The Dallas Morning News Aviation Blog just had this post.  United Airlines has just made it known that they expect some rather heavy losses in their fuel hedging program.  Fuel hedge are common practice among airlines to make fuel prices predictable (rather than necessarily always cheaper) and therefore allow airlines to financially plan for their needs.   Southwest Airlines is arguably the most successful at this strategy.

A fuel hedge is a kind of bet.  An airline purchases contracts and options to buy fuel oil (not jet fuel but fuel oil which tracks in line with jet fuel prices) at a specified price.  If an airline thinks fuel prices will go up, they will buy options and contracts for these fuels for a current market price for delivery some time in the future.  If in fact the prices go up, they sell these contracts for a profit and use the money to offset their jet fuel costs.   If the prices go down and the airline bets that they’ll go up, they suffer additional losses and the cost of their fuel goes up against their plans.

Since hedging is a risky business, a wise airline only hedges a portion of their fuel costs per quarter so they are not completely exposed to the risk of having bet wrong.  In addition, they’ll bet conservatively on prices so that the risk they expose themselves to is minimized as much as possible.  To manage all of this properly requires an army of financial analysts and hedging experts. 

The problem with hedges is you can both make and lose a lot money with them.  When you make a lot of gains, it becomes intoxicating to any airline.   The temptation is to hedge more and more and bet on directions that seem pre-ordained.  Just 1.5 months ago, everyone was betting that oil might go as high as $200 / barrel.  Just this last Monday (September 15, 2008), oil was trading at $97 / barrel.   United bet wrong and now has to report that they have had both real and unrealized losses involved with the trading.  Unrealized losses require them to hold cash in reserve to meet those potential costs.   That is “restricted” cash.

Lately you hear airlines talk about how much unrestricted cash they have on hand.  Southwest Airlines, American Airlines and others will have quite literally billions of unrestricted cash.  That is the money for which there are no real or potential obligations attached.  Going into a period of economic uncertainty, having a large amount of unrestricted cash is good because you can suffer short term losses and still operate sensibly.  If you have too little, you’ll quickly be forced to constrain your operations which quite often leads to a cycle of contraction for an airline.  Because they don’t have the cash, they become smaller and because they’ve become smaller, they have even less cash.

American Airlines continues to survive these industry contractions because they have a huge amount of unrestricted cash held in reserve.  It gives them maneuvering room and they are probably the best in the business when it comes to managing their finances.  That is one reason why they did not have to go into bankruptcy in the post September 11 industry crisis.

To return to hedges.  A hedge becomes risky when you are buying contracts that approach the forecasted market price of the fuel.  Ideally, you want to have options and contracts that are substantially lower than your current year’s price of fuel.  That way, if fuel prices drop your contracts will still realize a gain.  If you buy too close to market prices, particularly in a volatile market such as what oil is experiencing, you run a very real and damaging risk of being obligated to buy those commodoties at prices that are higher than the current market rate.

Hedges have often been described as an insurance policy against high fuel prices.  They aren’t.  They are a way of smoothing the peaks and valleys of fuel prices.  If you smooth those peaks and valleys, you can more accurately plan your financial obligations and that potentially allows you to make more money available for purchasing goods and labor.

The losses reported by United Airlines are just one more reason why I watch them carefully.  You can’t suffer those kinds of losses very often and, once again, it appears that their business plan is not accomodating the current market conditions in the airline industry. 

Filed under: Airline News, Death Watch by ajax
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The Fort Worth Star Telegram Sky Talk blog reports today that American Airlines has, in fact, won a reprieve from starting their Chicago-Beijing flights until 2010.  While this approval wasn’t unexpected, it is disappointing.  I wrote about this in a previous entry  and detailed my own objections to granting these delays.  Citing economic conditions for a delay is not, in my opinion, a satisfactory justification.  These airlines made rosy promises and commitments to serve these routes and to simply throw up your hands and ask for the status quo to be maintained is both unjustified and unfair to other airlines.

There are plenty of airlines who wanted these authorities and, quite frankly, got shoved aside in favor of airlines already serving China.  I could certainly understand and approve of a short delay if planned equipment remained unavailable due to delivery problems from an aircraft manufacturer but that isn’t the case here. 

US Air has also asked for delays on their Philadelphia – China route (and cited economic conditions as well but I suspect that the fact that they have been unable to source aircraft for that route also plays a part in things.  The aircraft that makes the most sense for them, an A340, is an expensive and fuel inefficient aircraft (when compared to A330 and B777 aircraft.  They don’t want to add yet another aircraft type to their fleet and they don’t want to lose the route so they have approached the current economic climate in the airline industry as a blessing on this route.

When the Department of Transportation grants these requests for the stated reasons, they maintain the status quo and that means that airlines are not forced to either re-tune their operations and they are not required to truly compete with each other.  Neither consumers nor the nation have anything to lose by forcing the airlines to adopt business models that are realistic for themselves.  If they cannot serve the routes, someone else who is willing to try should be given a chance.

Filed under: Airline News, Airline Service by ajax
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