which did not happen result in wasted money. In the current enviornment these hedges are expensive so only those with cash available (Ch 11 or otherwise) can purchase it, if they think it a wise investment. It's just like buying car insurance and not like it at all. It's similiar to the extent that it protects and dissimiliar to the extent that it's hugely expensive if you mis-guess. Today's prices highlight this truth. After peaking at $53 in January, nobody was surprised to see a retreat towards $42 in February. Who would have been buying hedges for March fuel at $50 in February? But at the moment it appears a wise choice. Go figure.. I'm not defending any legacy carrier's fuel procurement program, just talking about the difficulties they face.

caseyd

 

[Green]

In defense of the legacy carriers one could argue that many of the terminals, gates, airport improvements, concepts such as crm, etc. were financed by the legacy carriers. Then the LCC's came in and cherry-picked the most profitable routes with a relatively young workforce that has less in the way of longevity, medical costs, vacation, and so on. It seems that often a low cost carrier is given free gate space and other financial incentives to service an airport.

I am definitely not bashing the low cost airlines or their employees because I work for one, but it seems that the traditional major airlines are given almost zero credit for creating arguably the best aviation infrastructure in the world while the LCC's, who skim the cream off the top, have become the media darlings.

 

[English]

Sorry, I was referring to Aloha Airlines in my comments to Av8tortype, not a legacy carrier. Specifically, Aloha not hedging contributed to them now being in banckruptcy.

 

[lowecur]

Good Fuel Hedge/Bad Fuel Hedge

AWA had a bad fuel hedge in the 4th Q, they lost money. From what little I understand about puts/calls, they had what was known as non-cash collars. Most of the other carriers that hedged have premium cash collars, and made money. Maybe some experts would care to share their knowledge of the difference between the two.

Incidently, there are very few carriers that do their own hedging. I know B6 and now AWA sub it out to fuel hedge specialists.

 

[Captain Overs]

The unfortunate thing is that companies in BK (Chptr 11) are not allowed to hedge fuel contracts and therefore are at a distinct disadvantage. They end up paying spot rates.

Might as well give the captain a gas card and let him buy some beef jerky at the next fuel stop while he's at it.

Are you referring you SWA pulling into that gas station in Burbank?

 

[chase]

In defense of the legacy carriers one could argue that many of the terminals, gates, airport improvements, concepts such as crm, etc. were financed by the legacy carriers. Then the LCC's came in and cherry-picked the most profitable routes with a relatively young workforce that has less in the way of longevity, medical costs, vacation, and so on. It seems that often a low cost carrier is given free gate space and other financial incentives to service an airport.

I am definitely not bashing the low cost airlines or their employees because I work for one, but it seems that the traditional major airlines are given almost zero credit for creating arguably the best aviation infrastructure in the world while the LCC's, who skim the cream off the top, have become the media darlings.

Green,

While a portion of what you say may has some applicability there are some your partial generalization doesn't tell the entire story. I won't speak in terms of other carriers but in Southwest's case I'll present the following facts that some would argue make your arguement not terribly valid.

1. SWA stayed at an airport, DAL & continue to fund the changes & additions to it almost exclusively for the last 26 years....SWA has paid for these gates many times over & continues to do so.

2. HOU...similar situation there...in fact the argument could be made that the new terminal there is a direct result of SWA's growth & involvement & that other legacy carriers are benefitting from SWA's investment into HOU

3. MDW...another huge turn around...an airport that had basically died & SWA resurrected it....SWA was the major carrier, LCC or legacy that provided funds to the construction.

4. ISP...SWA rebuilt 4 gates & are about to add 4 more & then turn it over to the city of Islip....yes these gates will be ours to use but this benefits everyone in the area.

5. Wherever SWA goes (the Southwest effect) O&D traffic increases on all carriers & therefore even if SWA wasn't there when the first brick was laid, the arrival of SWA has allowed landing fees, taxes, vendor profits to increase...without SWA arriving that income wouldn't have been added to the coffers of the airport.

6. Routes were there for airlines to profit from before SWA arrives at an airport. Because another legacy carrier chooses to not fly the route at the price we do isn't something SWA (or anyone) have to apologize for or feel badly about....its called capitalism

7. Many other examples in SWA's case of where capital expenditures at cities were partially funded by SWA's investment & other carriers benefitted also. Taxpayers have voted for many improvements, not just for SWA gates, based upon the "Southwest effect" at their airports...these expansions wouldn't have occurred without Southwest coming in in my view.

Struggling legacy carriers have acknowledge their business model is flawed in today's environmnet. If the environment had never changed then they would be making money but no business has that type of exclusivity. LCCs have obviously learned from other carriers mistakes but SWA started the trend when there wasn't a trend for LCCs....it was revolutionary, no doubt but a suggestion by some that SWA or other LCCs have had an unfair advantage in "the market place" would to many readers be a slight distortion of the airline history of many LCCs & legacy carriers.

You're certainly entitled to your view but many would say it doesn't provide "the entire picture" of how we are where we are now in the industry.

 

[apdsm]

In the current enviornment these hedges are expensive so only those with cash available (Ch 11 or otherwise) can purchase it, if they think it a wise investment.

caseyd

I think you are mistaken. The bankrupcy court will not allow a bankrupt airline to hedge fuel.

 

[NEDude]

4. ISP...SWA rebuilt 4 gates & are about to add 4 more & then turn it over to the city of Islip....yes these gates will be ours to use but this benefits everyone in the area.

It wasn't a rebuild, it was totally new construction. There was nothing there until SWA built the terminal.

 

[mach zero]

In defense of the legacy carriers one could argue that many of the terminals, gates, airport improvements, concepts such as crm, etc. were financed by the legacy carriers. Then the LCC's came in and cherry-picked the most profitable routes with a relatively young workforce that has less in the way of longevity, medical costs, vacation, and so on. It seems that often a low cost carrier is given free gate space and other financial incentives to service an airport.

I am definitely not bashing the low cost airlines or their employees because I work for one, but it seems that the traditional major airlines are given almost zero credit for creating arguably the best aviation infrastructure in the world while the LCC's, who skim the cream off the top, have become the media darlings.

Green,
I think Chase has addressed your misconceptions for the most part with one exception. Your "relatively young" workforce comment definitely does not apply in SWA's case. I have flown with several Captains that are in their last years of their 20+ year career here. I ran into the same thing at ATA. Both ATA and SWA have been around since the early 70's and both companies have lots of senior employees still there.

 

[Purpledog]

Is SWA building that new wing in BWI?

 

[chase]

Purpledog,

Another good point PD...while SWA isn't building it by any stretch of the imagination, SWA is certainly paying its fair share & has done a lot to help BWI become the fastest growing airport of the 4 in the DC area over the last 10 years. The new construction will allow SWA to consolidate all of its operations into 2 concourses...I forgot the net gain in gates for us over the current situation...I would expect eventually the C concourse may see us return to it even after the new is open....growth in the east coast has still a long way to go in the view of many at SWA. Thanks for bringing that one up...another example of how SWA puts is money where it's mouth is.

NEdude,

You're exactly correct....I misstated what has gone on there. The 4 new gates are exactly that....I do believe the additional 4 gates that SWA is building now are to replace the "old gates" that have been the ones SWA has operated from since it arrived there....building the new ones from scratch allowed SWA to continue to operate from the old ones....replacing them now makes sense & will give us 8 gates when we're done....80 flights a day from an airport that was also slowly decaying. While some in Islip will argue the benefits haven't been so great for SWA to be there, others will say, particularly the folks who have jobs now because of it, are rather happy the Southwest effect occurred there....they have been great neighbors & the Long Island customers have been very loyal to SWA vs. driving all the way into the city to fly on the legacy carriers or other LCCs. Thanks again for the correction & allowing me to clarify

 

[smellthejeta]

It isn't the hub and spoke system that is in part killing the airlines, it's the reliance on a strict "bank" system where all of the planes come at once and all of the planes go at once. *That* is what causes the massive inefficiencies and the resulting cost bloat. Prior to FlyI, IAD was a ghost town at 3pm and 7pm. At those times, you have hundereds of employees on the payroll doing nothing to generate revenue for the company. Then, at 1710 (after most of the bank has left the gate), you've got planes #20 for takeoff burning all sorts of fuel. Neither situation has a positive contribution to the company's bottom line. Then during the winter, deice operations caused major backups, which is something that could have been mitigated by less of a reliance on a bank system. Does anybody know how AA's "Depeaking" experiment has worked for them?

Re: WN and labor costs. Yeah, WN has pilots close to retirement, but if you take an average of the seniority of all the employees at WN and compare them to the same employees at both U's, you will find that the average seniority at the U's is much higher. WN does enjoy a cost advantage because of the COMPARATIVELY (or RELATIVELY) younger age of their employees.

 

[mach zero]

It isn't the hub and spoke system that is in part killing the airlines, it's the reliance on a strict "bank" system where all of the planes come at once and all of the planes go at once. *That* is what causes the massive inefficiencies and the resulting cost bloat. Prior to FlyI, IAD was a ghost town at 3pm and 7pm. At those times, you have hundereds of employees on the payroll doing nothing to generate revenue for the company. Then, at 1710 (after most of the bank has left the gate), you've got planes #20 for takeoff burning all sorts of fuel. Neither situation has a positive contribution to the company's bottom line. Then during the winter, deice operations caused major backups, which is something that could have been mitigated by less of a reliance on a bank system. Does anybody know how AA's "Depeaking" experiment has worked for them?

Re: WN and labor costs. Yeah, WN has pilots close to retirement, but if you take an average of the seniority of all the employees at WN and compare them to the same employees at both U's, you will find that the average seniority at the U's is much higher. WN does enjoy a cost advantage because of the COMPARATIVELY (or RELATIVELY) younger age of their employees.

I disagree. We are one of the most heavily unionized airlines out there with lots of senior people in all departments. Believe it or not people actually like working here and therefore stay on for a career. The big difference between us and the Unitedsaurus is our people do not sit idle (for the most part) while at work.

 

[smellthejeta]

I disagree. We are one of the most heavily unionized airlines out there with lots of senior people in all departments. Believe it or not people actually like working here and therefore stay on for a career. The big difference between us and the Unitedsaurus is our people do not sit idle (for the most part) while at work.

Mach, I hate to pull a lowecur on this one, but any analyst will tell you that growth in and of itself helps bring lower costs. In fact, ATW recently ran an article discussing what will happen when airlines stop growing. (What do unions have to do with it anyway?) Part of this lower cost is additional labor at 1st year pay scales. Not only have the legacies stopped hiring/growing, they're also furloughing/shrinking. This has the combined affect of increasing the average tenure of an employee on the legacy pay scale. They don't have anybody on 1st year pay. Do you mean to tell me that the "average" tenure of a WN employee is higher than the average tenure of an employee at any of the U's, excluding their regional partners? I doubt it.

 

[lowecur]

Mach, I hate to pull a lowecur on this one, but any analyst will tell you that growth in and of itself helps bring lower costs.

Oh, who you kidding. And it's not analyst, it's analcyst. But you are correct on the cause and effect. SWA is lowering it's CASM by offering early retirement pkgs, selective limited hiring (ie: Pilots), and growing ASMs about 10% per year.