Risk Management

Hard Landings?

Lower oil costs remind some companies that there's a downside risk to hedging.
Lori CalabroDecember 26, 2006

Not everyone is flying high about lower oil prices.

The cooling in jet-fuel costs since last summer sounds like good news, but it caught some airline-hedging programs off guard. Indeed, Alaska Air Group recorded a third-quarter loss of $17.4 million in October, partly due to losses tied to fuel-hedging contracts. Similarly, US Airways got clipped for $88 million when it was forced to take a charge in order to reduce the book value of some outstanding fuel-hedging contracts.

Those and other major airlines locked in prices with hedges that later turned out to be above the current market value. And the volatility of oil prices in recent months, says John P. Heimlich, chief economist for the Air Transport Association, illustrates that “hedging is still a gamble.”

That doesn’t mean airlines plan to jettison hedging anytime soon. Although the overall value of Alaska Air Group’s hedging portfolio declined, the program still saved some $27.4 million during the third quarter. Meanwhile, Southwest Airlines actually upped its hedged exposure to 85 percent for 2007. “Even with the recent decline in energy prices,” says Scott Topping, Southwest’s vice president of finance and treasurer, “our cost per gallon was up 60 percent in the third quarter [as compared with last year]. Despite that, our hedging program gained us $200 million last quarter.”

In Alaska Air’s third-quarter conference call, CFO Brad Tilden reiterated the company’s commitment to hedging. “Fuel hedging is not a strategy to create profits…. It is a strategy to reduce the volatility of our fuel expense,” he said. The airline’s raw-fuel costs have gone from $300 million a year in 2002 to $900 million this year. “What we have is a commodity that’s very material to the company and very volatile. It argues for hedging.”

Meanwhile, some fliers are seeing benefits from lower fuel costs. Several international airlines, including Virgin Atlantic, KLM, and Lufthansa, have already dropped their fuel surcharges.