Southwest Airlines fuel hedging

A board bets on discipline, years ahead of any crisis

Southwest Airlines' board approved a standing hedging policy around 1998 to 1999, years before anyone had heard of the 2008 financial crisis. The policy committed the airline to hedge a large share of the fuel it expected to burn, years in advance, using instruments linked to crude oil. Jet fuel is one of an airline's largest costs, and it moves in a way ticket prices cannot always follow quickly. Southwest's answer was to lock in a large part of its future fuel bill ahead of time, using crude-oil futures, collar structures (bought calls combined with sold puts) and fixed-price swaps, topped up with refinery-margin contracts to narrow the gap between crude oil and refined jet fuel.

A quiet decade of accumulating savings

For most of the programme's life, the policy drew little attention. By January 2001, the Wall Street Journal was already describing Southwest's fuel-hedging operation as "state of the art" compared with its rivals. Through the 2000s the programme ran across years of both rising and falling oil prices, and the savings built up quietly against the industry's spot-price cost. By the time Southwest filed its Q1 2008 quarterly report with the US Securities and Exchange Commission (SEC) on 2 May 2008, it disclosed derivative positions covering over 70% of its remaining 2008 anticipated jet fuel requirements, at an average crude-oil-equivalent price of approximately $51 per barrel.

The 2008 spike vindicates the policy

That policy looked prescient through the first half of 2008. Oil was on a historic run: on 11 July 2008, West Texas Intermediate (WTI) crude oil futures on the New York Mercantile Exchange (NYMEX) touched an intraday record of $147.27 a barrel, the peak of the 2008 oil-price spike. Against Southwest's locked-in hedge price of near $51, rivals still paying spot faced a serious cost disadvantage.

The reversal and the accounting charge

The market then reversed hard. Oil fell from its July peak through the second half of 2008 as the financial crisis deepened and demand collapsed worldwide. By 23 December 2008, the WTI spot price at Cushing, Oklahoma had fallen to $30.28 a barrel, roughly the low point of the post-spike collapse (the course rounds this to "about $33 per barrel by December 2008"; both describe the same order-of-magnitude fall). That fall hit the fair value of Southwest's hedge book hard. In the third quarter of 2008 (1 July to 30 September), the airline recorded a $247 million net pre-tax special charge, mostly mark-to-market write-downs on the part of its fuel hedge portfolio covering future periods that did not qualify for special hedge accounting treatment under the accounting standard then in force (SFAS 133).

A headline loss with a cash-positive hedge underneath it

That charge was large enough to turn what would otherwise have been a profitable quarter into a loss. On 16 October 2008, Southwest reported a $120 million net loss for Q3 2008, its first quarterly net loss in more than 17 years. Excluding the special charge, the underlying result was net income of $69 million. The detail that matters most is this: the same quarter's fuel hedges generated $448 million of real cash settlement gains (versus $189 million in Q3 2007), and Southwest still posted its 70th consecutive quarter of operating profit. The loss came from an accounting mark on hedges covering fuel not yet burned, not from the hedging programme actually losing money in cash terms.

The hedge briefly turns against the airline, then the decade's gains hold

The fair value of Southwest's remaining fuel derivatives kept falling as oil kept falling: from about $2.5 billion at 30 September 2008 to about $550 million just two weeks later, on 15 October 2008. For the fourth quarter of 2008, Southwest had already locked in nearly 85% of its estimated fuel consumption at an average crude-oil-equivalent price of about $62 a barrel, a level that, with oil trading in the $30s and $40s by then, worked against the airline for a period. Even so, Southwest closed out the full year with net income of $178 million (its 36th consecutive year of profitability), including $1.3 billion of fuel-hedging cash settlement gains for 2008 as a whole. Over the roughly ten years from about 1999 to 2008, the programme is estimated to have saved Southwest on the order of $3 billion to $3.5 billion against paying prevailing spot or industry-average fuel prices.

This case sits on Lecture 3 (hedging strategies using futures), with the theme of basis risk.

Which side of the market Southwest is on

Southwest is a jet-fuel buyer, so a rising oil price is its enemy. It hedges by going long oil-linked derivatives (futures, collars, swaps): if oil rises, the derivatives gain value and offset the higher cash cost of fuel; if oil falls, the derivatives lose value, offsetting the benefit of cheaper fuel. This is the same logic that governs any fuel cross-hedge: a fuel buyer goes long futures because a price rise is what hurts it. Here that logic is applied at the scale of an entire airline's fuel book rather than one shipment.

A cross-hedge, not a perfect one

Southwest could not buy a jet-fuel futures contract that matched its physical exposure exactly, at the scale and tenor it needed, so it hedged using crude-oil-linked instruments, with refinery-margin contracts layered on top to narrow the gap between crude and refined jet fuel. That is a textbook cross-hedge: it removes most of the price risk in jet fuel, but it leaves basis risk, the gap between how crude oil and jet fuel actually move, which the hedge cannot close.

Two ways of measuring the same hedge

Southwest's hedges were also large, multi-year positions, and that is where the accounting story comes in. Under the accounting rules then in force, any part of the hedge book that did not qualify for special hedge accounting had to be marked to market through the income statement every period, even though the underlying cash flow (buying and burning the fuel) had not happened yet. When oil fell sharply after its July 2008 peak, the future-dated part of Southwest's hedge book lost value on paper, producing the $247 million charge, while the near-dated part of the same hedge book that actually settled in cash during Q3 2008 produced a real, positive $448 million gain. A derivatives position can be simultaneously "losing" by one accounting convention and "winning" in actual cash, in the same quarter, because mark-to-market accounting and realised cash settlement measure different things.

The competitor trap, in both directions

A competitor-trap mechanism is also at work here, and it runs in both directions. Through mid-2008, Southwest's locked-in hedge price of about $51 a barrel sat far below the spot price its rivals were paying (oil above $140). That gave Southwest a real cost advantage. Once oil collapsed towards $30 a barrel by December 2008, the same locked-in price became, for a period, above the new spot price, so the hedge briefly worked against Southwest relative to unhedged competitors buying fuel more cheaply in the open market. A hedge fixes a firm's own cost, but it can still move that firm ahead of or behind rivals depending on which way the market subsequently moves. The point of judging a hedge is not whether the market moved in its favour afterwards, but whether it removed a risk the firm could not otherwise afford to carry when the position was set.