Fuel Hedging in the Airline Industry

Only available on StudyMode
  • Download(s) : 239
  • Published : November 15, 2012
Open Document
Text Preview
Fuel Hedging in the Airline Industry: The Case of Southwest Airlines By Dave Carter a, Dan Rogers b, and Betty Simkins c

a

College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-5104, Email: dcarter@okstate.edu b

School of Business Administration, Portland State University, Portland, OR 97207-0751, Phone: (503) 725-3790, Email: danr@sba.pdx.edu c

CONTACT AUTHOR: College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-8625, Fax: (405) 744-5180, Email: simkins@okstate.edu

Review copy for use of the Case Research Journal. Not for reproduction or distribution.

Fuel Hedging in the Airline Industry: The Case of Southwest Airlines By Dave Carter, Dan Rogers, and Betty Simkins

“If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk.” Scott Topping, Director of Corporate Finance for Southwest Airlines

June 12, 2001: Scott Topping, the Director of Corporate Finance for Southwest Airlines (hereafter referred to as “Southwest”), was concerned about the cost of fuel for Southwest. High jet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew that since the industry was deregulated in 1978, airline profitability and survival depended on controlling costs.1 After labor, jet fuel is the second largest operating expense for airlines. If airlines can control the cost of fuel, they can more accurately estimate budgets and forecast earnings. It was Scott’s job to hedge fuel costs, however, he knows that jet fuel prices are largely unpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overall upward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. On September 11, 2000, the Gulf Coast jet fuel spot price was 101.25 cents/gallon – a whopping increase of 255 % in the spot price since the low in 1998. The prior day’s (June 11, 2001) spot price for Gulf Coast jet fuel closed at a price of 79.45 cents/gallon. While this price was lower than the highest level, Scott knew that future jet fuel prices would be uncertain. Figure 2 illustrates the high volatility of jet fuel prices. As shown, historical daily volatility over a recent 25-day period for Gulf Coast has averaged 58.7 percent.2 Clearly, fuel price risk is an important concern for airlines. 1

One of the most important events in the history of the airline industry was the Deregulation Act passed by U.S. Congress in 1978. This act removed all government controls over fares and domestic routes for the first time and gave airlines the opportunity to operate as true businesses.

For example, at the price of 79.45 cents/gallon for jet fuel, there is a 68% probability that the price will change by as much as +/-46.63 cents/gallon (i.e. 79.45 x 0.587). This means that there is a 68 percent probability that the price will range from 32.8 to 126.0 cents/gallon. Using a recent 10-week average volatility of 30.5% (data not shown),

2

1

Review copy for use of the Case Research Journal. Not for reproduction or distribution.

As a result of fuel price increases during the later half of 1999 and throughout 2000, Southwest’s fuel and oil expense per available seat-mile (ASM) for the year 2000 increased 44.1 percent over that for 1999.3 As shown in Table 1, Southwest’s average price per gallon of jet fuel in 2000 was $0.7869 compared to $0.5271 in 1999.4 About Southwest Airlines Southwest was formed in 1971 by Rollin King and Herb Kelleher and the airline began with three Boeing 737 aircraft serving the Texas cities -- Dallas, Houston, and San Antonio. The airline began with one simple strategy: “If you get your passengers to their destinations when they want to get there, on time, at the lowest possible fares, and make darn sure they have a good time doing it, people will fly your airline.”5 This strategy has been the key...
tracking img