Fuel Hedging in The Airline Industry

1
Fuel Hedging in the Airline Industry: The Case of Southwest Airlines

If we dont 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 Scotts 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 days (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.

2
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),
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2

As a result of fuel price increases during the later half of 1999 and throughout 2000, Southwests
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, Southwests 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 to Southwests
success. The airline realized early on that air travel would become a commodity business.

In May 1988, Southwest became the first airline to win the coveted Triple Crown for a month
Best On-time Record, Best Baggage Handling, and Fewest Customer Complaints. Since then,
the airline has won five annual Triple Crowns: 1992, 1993, 1994, 1995, and 1996. In addition to
being a top quality airline, Southwest was also innovative. They were the first airline with a
frequent flyer program to give credit for the number of trips taken and not the number of miles
flown. Additionally, they pioneered senior discounts, same-day airfreight delivery service,
ticketless travel, and many other unique programs.

By the year 2000, the small Texas airline had evolved to become the 4
th
largest U.S. carrier
based on domestic passengers boarded and the largest U.S. carrier based on scheduled domestic
departures. At year-end 2000, Southwest operated 344 Boeing 737 aircraft and provided service
to 58 airports in 57 cities in 29 states throughout the U.S. In 2000, Southwest commenced
service to Albany and Buffalo, New York, and in January 2001, to West Palm Beach, Florida.

Tables 2 and 3 provide Southwest Airlines consolidated statement of income and consolidated
balance sheet, respectively, for the years 1999 and 2000. Historically, Southwest has
experienced some seasonality in their business. For example, quarterly operating income and, to
a lesser extent, revenues tend to be lower in the first quarter. In 2000, quarterly operating
income represented 22 percent of annual operating income.

Fuel Hedging in the Airline Industry

there is a 68% probability that the price will change by as much as 24.23 cents/gallon. Given that Southwest spent
$484.7 million on jet fuel in the year 2000, there is a 68 % change that jet fuel can fluctuate by as much as $ 147.8
million using the 10 week volatility average (i.e. 0.303 x $484.7 million).
3
See the appendix for a glossary of airline terms.
4
These prices are net of the following gains from hedging -- approximately $113.5 million in 2000 and $14.8
million in 1999.
5
Refer to We Werent Just Airborne Yesterday, Southwest Airlines A Brief History,
http://www.southwest.com/.
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Airlines executives know that it is often impossible to pass higher fuel prices on to passengers by
raising ticket prices due to the highly competitive nature of the industry. Because large airlines
compete with one another on most of the routes they serve, they have little power to raise prices
in response to higher fuel costs. For example, Continental Airlines rescinded a fare hike after
trying a number of times to boost overall fares. The airline said the airfare increases were due to
high fuel costs, but intense airline competition has left the firm unable to pass along fuel costs to
customers.
6

Table 4 provides information on competition in the airline industry for both passenger airlines
(Panel A) and airfreight carriers (Panel B). As shown in Panel A, Southwest Airlines holds a
5.51% market share based on total available seat miles flown over the period 1994-2000. Over
the same period, Southwest holds a much smaller share of the freight market (see Panel B). By
2000, Southwest was the fourth largest carrier in the US based on passengers flown and the
largest based on departures (see previous section). Obviously, competition is a top concern for
Southwest. With air travel becoming a commodity business, being competitive on price is the
key to survival and success. As Warren Buffett states: You cannot be the high-cost producer in
a commodity business. Sometimes its not even any good to be the low-cost producer.
(McCartney, Michaels, and Rogers, 2002).

Airlines that want to prevent huge swings in operating expenses and bottom line profitability
choose to hedge fuel prices. In fact, Raymond Neidl (see Neidl and Chiprich, 2001) points out
that the carriers that produced an adequate return, especially in the second half of 2000, tended
to be those that had good fuel hedge positions in place. Airlines without hedges in place had
disappointing earnings or losses. For example, in the fourth quarter 2000, US Airways, which
was unhedged, estimated that its $88 million net loss would have been a profit of $38 million if
their fuel costs had not increased. Airlines are different from most commodity users or
producers in that it usually the airline companys treasury department (rather than the fuel
purchasers) that handles fuel hedging.

Fuel price risk management techniques were adopted by airlines around 1989 (Clubley, 1999).
Airlines use derivative instruments based on crude oil, heating oil, or jet fuel to hedge their fuel
cost risk. The majority of airlines rely on plain vanilla instruments to hedge their jet fuel costs,
including swaps, futures, call options (including average price options which are a type of call
option), and collars (including zero-cost collars).

There are two main reasons why several fuels other than jet fuel are used in jet fuel hedging by
airlines. The first reason requires a brief explanation of refining. When refiners process crude
oil, the main products are gasoline, middle distillates (heating oil, diesel fuel, and jet kerosene)
and residual fuel oil. Refiners often refer to these products as top, middle, or bottom of the
barrel, respectively. Products from the same part of the barrel share similar characteristics, and
as a result, the prices are highly correlated.
7
Hence, heating oil, which shares similar

6
See Continental Raises Domestic Fares, Cites Fuel Costs (Reuters, February 27, 2004) and Continental Airlines
Resends Latest Fare Hike (Reuters, June 7, 2004).
7
Jet fuel is a essentially pure kerosene with some additives. Two products from the barrel not mentioned above are
the gas liquids like butane at the very top and asphalt at the very bottom.
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characteristics to jet fuel, is frequently used in hedging by airlines. Also, since jet fuel is refined
from crude oil, crude oil is also used in hedging by airlines due to high price correlation.

The second reason why airlines use several fuels in hedging is because jet fuel is not a
sufficiently liquid market to warrant a futures contract or other type of exchanged-traded
contract. As a result, derivative contracts for jet fuel must be arranged on the over-the-counter
(OTC) markets. However, there are active and liquid markets for exchange-traded contracts on
crude oil and heating oil in New York (the New York Mercantile Exchange, NYMEX) and for
gasoil in London (the International Petroleum Exchange, IPE).
8
While exchange-traded products
offer high liquidity and low credit risk, typically these contracts are standardized and inflexible,
meaning that users often face large basis risk.

The term basis risk is used to describe the risk that the value of the commodity being hedged
may not change in tandem with the value of the derivative contract used to hedge the price risk.
While crude oil, heating oil, and jet fuel prices are highly correlated, significant basis risk can
emerge if the relationship between the commodities breaks down. In an ideal hedge, the hedge
would match the underlying position in every respect, removing any change of basis risk.
However, in actuality, basis risk is a high concern, even if the derivatives contract is for the exact
same commodity being hedge. More specifically, in the futures markets, basis is defined as the
differential between the cash price of a given commodity and the price of the nearest futures
contract for the same, or a related commodity.
9
Hence, basis risk when hedging using futures
contracts refers to the risk of the differential changing over the life of the hedge.

Why does basis risk occur? The following three basis risks occur frequently in hedging: product
basis risk, time basis risk, and locational basis risk. Product basis risk occurs when there is a
mismatch in the quality, consistency, weight, or underlying product. For example, airlines
frequently use crude oil contacts to hedge jet fuel, but obviously crude oil and jet fuel are two
different commodities and hence have large product basis risk. Even within the same
commodity category, such as crude oil, product basis risk occurs because there are many types of
crude oil varying in viscosity (such as heavy versus light crude) and sulfur content (sweet versus
sour crude). Time basis risk occurs when there is a mismatch in the time of the hedge. For
example, if a hedger wishes to hedge long-term but only has short dated contracts available, time
basis risk is very significant.
10
Locational basis risk, one of the most common types of basis risk,

8
Gas oil is the European designation for No. 2 heating oil and diesel fuel.
9
Refer to A Guide to Energy Hedging published by the New York Mercantile Exchange.
10
For one of the most famous examples of time basis risk, refer to Metallgesellschaft Refining and Marketing
(MGRM), which was an American subsidiary of Metallgesellschaft (MG), an international trading, engineering, and
chemicals conglomerate. In 1992, MGRM implemented what it believed to be a profitable marketing strategy. The
company agreed to sell specified amounts of petroleum products every month, for up to ten years, at fixed prices that
were higher than the current market price. MGRM then purchased short-term energy futures to hedge the long-term
commitments - a "stack" hedging strategy. This timing mismatch caused MGRM to go bankrupt. The MGRM hedge
also illustrates another type of hedging risk: "funding risk" - the risk that positions which may be profitable in the
long run can bankrupt a company in the short run if negative cash flows are mismatched with positive cash flows.
For a short summary of the MGRM hedging disaster, refer to
http://www.erisk.com/Learning/CaseStudies/ref_case_mg.asp.

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occurs when there is a mismatch in the price of the product from one location to another, a
mismatch in the delivery point for the derivatives contract, among others.

While such extreme breakdowns in correlations are rare, hedgers should be aware of basis risk.
Julian Barrowcliffe, director of global commodity swaps at Merrill Lynch (Schap, 1993) stated:
Some of the largest hedging losses have resulted from the assumption that heating oil and jet
kerosene were essentially the same product and heating oil futures could hedge jet. At times,
they havent tracked each other at all. For example, in late 1990 when Iraq invaded Kuwait
(which precipitated the first Gulf War), the differential between European jet fuel and heating oil
quickly increased to more than five times the usual margin. As shown in Figure 3, the spread
between jet fuel and heating oil for the Gulf Coast location increased to 28.5 cents per gallon.
This is 8.1 times the average spread of 3.5 cents per gallon and represents a 714% increase
relative to the average spread (i.e. (28.5 3.5)/ 3.5). It is important to note that since this period
of time, basis risk fundamentals between jet fuel and heating oil or crude oil have improved.
This is due primarily to the fact that there is significantly more storage of jet fuel in the Middle
East now, which places less price pressure on jet fuel in periods of higher demand due to military
conflict.

Frequently Used Fuel Hedging Instruments by Airlines

This section describes the most commonly used hedging contracts by airlines: swap contracts
(including plain vanilla, differential, and basis swaps), call options (including caps), collars
(including zero-cost and premium collars), futures contracts and forwards contracts.

Plain Vanilla Swap

The plain vanilla energy swap (called this because it is simple and basic when compared to more
exotic swap contracts) is an agreement whereby a floating price is exchanged for a fixed price
over a certain period of time. It is an off-balance-sheet financial arrangement, which involves no
transfer of the physical item. Both parties settle their contractual obligations by means of a
transfer of cash. In a fuel swap, the swap contract specifies the volume of fuel, the duration (i.e.,
the maturity of the swap), and the fixed and floating prices for fuel. The differences between
fixed and floating prices are settled in cash for specific periods (usually monthly, but sometimes
quarterly, semi-annually, or annually).

Figure 4 illustrates fuel hedging using two types of swap contracts. Example 1 in the figure
describes how a plain vanilla jet fuel swap arranged in the OTC market is used. Example 2
illustrates fuel hedging on the organized exchanges using a highly liquid contract -- the NYMEX
New York Heating Oil Calendar Swap contract. In all swap contracts, the airline is usually the
fixed-price payer, thus allowing the airline to hedge fuel price risk. For more information on
these contracts, refer to the NYMEX website at http://www.NYMEX.com.

Differential Swaps and Basis Risk

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While a plain vanilla swap is based on the difference between the fixed and floating prices for
the same commodity, a differential swap is based on the difference between a fixed differential
for two different commodities and their actual differential over time. Differential swaps can be
used by companies to manage the basis risk from other hedging activities. For instance, assume
an airline prefers to hedge its jet fuel exposure using a heating oil plain vanilla swap. The airline
can used an additional swap contract, the differential swap for jet fuel versus heating oil, to
hedge basis risk assumed from the heating oil swap. The net result is that the airline can
eliminate the risk that jet fuel prices will increase more than heating oil prices. Basis risk can be
an important concern for cross-hedges of this type. For more information on differential swaps,
refer to Chapter 1 of Falloon and Turner (1999).

Call Options (Caps)

A call option is the right to buy a particular asset at a predetermined fixed price (the strike) at a
time up until the maturity date. OTC options in the oil industry are usually cash settled while
exchange-traded oil options on the NYMEX are exercised into futures contracts. OTC option
settlement is normally based on the average price for a period, commonly a calendar month.
Airlines like settlement against average prices because an airline usually refuels its aircraft
several times a day. Since the airline is effectively paying an average price over the month, they
typically prefer to settle hedges against an average price (called average price options).

In the energy industry, options are often used to hedge cross-market risks, especially when
market liquidity is a concern. For example, an airline might buy an option on heating oil as a
cross-market hedge against a rise in the price of jet fuel. Of course, cross-market hedges should
only be used if the prices are highly correlated.

Airlines such as Southwest value the flexibility that energy options provide, but energy options
can be seen as expensive relative to other options. The reason is the high volatility of energy
commodities, which causes the option to have a higher premium. For this reason, zero-cost
collars (discussed next) are often used. Figure 5 provides a conceptual illustration for hedging
gains or losses using swaps, call options, and premium collars when locking into a 60-cent/gallon
price of jet fuel.

Collars, Including Zero-Cost and Premium Collars

A collar is a combination of a put option and a call option. For a hedger planning to purchase a
commodity, a collar is created by selling a put option with a strike price below the current
commodity price and purchasing a call option with a strike price above the current commodity
price. The purchase of a call option provides protection during the life of the option against
upward commodity price movements above the call strike price. The premium received from
selling the put option helps offset the cost of the call option. By establishing a collar strategy, a
minimum and maximum commodity price is created around a hedgers position until the
expiration of the options. Figure 6 provides an example of the net cost of jet fuel in $/gallon
using a collar where a call option is purchased with a $0.80 strike price and a put option is sold
with $0.60 strike price. As shown, the airline will never pay more than $0.80 for jet fuel no
matter how high prices rise, yet will never pay less than $0.60 regardless of how low jet fuel
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prices drop. A collar can be structured so that the premium received from the sale of the put
option completely offsets the purchase price of the call option. This type of collar is called a
zero cost collar.

If more protection against upward price movements is desired (i.e., having a lower call option
strike price) or more benefit from declining prices is desired (i.e., selling a put with a lower strike
price), a premium collar is used. With a premium collar, the cost of the call option is only
partially offset by the premium received from selling a put option. Refer to Figure 5 for a
conceptual illustration of the premium collar strategy.

Using a zero-cost collar or premium collar may appear to be a reasonable hedging strategy for an
airline since it involves no upfront cost (or low upfront cost) and involves no speculative return.
However, if jet fuel prices fall significantly, as illustrated in Figure 6, the airline may pay more
for jet fuel than its competitors who did not employ the collar strategy. Competitors may lower
their airfares aggressively as a result. Accordingly, the zero-cost collar should be more
accurately called a zero-upfront cost collar.

Futures and Forward Contracts

A futures contract is an agreement to buy or sell a specified quantity and quality of a commodity
for a certain price at a designated time in the future. The buyer has a long position, which means
he/she agrees to make delivery of the commodity (i.e., purchase the commodity). The seller has
a short position, which means he/she agrees to make delivery of the commodity (i.e., sell the
commodity). Futures contracts are traded on an exchange, which specifies standard terms for the
contracts (e.g., quantity, quality, delivery, etc.) and guarantees their performance (removing
counterparty risk). Only a small percentage of futures contracts traded result in delivery of the
commodity (less than one percent in the case of energy contract). Instead, buyers and sellers of
futures contracts generally offset their position.

A forward contract is the same as a futures contract except for two important distinctions: (1)
Futures contracts are standardized and traded on organized exchanges, whereas forward contracts
are typically customized and not traded on an exchange; and (2) Futures contracts are marked to
market daily, whereas forward contracts are settled at maturity only. For the futures contract,
this means that each day during the life of the contract, there is a daily cash settlement depending
on the current value of the commodity being hedged. The NYMEX exchange trades futures on
crude oil, heating oil, and gasoline (among other commodities).

Table 5 illustrates how a fuel hedger can use the NYMEX heating oil futures contract to hedge
jet fuel price risk. As shown, the hedger purchases a futures contract at 66.28 cents per gallon
(futures contract size is 42,000 gallons) in January. On the same day, the New York jet fuel spot
price is 80.28 cents per gallon. If the hedger closes out this futures contract for 42,000 gallons
on August 29, 2000 at 98.59 cents per gallon, he/she has made a profit of 32.31 cents per gallon
(98.59 minus 66.28). The spot price of NY jet fuel on August 29th is 103.6 cents per gallon.
(Note: If the hedger had not hedged, he would have paid 23.32 cents/gallon more for the fuel.)
However, by using the futures contract and purchasing jet fuel in the spot market, the gain of
32.31 on the futures more than offsets the 23.32 increase in jet fuel prices. In essence, the
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hedgers net cost of jet fuel is 71.29 cents per gallon (i.e., 103.6 spot price in August minus the
futures hedging gain of 32.31 cents/gallon).

Accounting for Derivatives According to SFAS 133

The Financial Accounting Standards Board (FASB) issued Statement 133 to make a companys
exposure to its derivative positions more transparent. Prior to SFAS 133, most derivatives were
carried off-balance sheet and reported only in footnotes to the financial statements. Under SFAS
133, depending on the reason for holding the derivative position and the derivatives
effectiveness in hedging, changes in the derivatives fair value is recorded either in the income
statement or in a component of equity known as other comprehensive income.

Table 6 summarizes the balance sheet and income statement impacts of cash flow hedges, fair
value hedges, and speculative transactions under SFAS 133. Under SFAS 133, managers such as
Scott Topping that want their hedge to receive hedge accounting treatment, must be certain their
hedge will pass the effectiveness measure. To qualify, the manager must measure the
effectiveness of the hedge at least each reporting period for the entire duration of the hedge. Any
ineffective portion or excluded portion of the change in derivative value must be reported
directly to earnings.

According to the FASB, hedge effectiveness should take into account both historical
performance (retrospective test) and anticipated future performance (prospective test). The
FASB has provided only broad guidelines for testing hedge effectiveness. The FASB has two
suggested approaches to measure historical performance: the 80-125 rule and the correlation
method. According to the 80-125 rule (also referred to as the dollar-value-offset method), a
hedge is deemed effective if the ratio of the change in value of the derivative to the change in
value of the hedged item falls between 80 % and 125%. Shown in equation form:

Effectiveness measure =
n
i=2
(P
H
)
i

n
i=2
(P
D
)
i

Where: (P
H
)
i
= (P
H
)
i
- (P
H
)
i-1

(P
D
)
i
= (P
D
)
i
- (P
D
)
i-1

P
H
= the daily price of the hedged item
P
D
= the daily price of the derivative
i = trading day i
n = total number of trading days in the period

According to the correlation measure, a hedge is deemed effective if the correlation between the
changes in the value of the hedged item and the derivative is high. In other words, a hedge
should be considered effective if the R-squared of the regression of this relation is around 80
percent. Furthermore, the slope of the regression line should be close to 1.0 (but this is not
explicitly referred to in SFAS 133).

For more information on measuring hedge effectiveness, refer to Kalotay and Abreo (2001), Risk
Books (1999), and Energy Information Administration (2002), among others.

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June 12, 2001

Senior management asked Scott to propose Southwests hedging strategy for the next one to
three years. Because of the current high price of jet fuel, Scott was unsure of the best hedging
strategy to employ. Table 7 provides Southwests hedging practices at year-end 2000 as
discussed in their annual report. Because Southwest adopted SFAS 133 in 2001, Scott needed to
consider this in his hedging strategy.

Southwests average fuel cost per gallon in 2000 was $0.7869, which was the highest annual
average fuel cost per gallon experienced by the company since 1984. As discussed previously,
fuel and oil expense per ASM increased 44.1 percent in 2000, primarily due to the 49.3 percent
increase in the average jet fuel cost per gallon. (Refer to Table 1: The average price per gallon of
jet fuel in 2000 was $0.7869 compared to $0.5271 in 1999.)

Although Scott thought the price of jet fuel would decrease over the next year, he cannot be sure
energy prices are notoriously hard to predict. Scott knew that: Predicting is very difficult,
especially as it concerns the future (Chinese Proverb). Any political instability in the Middle
East could cause energy prices to rise dramatically without much warning. If the cost of jet fuel
continued to rise, the cost of fuel for Southwest would rise accordingly without hedging. On the
other hand, if the cost of jet fuel declines, the cost of fuel would drop if Southwest were
unhedged.

To deal with these risks, Scott identified the following 5 alternatives. Scott estimated
Southwests jet fuel usage to be approximately 1,100 million gallons for next year.

1. Do nothing.
2. Hedge using a plain vanilla jet fuel or heating oil swap.
3. Hedging using options.
4. Hedge using a zero-cost collar strategy.
5. Hedge using a crude oil or heating oil futures contract.

Appendix 2 contains information on NYMEX futures contracts and futures options contracts,
both for crude oil and heating oil.

For alternative 2 above (i.e. hedging using a plain vanilla crude oil or heating oil swap), there
were two different possibilities:
11

(1) Enron offered Scott an over-the-counter plain vanilla jet fuel swap with a 1-year
maturity. The offer stipulated a fixed rate for Southwest Airlines of 76 cents/gallon. The
variable rate was based on the monthly average price for Gulf Coast jet fuel. Contract
payments would be made monthly during the life of the contract. The size of the swap
contract was one million gallons and for simplicity, assume that Enron was willing to

11
For the swap contract, use 1/12
th
of the hedge volume since the contracts are settled monthly over the one-year
period. In other words, for the 100% hedging, use swap contracts for a total of 1,100 million gallons divided by 12
= 91.67 swap contracts (or round to 92 contracts).
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enter into as many of these swap contracts as Southwest Airlines wanted. This swap was
similar to that explained in Example 1 of Figure 4.

(2) Scott also considered a NYMEX New York Heating Oil Calendar Swap (1-year
duration). The contract size was 42,000 gallons. The contract guaranteed a fixed rate for
Southwest Airlines of 73 cents/gallon for heating oil. The variable rate was based (per
NYMEX regulations) on the arithmetic average of the NYMEX New York Harbor
heating oil futures nearby month settle price for each business day during the month.
Contract payments would be made monthly during the life of the contract. This is similar
to Figure 4 (see Example 2).

Appendix 3 (see the first figure) contains information on the relation between jet fuel costs and
airline stock prices (11 major airlines). Note the negative correlation between the two lines.
Appendix 4 illustrates monthly load factors for U.S. domestic flights. As shown, demand varies
significantly by month and demand is highest in the summer months.

The Excel file (Jet Fuel Hedging Case Excel Data for Students.xls) contains historical prices for
jet fuel (spot), heating oil (spot and futures), and crude oil (spot and futures).

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Case Questions

1. Why do firms like Southwest hedge? What are the benefits of hedging? (Suggestion:
refer to Carter, Rogers, and Simkins (2004) for assistance in answering this question.)

2. Does heating oil or crude oil more closely follow the price of jet fuel? To answer this
question, use the information in the Excel spreadsheet.

3. (a) Evaluate each of the five proposed hedging strategies. What are the benefits of each
hedge based on two fuel price scenarios in one year? In other words, assume in June
2002 that one of these scenarios occurs. Calculate your net cost of jet fuel under each
scenario incorporating the hedging strategies used. (Note: you can analyze the hedges
under as many price scenarios as you wish, but be certain to include the following two
scenarios.) For both scenarios, consider full hedging and a 50% hedge strategy.

SCENARIO 1: 39.3 cents/gallon spot price for jet fuel; 38.8 cents/gallon spot price for
heating oil, or $14.10 per barrel spot price for crude oil, and
SCENARIO 2: 119.6 cents/gallon spot price for jet fuel; 118.6 cents/gallon spot price for
heating oil, and $40,00 per barrel spot price for crude oil.

(b) Discuss the pros and cons of each hedging strategy.
(c) Describe how a combination of the hedging strategies can be used.

4. What are the risks of being unhedged? Totally hedged? (Note: the February 24, 2004
Wall Street Journal article titled Outside Audit: Jet-Fuel Bets Are Risky Business by
Melanie Trottman may be useful.)

5. (a) What is basis risk and how is it different from price risk?
(b) What are the implications of a changing basis?
(c) Does basis risk exist for Southwest Airlines in their fuel hedging program?

6. (a) What is FAS 133 and how does it impact a firms hedging strategy?
(b) Using the effectiveness measure on page 6, calculate the effectiveness of hedges
using heating oil futures and crude oil futures for the period 2000-2001 (up until the time
of the case). How does the effectiveness measure impact a firms hedging decision.

7. Describe how a market in backwardation or contango (i.e. shape of the forward curve)
might impact hedging strategies. Are current crude oil markets in backwardation or
contango? (Note: Backwardation is the market situation when futures prices are
progressively lower in the distant delivery months when compared to the nearest
(prompt) month. Contango, the opposite of backwardation, is a market situation in which
prices in later delivery months are progressively higher than in the nearest delivery
(prompt) month.)

8. What do you recommend to Scott Topping? Why?
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References

Clubley, Sally, 1999, An Early Take Off, Risk (May), (see pg. 7 of Commodity Risk Special
Report in the issue).

Carter, David A., Dan Rogers, and Betty J. Simkins, 2004, Does Fuel Hedging Make Economic
Sense? The Case of the U.S. Airline Industry, Oklahoma State University working paper.

Energy Information Administration, 2002, Derivatives and Risk Management in the Petroleum,
Natural Gas, and Electricity Industries (October), U.S. Department of Energy.

Falloon, William and David Turner, editors, 1999, Managing Energy Price Risk, Risk
Publications (London).

Kalotay, Andrew and Leslie Abreo, 2001, Testing Hedge Effectiveness for FAS 133: The
Volatility Reduction Measure, Journal of Applied Corporate Finance Vol. 13 (No. 4), 93-99.

McCartney, Scott, Daniel Michaels, and David Rogers, 2002, Airlines Seek More Government
Aid, The Wall Street Journal, September 23, 2002, (pages A1, A10).

Neidl, Raymond E. and Erik C. Chiprich, 2001, Major U.S. Carriers 2000 Results and 2001
Outlook, Global Research, Ing-Barings.

Reuters, 2004, Soaring Jet Fuel Prices Threaten Airlines Bottom Lines, March 10.

Schap, Keith, 1993, Jet Fuel Swaps Ground Risk, Futures (February), 44-46.

Trottman, Melanie, 2004, Outside Audit: Jet-Fuel Bets Are Risky Business, Wall Street
Journal, February 24, page C3.

Paper #9100933
13
Table 1
Fuel Usage and Hedging Data for Southwest Airlines

Exposure variables
Hedging variables

Fiscal
year
ends Year
Hedge
Fuel?

Fuel
Used
(Million
Gallons)
Fuel Cost
($million)
Cost of
Fuel
($ per
gallon)
Available
Seat
Miles
(ASM)
(millions)
Cost/
ASM
Total
Expenses
($ Millions)
Fuel as a
% of
Expenses
Total
Revenue
($
Millions)
Fuel Cost
(% of
Revenue)
Gallons
Hedged
(millions)
% of
Next
Year
Hedged
Longest
Maturity
of
Hedges
(yrs)
31-Dec 2000 Yes 1022.2
$
804.4 $ 0.7869

59,910 $ 0.0081 $ 4,628 10.5% $ 5,649 8.6% N/A 80.00% 3.00
31-Dec 1999 Yes 939.1
$
495.0 $ 0.5271

52,855 $ 0.0094 $ 3,954 12.5% $ 4,736 10.5% 126.10 86.00% >1
31-Dec 1998 Yes 850.3
$
388.3 $ 0.4567

47,544 $ 0.0082 $ 3,480 11.2% $ 4,164 9.3% 290.00 33.00% 0.50
31-Dec 1997 Yes 792.4
$
495.0 $ 0.6246

44,487 $ 0.0111 $ 3,293 15.0% $ 3,817 13.0%
not
material
not
material N/A
31-Dec 1996 Yes 740.3
$
484.7 $ 0.6547

40,727 $ 0.0119 $ 3,055 15.9% $ 3,406 14.2%
not
material
not
material N/A
31-Dec 1995 Yes 662.2
$
365.7 $ 0.5522

36,180 $ 0.0101 $ 2,559 14.3% $ 2,873 12.7% 1.05 2.00% <1
31-Dec 1994 Yes 592.6
$
319.6 $ 0.5392

32,124 $ 0.0099 $ 2,275 14.0% $ 2,592 12.3% 2.10 5.00% <1
Paper #9100933
14
Table 2
SOUTHWEST AIRLINES CO. CONSOLIDATED STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31,
(In thousands, except per share amounts) 2000 1999 1998
----------- ----------- -----------
OPERATING REVENUES:
Passenger $ 5,467,965 $ 4,562,616 $ 4,010,029
Freight 110,742 102,990 98,500
Other 70,853 69,981 55,451
----------- ----------- -----------
Total operating revenues 5,649,560 4,735,587 4,163,980

OPERATING EXPENSES:
Salaries, wages, and benefits (Note 10) 1,683,689 1,455,237 1,285,942
Fuel and oil 804,426 492,415 388,348
Maintenance materials and repairs 378,470 367,606 302,431
Agency commissions 159,309 156,419 157,766
Aircraft rentals 196,328 199,740 202,160
Landing fees and other rentals 265,106 242,002 214,907
Depreciation (Note 2) 281,276 248,660 225,212
Other operating expenses 859,811 791,932 703,603
----------- ----------- -----------
Total operating expenses 4,628,415 3,954,011 3,480,369
----------- ----------- -----------
OPERATING INCOME 1,021,145 781,576 683,611

OTHER EXPENSES (INCOME):
Interest expense 69,889 54,145 56,276
Capitalized interest (27,551) (31,262) (25,588)
Interest income (40,072) (25,200) (31,083)
Other (gains) losses, net 1,515 10,282 (21,106)
----------- ----------- -----------
Total other expenses (income) 3,781 7,965 (21,501)
----------- ----------- -----------
INCOME BEFORE TAXES AND CUMULATIVE EFFECT
OF CHANGE IN ACCOUNTING PRINCIPLE 1,017,364 773,611 705,112
PROVISION FOR INCOME TAXES (NOTE 11) 392,140 299,233 271,681
----------- ----------- -----------
INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE 625,224 474,378 433,431
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING
PRINCIPLE, NET OF INCOME TAXES (NOTE 2) (22,131) -- --
----------- ----------- -----------
NET INCOME $ 603,093 $ 474,378 $ 433,431
=========== =========== ===========
NET INCOME PER SHARE, BASIC BEFORE CUMULATIVE
EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE $ 1.25 $ .94 $ .87
CUMULATIVE EFFECT OF CHANGE IN
ACCOUNTING PRINCIPLE (.04) -- --
----------- ----------- -----------
NET INCOME PER SHARE, BASIC $ 1.21 $ .94 $ .87
=========== =========== ===========

Paper #9100933
15
Table 3
SOUTHWEST AIRLINES CO. CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts) DECEMBER 31,
2000 1999
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents $ 522,995 $ 418,819
Accounts and other receivables (Note 7) 138,070 75,038
Inventories of parts and supplies, at cost 80,564 65,152
Deferred income taxes (Note 11) 28,005 20,929
Prepaid expenses and other current assets 61,902 52,657
----------- -----------
Total current assets 831,536 632,595

Property and equipment, at cost (Notes 3, 5, and 6):
Flight equipment 6,831,913 5,768,506
Ground property and equipment 800,718 742,230
Deposits on flight equipment purchase contracts 335,164 338,229
----------- -----------
7,967,795 6,848,965
Less allowance for depreciation 2,148,070 1,840,799
----------- -----------
5,819,725 5,008,166
Other assets 18,311 12,942
----------- -----------
$ 6,669,572 $ 5,653,703
=========== ===========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 312,716 $ 266,735
Accrued liabilities (Note 4) 499,874 430,506
Air traffic liability 377,061 256,942
Current maturities of long-term debt (Note 5) 108,752 7,873
----------- -----------
Total current liabilities 1,298,403 962,056

Long-term debt less current maturities (Note 5) 760,992 871,717
Deferred income taxes (Note 11) 852,865 692,342
Deferred gains from sale and leaseback of aircraft 207,522 222,700
Other deferred liabilities 98,470 69,100

Stockholders' equity (Notes 8 and 9):
Common stock, $1.00 par value: 1,300,000 shares authorized;
507,897 and 505,005 shares issued in 2000
and 1999, respectively 507,897 505,005
Capital in excess of par value 103,780 35,436
Retained earnings 2,902,007 2,385,854
Treasury stock, at cost: 3,735 and 5,579 shares in
2000 and 1999, respectively (62,364) (90,507)
----------- -----------
Total stockholders' equity 3,451,320 2,835,788
----------- -----------
$ 6,669,572 $ 5,653,703
=========== ===========
Paper #9100933
16

Table 4
Market Share of US Airlines

This table presents the market share of passenger-only or combined passenger and cargo carriers
(designated as passenger airlines) in Panel A and cargo-only carriers (designated as airfreight carriers) in
Panel B. Major airlines are defined as airlines with annual revenues of more than $1 billion, and regional
airlines are those carriers with annual revenues less than $1 billion. ASM stands for available seat miles
and represents one seat flown one mile. Average revenues are calculated as the average over 1994-2000
and market share in Panel A is calculated as the percentage of total ASM for the period 1994-2000.

Panel A: Market Share of Passenger Carriers Based on Available Seat Miles.
Airline
Average
Revenue
($ Millions)
Total Available
Seat Miles
(1994-2000)
Market Share
Based on ASM
Major Airlines

United Airlines
16,796
1,168,894.0 20.52%
American Airlines
16,913
1,126,177.0 19.77%
Delta Air Lines
13,528
966,188.0 16.96%
Northwest Airlines
9,750
657,477.6 11.54%
Continental Airlines
7,356
498,731.0 8.75%
US Airways Group
8,240
418,607.0 7.35%
Southwest Airlines
3,891
313,827.9 5.51%
America West Holdings
1,879
160,005.0 2.81%
Alaska Air Group
1,746
119,565.0 2.10%

Regional Airlines
Amtran
880
94,232.6 1.65%
Hawaiian Airlines
423
38,455.1 0.67%
Airtran Holdings
360
27,787.1 0.49%
Midwest Express Holdings
347
17,603.5 0.31%
Mesa Air Group
452
16,966.4 0.30%
Comair Holdings
517
15,113.9 0.27%
Frontier Airlines
151
14,992.8 0.26%
SkyWest
291
12,147.6 0.21%
Mesaba Holdings
235
12,054.7 0.21%
Midway Airlines
200
9,775.3 0.17%
Atlantic Coast Airlines
253
8,642.7 0.15%
Total

5,697,244.20 100.00%
Paper #9100933
17
Table 4. Continued

Panel B: Market Share of Cargo Carriers based on Freight Ton-miles
(in Millions)

Airfreight
Carrier
Freight
Ton-miles
(in Millions)
Market Share Based
on Freight Ton-miles
FedEx
7,401.9
31.71%
United Parcel Service
4,339.1
18.59%
United Airlines
2,529.9
10.84%
Northwest Airlines
2,205.1
9.45%
American Airlines
1,916.7
8.21%
Delta Airlines
1,435.0
6.15%
Atlas Air
1,048.3
4.49%
Continental Airlines
995.1
4.26%
Airborne Express
887.0
3.80%
US Airways
277.7
1.19%
TransWorld Airlines
129.6
0.56%
Southwest Airlines
69.1
0.30%
Alaska Air
57.4
0.25%
Hawaiian Airlines
53.7
0.23%
Total
23,345.60
100.00%
Note: FedEx, United Parcel Service, Atlas Air, and Airborne Express are
cargo-only carriers. The other firms listed are primarily passenger
airlines.

Paper #9100933
18

Table 5
Example of a Jet Fuel Cross-hedge Using the NYMEX Heating Oil Futures Contract

On January 6, 2000, a fuel purchasing director wants to hedge his September
jet fuel consumption at current prices. He buys a September New York Harbor
heating oil futures contract on the NYMEX at 66.28 cents per gallon (contract
size is for 42,000 gallons). On the same day, the New York jet fuel spot price
is 80.28 cents per gallon. The director closes out this futures contract on
August 29, 2000 at 98.59 cents per gallon. As shown below, the director has
made a profit of 32.31 cents per gallon (98.59 minus 66.28) on the futures
contract. In essence, the hedger bought a futures contract (a long hedge) in
January and then sold back the futures contract in August. The spot price of
NY jet fuel on August 29th is 103.6 cents per gallon. Without the futures
hedge, the director would have paid 23.32 cents/gallon more for the fuel.
However, by using the futures contract and purchasing jet fuel in the spot
market, the gain of 32.31 on the futures offsets the 23.32 increase in the jet fuel
spot price. As a result, the directors net cost of jet fuel is 71.29 cents per
gallon (i.e. 103.6 spot price in August minus the futures hedging gain of 32.31
cents/gallon).

Cash Price
(i.e. Spot Price)
Futures Price Basis
(Cash price minus futures
price)
January 6 cash price
80.28 cents/gallon

66.28 cents/gallon 14.00 cents/gallon
August 29 cash price
103.6 cents/gallon
98.59 5.01

32.31 cents/gallon gain

8.99 cents/gallon basis loss

Result:

Cash purchase price of jet fuel 103.6 cents/gallon
Minus heating oil futures gain - 32.31 cents/gallon
Net purchase price of jet fuel 71.29 cents/gallon

Paper #9100933
19

Table 6
Statement of Financial Accounting Standards 133 (SFAS 133) Balance Sheet and
Income Statement Impacts of Cash Flow and Fair Value Hedges

This table summarizes the balance sheet and income statement impacts of hedging
according to SFAS 133.

Type of Derivative Balance Sheet Impact Income Statement Impact
Cash Flow Hedge Derivative (asset or liability) is
reported at fair value. Changes in fair
value of derivative are reported as
components of Other Comprehensive
Income (balance sheet)
No immediate income statement
impact. Changes in fair value of
derivatives are reclassified into the
income statement (from Other
Comprehensive Income in the balance
sheet) when the expected (hedged)
transaction affects the net income.
Derivative must qualify for hedge
accounting treatment.

Fair Value Hedge Derivative (asset or liability) is
reported at fair value. Hedged item is
also reported at fair value.
Changes in fair value are reported as
income/loss in the income statement.
Offsetting changes in fair value of the
hedged item are also reported as an
income/loss in the income statement

Speculative Transaction Derivative (asset or liability) is
reported at fair value
Changes in the fair value are reported
as income/loss in the income
statement.
Paper #9100933
20

Table 7
Disclosures on Hedging From Southwest Airlines 2000 Annual Report

FINANCIAL DERIVATIVE INSTRUMENTS The Company utilizes a variety of
derivative instruments, including both crude oil and heating oil based derivatives, to
hedge a portion of its exposure to jet fuel price increases. These instruments consist
primarily of purchased call options, collar structures, and fixed price swap agreements.
The net cost paid for option premiums and gains and losses on fixed price swap
agreements, including those terminated or settled early, are deferred and charged or
credited to fuel expense in the same month that the underlying jet fuel being hedged is
used. Hedging gains and losses are recorded as a reduction of fuel and oil expense.
Beginning January 1, 2001, the Company will adopt Statement of Financial Accounting
Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging
Activities which will change the way it accounts for financial derivative instruments. See
Recent Accounting Developments.

RECENT ACCOUNTING DEVELOPMENTS In 1998, the Financial Accounting
Standards Board (FASB) issued SFAS 133. SFAS 133, as amended, is required to be
adopted in fiscal years beginning after June 15, 2000. The Company will adopt SFAS 133
effective January 1, 2001. SFAS 133 will require the Company to record all derivatives
on its balance sheet at fair value. Derivatives that are not designated as hedges must be
adjusted to fair value through income. If the derivative is designated as a hedge,
depending on the nature of the hedge, changes in the fair value of derivatives that are
considered to be effective, as defined, will either offset the change in fair value of the
hedged assets, liabilities, or firm commitments through earnings or will be recorded in
other comprehensive income 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, may
have to be immediately recorded in earnings. Any portion of a change in a derivative's
fair value that the Company has elected to exclude from its measurement of effectiveness,
such as the change in time value of option contracts, will be recorded in earnings.

The Company will account for its fuel hedge derivative instruments as cash flow hedges,
as defined. Although the fair value of the Company's derivative instruments fluctuates
daily, as of January 1, 2001, the fair value of the Company's fuel hedge derivative
instruments was approximately $98.3 million, of which approximately $75.8 million was
not recorded in the Consolidated Balance Sheet. The $75.8 million will be recorded as an
asset on the Company's balance sheet as part of the transition adjustment related to the
Company's adoption of SFAS 133. The offset to this balance sheet adjustment will be an
increase to "Accumulated other comprehensive income", a component of stockholders'
equity. The portion of the transition adjustment in "Accumulated other comprehensive
income" that relates to 2001 hedge positions, based on fair value as of January 1, 2001, is
approximately $73.9 million and will be reclassified into earnings during 2001. The
remainder of the transition amount will be reclassified to earnings in periods subsequent
to 2001. The Company believes the adoption of SFAS 133 will result in more volatility in
its financial statements than in the past.
Paper #9100933
21

Figure 1
OPIS Regional Jet Fuel Prices
25
45
65
85
105
125
1
/
3
/
1
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Date
U
.
S
.

C
e
n
t
s
/
G
a
l
l
o
n
OPIS Chicago Jet 54
OPIS Gulf Coast Jet 54
OPIS Los Angeles Jet 54
OPIS N.Y. Harbor Jet 54
OPIS San Francisco Jet 54
Paper #9100933
22
Figure 2
Historical Gulf Coast Spot Jet Fuel Price Volatility

COMPUTING VOLATILITY (Standard Deviation)
Results: Periodic Annualized
Variance 0.001378 0.344570998
Standard Deviation (i.e. VOLATILITY) 3.71% 58.70%
Mean -0.06% N/A
Obs. Date
Jet Fuel
Price
Simple
Rate of
Return
Continuously
Compounded
Rate of Return
Squared
Deviation
1 1/2/2001 86.8 NA NA NA
2 1/3/2001 81.65 -5.93% -6.12% 0.003741
3 1/4/2001 82.8 1.41% 1.40% 0.000196
4 1/5/2001 85.83 3.66% 3.59% 0.001292
5 1/8/2001 82.13 -4.31% -4.41% 0.001942
6 1/9/2001 79.98 -2.62% -2.65% 0.000704
7 1/10/2001 86 7.53% 7.26% 0.005267
8 1/11/2001 84.43 -1.83% -1.84% 0.000339
9 1/12/2001 85.4 1.15% 1.14% 0.000130
10 1/16/2001 87.75 2.75% 2.71% 0.000737
11 1/17/2001 87.25 -0.57% -0.57% 0.000033
12 1/18/2001 90.15 3.32% 3.27% 0.001069
13 1/19/2001 91.47 1.46% 1.45% 0.000211
14 1/22/2001 92.4 1.02% 1.01% 0.000102
15 1/23/2001 91.82 -0.63% -0.63% 0.000040
16 1/24/2001 85.88 -6.47% -6.69% 0.004473
17 1/25/2001 89 3.63% 3.57% 0.001273
18 1/26/2001 93.25 4.78% 4.66% 0.002176
19 1/29/2001 90.13 -3.35% -3.40% 0.001158
20 1/30/2001 85.83 -4.77% -4.89% 0.002390
21 1/31/2001 86.78 1.11% 1.10% 0.000121
22 2/1/2001 82.84 -4.54% -4.65% 0.002159
23 2/2/2001 87.83 6.02% 5.85% 0.003421
24 2/5/2001 87.3 -0.60% -0.61% 0.000037
25 2/6/2001 87.95 0.74% 0.74% 0.000055
26 2/7/2001 87.63 -0.36% -0.36% 0.000013
Totals Count= 25 0.033079
Paper #9100933
23
Figure 3

Price Spread Between Jet Fuel and Heating Oil for Gulf Coast Prompt
0
5
10
15
20
25
30
M
a
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Source: Bloomberg
Paper #9100933
24
Figure 4
Fuel Hedging Using Swap Contracts

Example 1 using a Plain Vanilla Jet Fuel Swap Arranged in the OTC Market

Typically, the airline pays a fixed price and receives a floating price, both indexed to expected jet
fuel use during each monthly settlement period. The volume of fuel hedged is negotiated
because this is a customized contract. During the life of the swap contract, the airline buys jet
fuel in the cash market, as usual, but the swap contract makes up the difference when prices rise
and removes the difference when prices decline. The result for the airline is a fixed price for the
period covered. The fixed rate payment is set based on market conditions when the swap contract
is initiated. The floating price of jet fuel is commonly based on Platts New York Harbor jet
fuel price and is calculated monthly using daily prices for the month. The net monthly payment
(or cost) to the fixed-rate payer is the floating rate minus the fixed rate. For example, if the
floating rate for a month averages 80 cents per gallon and the fixed rate is 70 cents per gallon,
then the floating rate payer makes a 10 cents per gallon payment that month to the airline. If the
size of the contract is 100,000 gallons, a payment of $10,000 is made to the airline (i.e. $0.10 x
100,000).

Example 2 using the NYMEX New York Harbor Heating Oil Calendar Swap

The NYMEX New York Heating Oil Calendar Swap lets hedgers arrange positions in the heating
oil market as far forward as 36 months. The price settlement of the contract is based on the
arithmetic average of the NYMEX New York Harbor heating oil futures nearby month
settlement price for each business day during the contract month. The swap contract is for
42,000-gallons the same size as the NYMEX heating oil futures contract. Consider an 18-
month swap currently trading with a fixed-price of 0.6841 cents/gallon. Suppose the futures
average daily price for the month was 0.5900. The hedger who is long the futures contract (such
as the airline) will make a payment to the counterparty of $3952.20 [i.e. (0.6841 0.5900) x
42,000]. The airline would purchase jet fuel in the spot market. Assuming the basis has not
changed between jet fuel and heating oil (i.e. the high correlation between heating oil and jet fuel
remains unchanged), the loss on the futures contract will be offset by the lower cash price of jet
fuel. As a result, the airline effectively pays a fixed price for jet fuel.

Counterparty is
Floating-rate
payer
Pay fixed rate of $X per gallon
per the swap contract
Airline receives floating rate based on
monthly average jet fuel price
Airline is
Fixed-rate payer
Paper #9100933
25

Figure 5
Swap, Call Option, and Premium Collar Illustration

Paper #9100933
26
Figure 6
Net Cost of Jet Fuel Using a Collar Strategy (Buy 80 Cent/Gallon Call and Sell 60 Cent/Gallon Put)

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Appendix 1
Glossary of Airline Terms

Aircraft (average during period): The average number of aircraft operated during the period.

Aircraft utilization: The average number of block hours operated in scheduled service per day per aircraft for the
total fleet of aircraft.

Available seat miles (ASMs): The number of seats available for scheduled passengers multiplied by the number of
miles those seats were flown.

Average fare: The average fare paid by a revenue passenger.

Average seats per departure: The average number of available seats per departing aircraft.

Average stage length: The average number of miles flown per flight.

Block hour: The total time an aircraft is in motion from brake release at the origination to brake application at the
destination.

Break-even load factor: The load factor at which scheduled passenger revenues would have been equal to
operating plus non-operating expenses/(income) (holding yield constant).

Cost per available seat mile (CASM): Operating expenses plus non-operating expenses/(income) divided by
ASMs.

Departure: A scheduled aircraft flight.

Fuel price per gallon: The average price per gallon of jet fuel for the fleet (excluding into plane fees)

Load factor: RPMs divided by ASMs.

Onboard passengers: The number of revenue passengers carried.

Revenue passenger miles (RPMs): The number of miles flown by revenue passengers.

Passenger revenue per available seat mile (PRASM): Passenger revenues divided by ASMs.

Yield: The average scheduled passenger fare paid for each mile a scheduled revenue passenger is carried.

Paper #9100933
28
Appendix 2

Futures Options Data as per Barrons on 6-11-01 (NYMEX)
CRUDE OIL CALLS CRUDE OIL PUTS
Month Strike Volume Premium Month Strike Volume Premium
Jul-01 $27.50 706 $1.05 Jul-01 $24.00 1,792 $0.01
Jul-01 $28.00 3,610 $0.71 Jul-01 $25.00 1,274 $0.02
Jul-01 $28.50 3,085 $0.47 Jul-01 $25.50 881 $0.03
Jul-01 $29.00 5,122 $0.29 Jul-01 $26.00 2,145 $0.04
Jul-01 $29.50 2,659 $0.18 Jul-01 $26.50 750 $0.07
Jul-01 $30.00 8,575 $0.10 Jul-01 $27.00 4,005 $0.12
Jul-01 $30.50 708 $0.06 Jul-01 $27.50 1,583 $0.22
Jul-01 $31.00 2,463 $0.04 Jul-01 $28.00 5,128 $0.38
Jul-01 $32.00 4,086 $0.02
Jul-01 $36.00 506 $0.01
Aug-01 $28.00 1,966 $1.43 Aug-01 $23.00 535 $0.05
Aug-01 $28.50 4,054 $1.16 Aug-01 $24.00 761 $0.07
Aug-01 $29.00 2,930 $0.91 Aug-01 $25.00 1,022 $0.12
Aug-01 $29.50 4,892 $0.73 Aug-01 $26.00 2,957 $0.24
Aug-01 $30.00 6,127 $0.58 Aug-01 $26.50 1,003 $0.33
Aug-01 $31.00 1,726 $0.34 Aug-01 $27.00 2,026 $0.46
Aug-01 $31.50 1,012 $0.26 Aug-01 $27.50 1,017 $0.62
Aug-01 $32.00 7,880 $0.19 Aug-01 $28.00 5,064 $0.80
Aug-01 $33.00 1,880 $0.13
Aug-01 $35.00 2,309 $0.09
Aug-01 $40.00 1,161 $0.02
Aug-01 $45.00 1,000 $0.01
Sep-01 $28.00 750 $1.75 Sep-01 $24.00 733 $0.16
Sep-01 $28.50 921 $1.48 Sep-01 $25.00 921 $0.28
Sep-01 $29.00 900 $1.22 Sep-01 $26.50 810 $0.59
Sep-01 $30.50 700 $0.71 Sep-01 $27.50 1,200 $0.92
Sep-01 $33.00 1,371 $0.26 Sep-01 $28.00 1,708 $1.12
Sep-01 $34.00 4,305 $0.18 Sep-01 $31.00 500 $2.93

Oct-01 $28.00 675 $1.92 Oct-01 $20.00 815 $0.06
Oct-01 $33.00 945 $0.39 Oct-01 $24.00 520 $0.27
Oct-01 $34.00 2,430 $0.29 Oct-01 $27.00 655 $1.02
Oct-01 $28.00 525 $1.42

Nov-01 $32.00 2,700 $0.63 Nov-01 $20.00 1,250 $0.10
Nov-01 $24.00 3,325 $0.40

Dec-01 $27.50 568 $2.24 Dec-01 $22.00 1,055 $0.22
Dec-01 $28.00 602 $1.89 Dec-01 $23.00 5,850 $0.34
Dec-01 $29.00 500 $1.46 Dec-01 $25.00 2,750 $0.77
Dec-01 $30.00 579 $1.14 Dec-01 $26.00 3,151 $1.08
Dec-01 $34.00 600 $0.42 Dec-01 $27.50 650 $1.67

Apr-02 $26.50 525 $2.50
Jun-02 $22.50 900 $1.80
Jun-02 $26.00 1,287 $2.61 Jun-02 $20.50 950 $0.56
Jun-02 $28.00 600 $1.80
Dec-03 $23.00 700 $2.91 Dec-03 $23.00 700 $2.65

Paper #9100933
29

Futures Data as per Barrons on 6-11-01
Heating Oil (NYMEX HO)
42,000 gallons per contract (cents/gallon)
Month Weeks High Weeks Low Weeks Settle Open Interest
Jul 01 78.40 75.00 76.65 29,709
Aug 01 78.35 75.70 77.12 19,087
Sep 01 78.90 76.30 77.77 12,679
Oct 01 79.55 77.50 78.52 7,415
Nov 01 80.35 78.10 79.27 9,606
Dec 01 80.90 78.80 79.82 21,185
Jan 02 80.90 79.00 80.02 8,576
Feb 02 80.40 78.00 78.87 7,055
Mar 02 77.80 75.60 76.17 9,774
Apr 02 74.90 73.18 73.62 1,981
May 02 71.90 70.95 71.27 1,584
Jun 02 70.75 69.75 70.02 1,795
Jul 02 70.02 69.62 69.62 474
Aug 02 69.77 289
Sep 02 70.12 289
Oct 02 70.52 207
Nov 02 71.9 70.38 70.92 382
Dec 02 71.73 71.65 71.42 103

Light Sweet Crude (NYMEX CL)
1,000 barrels per contract (dollars/barrel)
Jul 01 28.74 27.25 28.33 93,423
Aug 01 28.90 27.71 28.63 95,499
Sep 01 28.85 27.90 28.63 46,117
Oct 01 28.61 27.90 28.50 23,347
Nov 01 28.33 27.81 28.32 21,390
Dec 01 28.20 27.55 28.07 35,792
Feb 02 27.65 27.20 27.51 9,215
Mar 02 27.21 26.87 27.23 5,214
May 02 26.67 4,616
Jun 02 26.42 26.10 26.39 19,331
Jul 02 26.13 4,822
Aug 02 25.74 25.60 25.87 2,687
Sep 02 25.62 8,269
Oct 02 25.38 4,494
Nov 02 25.16 3,246
Dec 02 24.99 24.71 24.96 18,953
Jan 03 24.77 3,976
Feb 03 24.59 819
Mar 03 24.43 904
Paper #9100933
30
Apr 03 24.28 267
May 03 24.14 217
Jun 03 24.10 23.79 24.01 6,504
Jul 03 23.88 169
Aug 03 23.75 230
Sep 03 23.62 415
Oct 03 23.49
Nov 03 23.37
Dec 03 23.26 9,995
Jun 04 22.88 22.67 22.88 200
Dec 04 22.69 22.65 22.57 5,999
Dec 05 22.17 5,302
Dec 06 21.82 1,996
Dec 07 21.77 375

Paper #9100933
31
Appendix 3
Monthly Stock Returns of 11 Major Airlines Versus the Montly Percentage Change in Jet Fuel
Costs Over the Period 1994-1999
-25.00%
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Paper #9100933
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Appendix 4

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Source: Bloomberg
Paper #9100933

Teaching Note for Fuel Hedging in the Airline Industry: The Case of Southwest Airlines
1
TEACHING NOTE

Fuel Hedging in the Airline Industry: The Case of Southwest Airlines

Synopsis and Objectives

Set in J une 2001, the case places the student in the role of Scott Topping, Director
of Corporate Finance at Southwest Airlines. Scott is responsible for the airlines fuel
hedging program. The case describes the importance of jet fuel hedging in the airline
industry, the volatility of jet fuel prices, hedging strategies available to manage jet fuel
price risk, and related issues. [Note: The time period of the case allows the instructor to
discuss additional issues not specifically addressed in the case such as the impact of
September 11
th
, 2001 terror attacks on the airlines hedging strategy and the collapse of
Enron (e.g., counterparty credit risk in hedging).]

Southwest Airlines has a business model based on being a low cost provider and has
been very successful at offering the lowest airfares in the industry. This business strategy
has effectively resulted in a consistently increasing market share over the years. A
dominant factor on the expense side of its business is the cost of fuel. Fuel is the second
largest expense behind labor. Most recently, fuel costs have reached the highest annual
average over the six-year period from 1994 to 2000 at $0.7869 per gallon in 2000. This
fact has led to the increased importance of minimizing fuel cost for 2001 and beyond. To
mitigate the sensitivity to fuel prices, Southwest has consistently hedged its fuel usage
but wants to reevaluate the strategies it employs. As listed in the case, the student is
asked to evaluate the following hedging strategies: (1) doing nothing, (2) hedge using
plain vanilla swaps, (3) hedge using options, (4) hedge using zero cost collars, and (5)
hedge using futures contracts.

The case is intended for use in an advanced corporate finance course or risk
management at the graduate level. However, the case can also be used in an
undergraduate risk management course.

Specific learning objectives are to:

Introduce students to the topic of corporate risk management and reasons
why firms should hedge.

Understand the importance of price volatility for an input price in an
industry that is highly competitive.

Teach about different derivatives instruments used in hedging. While the
case deals with the commodity jet fuel, these hedging strategies are
Paper #9100933

2
commonly used in other areas of the energy industry and in hedging
agricultural commodities, metals, currencies, interest rates, etc.

Cover more advanced risk management topics such as basis risk,
backwardated markets, contango markets, and accounting issues (i.e.,
SFAS 133).

Available Computer Spreadsheets

Student spreadsheet: J et fuel hedging case Excel data for students.xls. This
spreadsheet should be provided to students before analyzing the case.

Solution spreadsheet: J et Fuel Hedging Solution Spreadsheet.xls contains detailed
calculations and provides assumptions used.

Description of Case Research Development

In developing the case, numerous interviews were conducted with Scott Topping,
Director of Corporate Finance at Southwest Airlines, over the period 2002 through
Spring 2004. Scott Topping visited Oklahoma State University to speak to an MBA class
about fuel hedging at Southwest Airlines during the Spring, 2002 when the case was first
used. At this time, two of the case authors interviewed Scott in person. In addition, one
of the authors went to Southwest Airlines headquarters in Dallas, Texas during
September 2003 to conduct additional field interviews. Scott Topping also participated
in a phone interview with MBA students during the Spring, 2004 semester when the case
was used in a graduate level corporate finance course. At this time, Scott provided an
update on their view of fuel hedging and related issues.

Scott Topping reviewed an early draft of the case during the Spring semester of 2002 and
provided extensive comments and corrections at that time. This was very helpful in
focusing the case on relevant issues and clarification of hedging strategies.

Most of the data on Southwest Airlines presented in the case is based on publicly
available financial information obtained from annual and quarterly financial statements
and from Bloomberg.

Useful Reference Articles for Students:

Carter, David A., Daniel A. Rogers, and Betty J . Simkins, 2004, Does Fuel Hedging
Make Economic Sense? The Case of the U.S. Airline Industry, Oklahoma State
University working paper.

Energy Derivatives and the Transformation of the U.S. Corporate Energy Sector, 2001,
Journal of Applied Corporate Finance, Vol. 13 (No. 4), 50-75.

Paper #9100933

3
Energy Information Administration, 2002, Derivatives and Risk Management in the
Petroleum, Natural Gas, and Electricity Industries (October), U.S. Department of
Energy.

Haushalter, David, 2001, Why Hedge? Some Evidence From Oil and Gas Producers,
Journal of Applied Corporate Finance, Vol. 13 (No. 4), 87-92.

NYMEX, A Guide to Energy Hedging, (available at
http://www.nymex.com/media/energyhedge.pdf).

Stulz, R.M., 1996, Rethinking Risk Management, Journal of Applied Corporate
Finance, Vol. 9, 8-24.

Trottman, Melanie, 2004, Outside Audit: J et-Fuel Bets Are Risky Business, The Wall
Street Journal Online, February 24.

Paper #9100933

4
DISCUSSION AND ANALYSIS

Case Questions and Answers

1. Why do firms like Southwest hedge? What are the benefits of hedging?

Answer:

The instructor might want to open the discussion by stating Scott Toppings quote at the
beginning of the case: If we dont hedge jet fuel price risk, we are speculating. It is our
fiduciary duty to try and hedge this risk.

Then, the instructor should ask the class: Why would someone like Scott Topping say
this? What does he mean?

More generally, the following discussion summarizes the answer.

Southwest realizes that jet fuel prices are highly unpredictable. Most airlines realize it is
often impossible to pass on higher fuel prices to its customers, because this would require
raising ticket prices in a highly competitive industry. An example would be one airline
that is not hedged for higher fuel prices, having to raise its ticket prices to remain
profitable. However, its competitors (who have a fuel hedging strategy) do not raise
ticket prices, thus having a lower price in what has become a commodity service. As a
result, the un-hedged airline is forced to go back to its original prices in order not to lose
sales and to remain competitive. This happened to Continental Airlines as described on
page 3 of the case:

For example, Continental Airlines rescinded a fare hike after trying a number of
times to boost overall fares. The airline said the air fare increases were due to
high fuel costs, but intense airline competition has left the firm unable to pass
along fuel costs to customers .
1

The instructor may want to start a more in-depth discussion by first discussing the
theoretical academic perspective on risk management:

The starting point is typically the seminal work of Modigliani and Miller (1958)
(M&M) on corporate finance and optimal capital structure. M&M find that under perfect
capital markets assumptions (e.g., no taxation, no bankruptcy costs, and well-diversified
investors, etc.), the value of a firm does not depend on how the firm is financed. A
corollary to the M&M conclusion is that there is no value to risk management because
shareholders can do it for themselves (by simply holding a well-diversified portfolio and
make the necessary asset allocation decisions themselves if they seek to bear more risk).
However, when relaxing the M&M assumptions to more real world assumptions, the
conclusion is that risk management can add value. How? This is described next.

1
See Continental Raises Domestic Fares, Cites Fuel Costs (Reuters, February 27, 2004) and Continental Airlines
Resends Latest Fare Hike (Reuters, J une 7, 2004).
Paper #9100933

5

At this point, the instructor may want to summarize theoretical motivations and
evidence for hedging from the academic literature:

Most theoretical research in corporate risk management identifies value-
maximizing rationales for hedging. Empirical research in this area has found the
following: Many published articles conclude that firms hedge to reduce expected costs of
distress.
2
Other papers deduce that firms hedge because of high investment
opportunities.
3
Carter, Rogers, and Simkins (2004) present evidence that hedging airlines
are more highly valued in the market place (based on Tobins Q). Such hedging provides
firms with the opportunity to buy underpriced assets from distressed airlines during
periods of high jet fuel prices and/or protects the ability to meet previously contracted
purchase commitments. They point out that large airlines (such as Southwest Airlines)
are typically in the best position to buy distressed airlines (or desirable parts). Hedging
future jet fuel purchases allows these firms a means to manage a significant source of
variation in cash flows. Given that jet fuel price increases often coincide with distress in
the airline industry, hedging provides an additional source of cash for making
acquisitions during these periods. Allayannis and Weston (2001) examine the effect of
currency derivatives usage on relative market value and find a positive relation between
currency hedging and Tobins Q. Graham and Rogers (2002) test the effect of
derivatives hedging on debt in a capital structure model and find that hedging has a
positive effect on debt ratios.

The more astute student may also point out the following reasons cited in the
suggested readings:

The article from the Journal of Applied Corporate Finance titled Why hedge:
Some evidence from Oil and Gas producers, states firms hedge for two reasons. The
first being that management is risk averse, meaning that management wants to reduce the
likelihood that they may lose their jobs if the price of a major input/output changes
unfavorably. The second reason stated is that hedging can reduce the likelihood that a
company will incur financial distress and therefore increase the ability to fund profitable
capital projects.

In the article Energy Derivatives and the Transformation of the U.S. Corporate
Energy Sector from the Journal of Applied Corporate Finance it states . . . derivative
markets help enable companies to take the risks that they want to take in part by getting
rid of the risks that they dont want to take . . . allowing them to concentrate more on
their core competence. So, if they can reduce or eliminate that price risk, then
shareholders should feel better about that. By transferring the risk of business processes
that firms do not have any insight into or control over, a firm is able to concentrate its

2
Berkman and Bradbury (1996), Dolde (1995), Gay and Nam (1998), Graham and Rogers (2002),
Haushalter (2000), and Howton and Perfect (1998) are examples of papers reaching this conclusion.
3
Allayannis and Ofek (2001), Dolde (1995), Gay and Nam (1998), Gczy et al. (1997), and Nance et al.
(1993) find that hedging increases with the level of R&D expenditures.
Paper #9100933

6
efforts on those competencies which they are best at, increasing the overall
effectiveness and efficiency of the firm.

To summarize, the benefits of hedging are:

Reduce risk of financial distress
Increase ability to make profitable investment opportunities
Minimizes price risk
Improves firm value
Manages the volatility of earnings
Reduce the firms cost of capital

2. Does heating oil or crude oil more closely follow the price of jet fuel? To
answer this question, use the information in the Excel spreadsheet.

Answer:

[Note: The main purpose of this question is to have the student understand the
relationship between prices for related commodities in hedging and realize why cross-
hedges are sometimes used. Question 5 further analyzes this issue by covering basis
risk.]

Refer to the solution spreadsheet. Using daily prices from J an. 2, 1991 through
J une 12, 2001, the correlation is 97.9% for jet fuel and heating oil and 95.3% for jet fuel
and. crude oil. This is a correlation using prices, not returns. As shown, both
commodities have a high correlation to jet fuel, but heating oil has the highest correlation.
Students will calculate different correlations depending on the period and interval used
(i.e., daily versus monthly or weekly). The instructor may have the students calculate the
correlation based on returns instead of price levels. The main purpose of this question is
for the student to understand why cross-hedges are sometimes used.

The following figure (also included in the solution spreadsheet see Tab
Q2&Q5 Basis & Corr. Coeff.) illustrates the relationship between heating oil futures
and crude oil futures and the spot price of jet fuel. Note the high correlation and similar
prices for jet fuel and heating oil. The futures contracts are for the nearby contract.

Paper #9100933

7

3. (a) Evaluate the 5 proposed hedging strategies. Evaluate each hedge under
two fuel price scenarios. (Note: You can evaluate the hedges under as many price
scenarios as you wish, but be certain to analyze the following two scenarios.)

SCENARIO 1: 39.3 cents/gallon spot price for jet fuel; 38.8 cents/gallon spot price
for heating oil, or $14.10 per barrel spot price for crude oil, and

SCENARIO 2: 119.6 cents/gallon spot price for jet fuel; 118.6 cents/gallon spot
price for heating oil, and $40,00 per barrel spot price for crude oil. For both
scenarios, consider full hedging and a 50% hedge strategy.

The 5 proposed hedging strategies are:

1. Do nothing.
2. Hedge using a plain vanilla jet fuel or heating oil swap.
3. Hedging using options.
4. Hedge using a zero-cost collar strategy.
5. Hedge using a crude oil or heating oil futures contract.

Answer:

This question is by far the most difficult one in the case because it requires lengthy
calculations. Based on our experience using the case, the instructor should provide
students with simple examples of how to analyze some of the hedging strategy in class
lectures when the case is assigned.

The answers students calculate will depend on the assumptions they make. In our
analysis, we have made the following assumptions:
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New York, NY Crude Oil Future Contract 1 ($/bbl)
New York, NY No 2 Fuel Oil / Heating Oil Future Contract 1 (C/gal)
Gulf Coast J et Fuel Kero Spot Price FOB (C/gal)
Paper #9100933

8

For calculating the cost of jet fuel using the swap contracts for the one-year
period, we assumed the monthly floating prices either increased (Scenario 2) or
decreased (Scenario 1) linearly to the spot price in one year (see prices given in
the case). The same instructions were given to the students before analyzing the
case. For example, for the jet fuel swap, we assumed that prices declined at a
linear rate from 79.45 cents/gallon in J une 2001 to 39.3 cents per gallon in J une
2002. The solution spreadsheet shows the detailed calculations. (Note: Of course,
actual numbers can be used when conducting ex-post analysis.)

The solution for the crude oil option strategy is based on buying a $28.00 call
option with a premium of $1.80.

The solution for the costless collar strategy assumes the purchase of a $28.00 call
option ($1.80 premium paid) and the sale of a $22.50 put ($1.80 premium
received).

The solutions for the crude oil and heating oil futures strategy (5a and 5b) are
based on selecting the futures contract maturing in J une 2002. For simplicity,
calculations are summarized over the time period (see solution file). Futures
contracts are offset before maturity and futures contract prices are assumed to
converge on the future spot price (using the spot prices provided in the case
scenarios). In other words, the futures hedge is treated as a static hedge for the
entire annual jet fuel usage using a one-year futures contract. This assumption is
used to simplify calculations but in reality, the assumption is unrealistic. Please
refer to the response to part C of this question for a more realistic futures strategy.

The following table provides a summary of the answers (in millions of $) for the total
cost of jet fuel including the hedging gains or losses. As shown, under Scenario 1, the
lowest cost would be strategy #1 do nothing, and the next best strategy is #3 using
crude oil options. Under Scenario 2, the futures contracts using heating oil provides the
minimum cost of fuel.

Paper #9100933

9

Scenario 1 Scenario 2
Full Hedge 50%
Hedge
Full
Hedge
50% Hedge
1 Do nothing 432.3 N/A 1315.6 N/A
2a J et Fuel Swap 633.6 532.9 1038.4 1177.0
2b Heating Oil Swap 651.1 541.7 1058.9 1187.3
3 Crude Oil Options 479.4 455.9 1037.5 1182.0
4 Zero-cost Collar 652.3 542.3 1001.3 1158.5
5a Crude Oil Futures 754.2 593.2 959.2 1137.4
5b Heating Oil Futures 775.7 604.0 781.2 1048.4

Total Costs - Scenario 1
0
200
400
600
800
1000
1200
1400
1 2a 2b 3 4 5a 5b
C
o
s
t
s

(
$
M
M
)
Full Hedge
50% Hedge
Total Costs - Scenario 2
0
200
400
600
800
1000
1200
1400
1 2a 2b 3 4 5a 5b
C
o
s
t
s

(
$
M
M
)
Full Hedge
50% Hedge
Paper #9100933

10
Refer to J et Fuel Hedging Solution Spreadsheet.xls for the detailed calculations and
assumptions.

To illustrate solutions provided in the spreadsheet the following is the solution for
strategy #2 using the jet fuel swap and prices under Scenario 1:

Scenario 1-JET
FUEL

Assume: Floating prices chg
linearly to end spot. So avg
monthly floating price chg =
(0.0335)
Time Fixed Floating SWA Net
Payment
$/gal
0 J un-01 0.76 0.7945
1 J ul-01 0.76 0.7610 (0.0010)
2 Aug-01 0.76 0.7276 0.0324
3 Sep-01 0.76 0.6941 0.0659
4 Oct-01 0.76 0.6607 0.0993
5 Nov-01 0.76 0.6272 0.1328
6 Dec-01 0.76 0.5938 0.1663
7 J an-02 0.76 0.5603 0.1997
8 Feb-02 0.76 0.5268 0.2332
9 Mar-02 0.76 0.4934 0.2666
10 Apr-02 0.76 0.4599 0.3001
11 May-02 0.76 0.4265 0.3335
12 J un-02 0.76 0.3930 0.3670
Avg PMT= 0.1830

Total Cost=Spot * Gal +Paid to Enron
Fuel Cost Swap Cost
432.3 201.3
Total
Cost=
633.6

50% Hedge
Fuel Cost Swap Cost
432.30 100.6385
Total
Cost=
532.94

Paper #9100933

11
(b) Discuss the pros and cons of each hedging strategy.

Answer:

To fully address this question, the student should discuss the pros (advantages)
and cons (disadvantages) of each strategy separately.

Strategy #1: Do Nothing
Pros
No upfront cash costs
Cons
Unlimited market risk
If prices increase dramatically, it can impact the firms profitability and cause
financial distress.

Strategy #2: Hedge using a plain vanilla jet fuel or heating oil swap
Pros
Cash flows occur monthly which more closely matches actual fuel expenditures
No upfront cash costs
Cons
Counterparty credit risk with Enron swap
Heating oil swap has basis risk
Liquidity may be a concern if Southwest wants to unwind the position early
Limited ability to benefit financially if jet fuel prices decline

Strategy #3: Hedge using options
Pros
Greatest flexibility of all alternatives
No counterparty credit risk since traded on NYMEX
Upside price protection and firm still benefits from declining prices
Cons
High upfront cash costs in form of option premiums
Basis risk

Strategy #4: Hedge using a zero-cost collar strategy
Pros
High flexibility
No counterparty credit risk if hedger utilizes crude oil or jet fuel traded on
NYMEX
Upside price protection and firm still benefits from declining prices until the put
strike price is reached
Low or zero upfront cash costs
Cons
If prices drop below the put strike price, the firm loses the benefit of lower prices
Basis risk

Paper #9100933

12
Strategy #5: Hedge using crude oil or heating oil futures contract strategy
Pros
No counterparty credit risk if hedger utilizes crude oil or jet fuel traded on
NYMEX
Low upfront cash costs (just margin that needs to be posted but can be substantial)
Cons
The firm does not benefit from lower prices
Basis risk
Contracts are marked-to-market daily, which may require additional cash
payments over the life of the contract

(c) Describe how a combination of the hedging strategies can be used.

Answer:

Answers will vary and it is difficult to say with certainty that one strategy clearly
dominates. Nevertheless, students should not select #1: Do Nothing Southwests
strategy of providing air travel at the lowest possible fares demands strict cost
management. By not hedging its fuel costs, Southwest might place its entire business
strategy at risk.

The more astute student will suggest, for example, a futures strip to more closely
match actual fuel needs for each month. In Appendix 3 of the case, monthly load factors
for U.S. domestic flights are provided. The student could use this information to obtain a
rough estimate of monthly jet fuel requirements. A futures strip is a series of futures
contracts that expire monthly. For this case, a one-year strip (futures contracts expiring
over the next 12 months) is appropriate.

4. What are the risks of being unhedged? Totally hedged?

Answer:

After labor, jet fuel is the second largest cost for airlines. The price paid for this
commodity can significantly impact earnings, the viability of an airline, the ability of the
airline to remain competitive with other airlines. The typical airline customer is very
sensitive to ticket prices. In other words, most customers do not exhibit product loyalty
and will switch airlines based on prices. If an airline was to raise the costs of their tickets
to offset the rise in fuel costs, they may lose business.

Hedging protects companies from the price fluctuations that can occur with
commodities like jet fuel. The volatility of prices can cause operating costs to increase
dramatically. Hedging allows an firm to set a fixed price for the commodity in the future.
Hedging reduces the risk associated with price fluctuations.
Paper #9100933

13

If a company is unhedged, it assumes all risk associated with price volatility.
With the price of jet fuel rising and uncertainty in prices, companies can be assume major
financial risk if they do not hedge. For Southwest, a 25 cents gallon jet fuel increase will
raise the fuel price by $275 million. Not hedging has caused airlines to file bankruptcy in
the past. However, if an airline is completely hedged, they will not benefit from
declining prices (depending on the derivative contract used). This is clear from the
analysis in Question 3.

The more thorough student might talk about price elasticity of demand of air
travel, and the extent to which oil prices may be related to important macroeconomic
conditions affecting business and leisure travel (i.e., GDP growth, interest rate levels,
etc.).

To expand the discussion to the transportation industry, the instructor may want to
point out that unlike the airline industry, large firms in the trucking industry are more
able to pass on the extra cost of fuel to their customers. Why? Airlines compete with one
another on almost all of the markets they serve. Price competition is extremely high in
the airline industry. The trucking industry is structured differently and their service can
be viewed as more customized. For this reason, long-haul trucking firms often have
formalized fuel surcharges. This allows these firms to add a fuel surcharge that varies
with the price of fuel. The biggest fuel-related risk for large trucking firms, such as J B
Hunt Transport Services, among others, is that the price of fuel may increase significantly
before the firm is able to pass extra costs to customers (causing a short-term decrease in
earnings). Smaller trucking firms and independent contractors often receive a flat fee for
shipping, and as a result, increased fuel costs directly impact earnings.

It is interesting to note that, similar to airlines, long-haul trucking firms have fuel
costs comprising 10 to 15 percent of total expenses. Meanwhile, for firms such as UPS
and FedEx, fuel costs represent approximately 4 to 6 percent of expenses.

5. (a) What is basis risk and how is it different from price risk?

Answer:

As discussed in the case, quoting directly:

The term basis risk is used to describe the risk that the value of the
commodity being hedged may not change in tandem with the value of the
derivative contract used to hedge the price risk. While crude oil, heating oil, and
jet fuel prices are highly correlated, significant basis risk can emerge if the
relationship between the commodities breaks down. In an ideal hedge, the hedge
would match the underlying position in every respect. However, in actuality,
basis risk is a high concern, even if the derivatives contract is for the exact same
commodity being hedged. . Why does basis risk occur? The following
Paper #9100933

14
three basis risks occur frequently in hedging: product basis risk, time basis risk,
and locational basis risk.

The student may also use the following definition of basis (see, for example, A
Guide to Energy Hedging by NYMEX): basis is the differential that exists between the
cash price of a given commodity and the price of the nearest futures contract for the
same, or a related commodity.

Most of the hedging strategies evaluated involve basis risk since in many cases,
the hedging instrument is a different commodity than the needed commodity product (i.e.
jet fuel.)

Basis risk is not the same as price risk. Price risk is the magnitude of the
volatility associated with any particular commodity product whereas basis risk involves
the differential between prices.
4
A change in the differential between prices over time
leads to a change in the effectiveness of the hedge as it no longer accurately tracks the
price movements of the hedged commodity. This could lead to either more protection or
less protection but either way, it introduces additional uncertainty into a strategy whose
purpose is to reduce uncertainty.

Basis risk will affect Southwests hedging strategies since most of the hedge
strategies do not use a jet fuel based derivative but rather related commodities such as
heating oil and crude oil. Refer to the figure below (also included in the solution
spreadsheet see Tab Q2&Q5 Basis & Corr. Coeff.) for an illustration of the basis
between jet fuel and heating oil/crude oil. As shown, the basis can dramatically change
from time to time.

4
The instructor can refer the student to their spreadsheet (see tab Volatility) to see how it is calculated for jet fuel.
-30
-20
-10
0
10
20
30
40
1
/
2
/
1
9
9
1
1
/
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/
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/
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/
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/
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C
e
n
t
s
/
g
a
l
l
o
n
Basis Heating Oil Basis Crude Oil
Paper #9100933

15

(b) What are the implications of a changing basis?

Answer: The change in basis impacts hedge performance and can cause either a loss or
gain to occur as a result of hedging. For example, employing the following definition of
basis:

Basis = cash price futures price

One can readily see that a party entering into a long hedge (such as Southwest) will earn
a profit from the hedged position if the futures price increases more than does the cash
price (or decreases less). On the other, a loss will result if cash price increases relative to
the futures price. A perfect hedge (ex post) results only if the basis does not change when
measured between the inception date of the hedge and its liquidation.

(c) Does basis risk exist for Southwest Airlines in their fuel hedging program?

Answer: The answer to this question is yes but the degree of basis risk depends on the
hedging instruments used. The greatest basis risk is for strategies involving a cross hedge
(i.e., heating oil or crude oil). The reason is that the price of the cash commodity (jet
fuel) and the price of the futures contract may not always move in tandem.

6. (a) What is SFAS 133 and how does it impact a firms hedging strategy?

Answer: A recent development related to hedging is SFAS 133, which is a
requirement by the Financial Accounting Standards Board for the disclosure of any
derivative transaction entered into by a corporation. From a strictly theoretical point of
view, the change in the accounting disclosure requirements should have no effect on a
firms hedging strategy. Nevertheless, one can find many examples of situations in which
changes in accounting policy has caused firms to change business behaviors. A concern
voiced by heavy users of derivatives is that, by introducing unrealized gains and losses
from derivative instruments that fail to qualify for hedge accounting, SFAS 133 would
cause more volatility in reported earnings. In such cases, firms may be discouraged from
entering into cross-hedges that may be subject to significant levels of basis risk. Smaller
users of derivatives suggested that the added costs from complying with SFAS 133 would
negate the benefits associated with hedging.

(b) Using the effectiveness measure on page 6, calculate the effectiveness of hedges
using heating oil futures and crude oil futures for the period 2000-2001 (up until the
time of the case). How does the effectiveness measure impact a firms hedging
decision.

Answer:

Hedge effectiveness is determined by reviewing historical performance of a hedge
instrument and the hedged item along with an evaluation of anticipated future
Paper #9100933

16
performance. FASB has two suggested methods of measuring the historical performance
the 80-125 Rule and the Correlation Method. Under the 80-125 Rule, a hedge is
considered effective if there is a high degree of confidence that the dollar offset ratio will
remain within a range of 0.80 to 1.25 over the hedge horizon . In other words, this means
that the change in value of the derivative will be between 80% and 125% of the change in
value of the hedged item.
5
Both of these methods were applied to the daily period from
J anuary 4, 2000 through J une 12, 2001 using jet fuel as the hedged item and crude oil and
heating oil as the hedge instrument. Refer to the Excel tab Q5 Effectiveness Test
Results in the solution spreadsheet for complete details.

RETROSPECTIVE
TEST
FAS 133
Requirement
Heating Oil
Futures Contract
Crude Oil
Futures Contract
80-125 Rule 80%-125% 70.22% 100.66%
Correlation Measure >80% 76.74% 57.58%

As shown, the crude oil futures passes the hedge effectiveness test based on the
80-125 Rule but not under the Correlation Method. On the other hand, the heating oil
futures contract almost passes the correlation measure (77% versus the minimum of
80%). This suggests that under SFAS 133, some hedges involving either heating oil or
crude oil may not be classified as cash flow hedges and the results would be sensitive to
the retrospective test used. If a hedge does not pass the hedge effectiveness test, changes
in the fair value of the derivative would have to be reported as income/loss in the income
statement. However, this is not a certainty as there is plenty of gray area in SFAS 133.
For example, the time period for performing the retrospective test is not specified with
any detail so more (or less) data could be used in performing this test. Also, a
prospective test is supposed to be used to take into account anticipated future
performance. Since this particular test involves estimates of future prices, much leeway
could be used. Hedging effectiveness under SFAS 133 is a advanced subject in the area
of risk management and can quickly come very complex. This question in the case is
meant to be an introduction to the topic so that the student is at least aware of these
issues. For additional articles on SFAS 133, refer to Canabarro (1999), Charnes, Koch,
and Berkman (2003), Kalotay and Abreo (2001), and Kawaller and Koch (2000). Refer
to the reference list at the end of this teaching note for publication details on these
articles.

This effectiveness measure puts strain on managements decision making process
when entering into hedges. Overall, management should educate investors and analysts
about why hedging is important for the firm to effectively manage its expenses.

5
The dollar offset ratio has been criticized because it can give false signals about hedge effectiveness. For
example, the ratio can frequently fall outside the 80-125 band even when the prices of the hedged item
and the derivative are highly correlation. See Charnes, Koch, and Berkman (2003) and Canabarro
(1999).
Paper #9100933

17
It is important to note the following: Scott Topping states that while SFAS 133 is
an important concern, generally speaking, their strategy is chosen based on the economics
-- not the accounting issues.

7. Describe how a backwardated market or contango market (i.e. shape of the
forward curve) might impact hedging strategies. Are current crude oil
markets in backwardation or contango?

Answer:

Contango is a market situation where prices are progressively higher in the distant
delivery months. Backwardation is a market situation where prices are progressively
lower in distant delivery months. If the jet fuel markets were in contango, there would be
a financial incentive to purchase fuel in an earlier period for use in later periods if the
storage costs were less than the price increases. Southwest might choose to lease
additional fuel tanks as its hedging strategy rather than hedge in the commodity markets
(only if the carrying costs of this storage is less than the time basis between months.)
According to Scott Topping, such a strategy is too expensive because storage is typically
expensive relative to the time basis. When markets are in backwardation, a hedging
strategy using futures contracts may be useful.

This lack of storability is one reason that crude oil markets tend to exhibit
backwardation. Therefore, Southwest must rely on financial instruments to protect itself
against rising fuel costs. Appendix 2 in the case demonstrates the backwardation in the
crude oil and heating oil futures market. For example, notice that the heating oil futures
prices are progressively lower for futures contracts with longer maturities. The same
trend is evident in crude oil futures prices, as shown in the following graph:

Crude Oil (NYMEX CL) Futures
(6-11-01)
22
23
24
25
26
27
28
29
J
u
l
-
0
1
S
e
p
-
0
1
N
o
v
-
0
1
J
a
n
-
0
2
M
a
r
-
0
2
M
a
y
-
0
2
J
u
l
-
0
2
S
e
p
-
0
2
N
o
v
-
0
2
J
a
n
-
0
3
$
/
b
a
r
r
e
l
Paper #9100933

18

To challenge students, the instructor can pose this question to the class: What happens
when the market switches from backwardation to contango (or vice versa). How does this
impact hedging strategies? The most famous example of what can happen to a hedging
strategy when energy markets switch from backwardation to contango is the case of
MGRM (Metallgesellschaft Refining and Marketing) in 1993. (See
http://www.erisk.com, Wheel of Misfortune, for more on this subject, or published
articles on this topic.). This question and the story about MGRM can lead to an insightful
and fascinating classroom discussion.

8. What do you recommend to Scott Topping? Why?

Answer: Most likely, students answers to this question will vary. The student should
explain the pros and cons of the strategy selected and discuss why they selected a
particular strategy over the other strategies.

Southwest prefers to use the collar strategy (a premium collar) because it provides a good
compromise to achieve flexibility at a reasonable cost. However, over time, they have
used different strategies. Most of their hedging is in the OTC market through Goldman
Sachs, Morgan Stanley, and Barclays.

The instructor may want to make the following points when wrapping up the discussion:

It is managements responsibility to fully understand the key risks of the hedging
strategy selected.

Management should assess the interrelationships between market risks, liquidity risks,
and basis risk in their hedging strategy.

The manager should communicate these risks to upper management and the board of
directors when applicable.

Paper #9100933

19

CONCLUSION

When presenting the conclusion, we suggested that the instructor give an epilogue
for the case. This information is provided next in this teaching note.

In concluding the case, the instructor should pose the following question to the
class: If jet fuel hedging is a valuable activity, then why dont all airlines engage in this
practice? In other words, do non-hedgers act sub-optimally? After students discuss this
question, the following is our summary of the answer:

No, non-hedgers may not be acting sub-optimally. If the benefits of hedging are
less than the costs of hedging, then no net benefit would be gained from hedging
by the airline. Given that smaller airlines do not hedge jet fuel purchases with
derivatives suggests that the costs may outweigh the benefits for these firms.

Furthermore, airlines that are financially distressed will find it more difficult and
expensive to hedge, whereas airlines with investment grade credit ratings can
more easily hedge and have much greater flexibility in hedging strategies.
Fundamentally, stronger credit ratings allow for more hedging, longer-dated
hedging, and different types of hedging strategies that are not available to weaker
airlines.

Also, smaller airlines that are a regional carrier for a major airline may have a
fuel pass-through agreement, which allows the smaller airline to pass on fuel price
increases. This is a type of operational hedge and would reduce the need for a
financial hedge. Charter airlines have a greater ability to increase ticket prices in
response to fuel price increases due to the custom nature of their business.

Additional issues the instructor may wish to discuss is the impact of September
11
th
, 2001 on the airline industry. Indirectly, this relates to fuel hedging because for the
next year, air travel was significantly lower. For an article on the impact of September
11
th
on the airline industry, refer to: The Markets Reaction to Unexpected,
Catastrophic Events: The Case of Airline Stock Returns and the September 11
th
Attacks
by David A. Carter and Betty J . Simkins, forthcoming in the Quarterly Review of
Economics and Finance.
Paper #9100933

20
Epilogue

When providing the epilogue, the instructor should first discuss jet fuel prices
over the subsequent year. (Note: The instructor may want to ask students to analyze how
the hedges performed using actual prices. To do this, the instructor should ask students
to go to the Energy Information Administration (EIA) website and download all energy
prices that are needed. The website is: http://www.eia.doe.gov/.)

To view jet fuel prices over this period, See Exhibit 1 provided at the end of the
epilogue. As shown, jet fuel prices dropped over the one-year period ending J une 14,
2002 from 79.45 to 66.75 cents per gallon for the Gulf Coast spot price of jet fuel. On
J une 14, 2002, the spot prices of heating oil and crude oil were 65.8 cents per gallon and
$25.90 per barrel, respectively. Ex-post, the best choice would have been to not hedge.
However, it should be emphasized to students that prices could have increased instead.
In other words, for Southwest to remain unhedged would be too risky and violate their
business strategy.

At this point, it is useful to restate the quote by Scott Topping provided at the
beginning of the case:

If we dont hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try
and hedge this risk.

To further emphasize the importance of hedging jet fuel costs, the instructor may want to
quote the excerpts below from the article (U.S. Airlines Show Disparity in Hedging for
J et-Fuel Costs) by Melanie Trottman, published in the Wall Street Journal on March 10,
2003.

Jet fuel, now more than twice as expensive as a year ago, is emerging as a major factor in survival
and bankruptcy for airlines, as several carriers, including some of the weakest, find themselves with
few protective price hedges in place.

Airlines typically hedge by locking in fuel at prearranged prices or buying securities that rise in value
when oil climbs. Yet the industry finds itself with wide disparity in hedging, with some airlines fully
hedged at low prices, and others completely exposed to huge price increases.

UAL Corp.'s United Airlines, operating under bankruptcy-court protection, has no hedges in place this
year. That will likely cost the nation's second-largest airline more than $100 million in added fuel
costs during the current quarter alone, estimates UBS Warburg analyst Samuel Buttrick. Analysts
suspect US Airways Group Inc., also reorganizing in bankruptcy, has few hedges in place. US Air says
it is hedged for 2003, but it wouldn't disclose prices or percentages.

By contrast, Southwest Airlines, the only profitable major carrier, hedged 100% of its jet-fuel needs for
the current quarter at prices that are the equivalent of $23 a barrel for crude oil, compared with
recent crude-oil prices hovering around $36 a barrel. Southwest has lined up more than 75% of its fuel
for the rest of this year and next at $23 a barrel for crude oil.

Paper #9100933

21
On April 29
th
, 2004, a conference call was held with Scott Topping, Director of
Corporate Finance, Southwest Airlines, to get an update on his view of fuel hedging.
Scott Topping emphasizes that their hedging program is integral to Southwests unit cost
management and competitive advantage. He stresses that it helps Southwest to maintain
their competitive advantage as the low cost provider in the industry.

Below are six questions that students asked Scott Topping, together with a brief
summary of his reply:

Question #1: Do you think Southwest would be this financially sound if it did not choose
to hedge jet fuel prices?
Not quite, but still viable. We would have posted some quarterly losses, for
instance, last quarter $ 24illion.

Question #2: What hedging strategies are you currently using? What is your most used
hedging strategy?
If you define strategy as a structure collars (upside protection w/ some cost
reduction via managed downside).

Question #3: Do you closely consider current trends in jet fuel prices when considering
hedging strategies or are fuel prices too unpredictable to consider this?
Trends are one factor to consider, especially when important technical levels are
broken through. I wouldnt consider technical analysis to be a major decision factor
however.

Question #4: Whats the most effective hedging method used by Southwest to control the
volatile jet fuel price over-time? (I mean: futures? options/collar? And Why?)
With the benefit of hindsight, we could have spent less on options and managed risk
with swaps in this bull market. However, that would not have been good risk
management. All methods have been successful we feel the collar is a good
compromise to achieve optionality at a reasonable cost.

Question #5: How do you choose the hedging strategy dynamically?
It takes a fair amount of market intelligence. You must have trusted sources and act
upon the changing environment as it relates to your overall risk management
objectives. Example: Preparing last year for the Iraq war and making a decision
about hedging jet fuel directly or remaining in crude oil /heating oil as a proxy.

Question #6: How has FAS 133 affected your hedging strategy at Southwest?
So far, a minor factor, we try not too put accounting ahead of economic sense.
However, FAS 133 adds a lot of complexity to the corporate accounting/financial
reporting side.

Paper #9100933

22
Exhibit 1
Paper #9100933

23
Additional References Cited in the Teaching Note

Kalotay, Andrew and Leslie Abreo, 2001, Testing Hedge Effectiveness for FAS 133:
The Volatility Reduction Measure, Journal of Applied Corporate Finance, Vol.
13 (No. 4), 93-99.

Allayannis, G., Ofek, E., 2001, Exchange Rate Exposure, Hedging, and the Use of
Foreign Currency Derivatives, Journal of International Money and Finance, 20,
273-296.

Allayannis, G., Weston, J .P., 2001, The Use of Foreign Currency Derivatives and Firm
Market Value, Review of Financial Studies, Vol. 14, 243-276.

Berkman, H., Bradbury, M.E., 1996, Empirical Evidence on the Corporate Use of
Derivatives, Financial Management, Vol. 25 (No. 2), 5-13.

Canabarro, Eduardo, 1999, A Note on the Assessment of Hedge Effectiveness Using the
Dollar Offset Ratio Under FAS 133, Goldman Sachs Research Paper (J une).

Charnes, Koch, and Berkman, 2003, Measuring Hedge Effectiveness for FAS 133
Compliance, Journal of Applied Corporate Finance, Vol. 15 (No. 4), 95-103.

Dolde, W., 1995, Hedging, Leverage, and Primitive Risk, Journal of Financial
Engineering, Vol. 4, 187-216.

Gay, G.D., Nam, J ., 1998, The Underinvestment Problem and Corporate Derivatives
Use, Financial Management, Vol. 27 (No. 4), 53-69.

Graham, J .R., Rogers, D.A., 2002, Do Firms Hedge in Response to Tax Incentives?
Journal of Finance, Vol. 57, 815-839.

Haushalter, G.D., 2000, Financing Policy, Basis Risk, and Corporate Hedging: Evidence
from Oil and Gas Producers, Journal of Finance, Vol. 55, 107-152.

Howton, S.D., Perfect, S.B., 1998, Currency and Interest-rate Derivatives Use in U.S.
Firms, Financial Management, Vol. 27 (No. 4), 111-121.

Kalotay, Andrew and Leslie Abreo, 2001, Testing Hedge Effectiveness for FAS 133:
The Volatility Reduction Measure, Journal of Applied Corporate Finance, Vol.
13 (No. 1), 93-99.

Kawaller, Ira and Paul Koch, 2000, Highly Effective Expectation Criterion for Hedge
Accounting, Journal of Derivatives, Vol. 7 (Summer), pp. 79-87.

Nance, D.R., Smith, C.W., J r., Smithson, C.W., 1993, On the Determinants of Corporate
Hedging, Journal of Finance, Vol. 48, 267-284.
Paper #9100933

Fuel Hedging in The Airline Industry

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Fuel Hedging in the Airline Industry: The Case of Southwest Airlines

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