2004 - Fuel Hedging in the Airline Industry

Embed Size (px)

Citation preview

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    1/33

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

    By

    Dave Carter a, Dan Rogersb, and Betty Simkins c

    aCollege of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011,

    Phone: (405) 744-5104, Email: [email protected]

    b

    School of Business Administration, Portland State University, Portland, OR 97207-0751,Phone: (503) 725-3790, Email: [email protected]

    cCONTACT AUTHOR: College of Business Administration, Oklahoma State University,

    Stillwater, OK 74078-4011, Phone: (405) 744-8625, Fax: (405) 744-5180,

    Email:[email protected]

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    2/33

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

    ByDave Carter, Dan Rogers, and Betty Simkins

    If we dont hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try andhedge 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. Highjet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew thatsince 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. Ifairlines can control the cost of fuel, they can more accurately estimate budgets and forecastearnings.

    It was Scotts job to hedge fuel costs, however, he knows that jet fuel prices are largelyunpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overallupward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. OnSeptember 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) spotprice for Gulf Coast jet fuel closed at a price of 79.45 cents/gallon. While this price was lowerthan 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 overa recent 25-day period for Gulf Coast has averaged 58.7 percent.

    2 Clearly, fuel price risk is an

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    3/33

    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 overthat for 1999.3As 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. Theairline began with one simple strategy: If you get your passengers to their destinations whenthey want to get there, on time, at the lowest possible fares, and make darn sure they have a goodtime doing it, people will fly your airline.5 This strategy has been the key to Southwestssuccess. 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 tobeing a top quality airline, Southwest was also innovative. They were the first airline with afrequent flyer program to give credit for the number of trips taken and not the number of milesflown. 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 4th

    largest U.S. carrier

    based on domestic passengers boarded and the largest U.S. carrier based on scheduled domesticdepartures. At year-end 2000, Southwest operated 344 Boeing 737 aircraft and provided serviceto 58 airports in 57 cities in 29 states throughout the U.S. In 2000, Southwest commencedservice 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 consolidatedbalance sheet, respectively, for the years 1999 and 2000. Historically, Southwest hasexperienced 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 operatingincome represented 22 percent of annual operating income.

    Fuel Hedging in the Airline Industry

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    4/33

    Airlines executives know that it is often impossible to pass higher fuel prices on to passengers byraising 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 pricesin response to higher fuel costs. For example, Continental Airlines rescinded a fare hike aftertrying a number of times to boost overall fares. The airline said the airfare increases were due tohigh fuel costs, but intense airline competition has left the firm unable to pass along fuel costs tocustomers.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. Overthe same period, Southwest holds a much smaller share of the freight market (see Panel B). By2000, Southwest was the fourth largest carrier in the US based on passengers flown and thelargest based on departures (see previous section). Obviously, competition is a top concern forSouthwest. With air travel becoming a commodity business, being competitive on price is thekey to survival and success. As Warren Buffett states: You cannot be the high-cost producer ina 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 profitabilitychoose to hedge fuel prices. In fact, Raymond Neidl (see Neidl and Chiprich, 2001) points outthat the carriers that produced an adequate return, especially in the second half of 2000, tendedto be those that had good fuel hedge positions in place. Airlines without hedges in place haddisappointing earnings or losses. For example, in the fourth quarter 2000, US Airways, whichwas 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 orproducers in that it usually the airline companys treasury department (rather than the fuelpurchasers) 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 fuelcost 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 byairlines. The first reason requires a brief explanation of refining. When refiners process crudeoil, 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

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    5/33

    characteristics to jet fuel, is frequently used in hedging by airlines. Also, since jet fuel is refinedfrom 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 asufficiently liquid market to warrant a futures contract or other type of exchanged-tradedcontract. 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 oncrude oil and heating oil in New York (the New York Mercantile Exchange, NYMEX) and forgasoil 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 hedgedmay 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 canemerge if the relationship between the commodities breaks down. In an ideal hedge, the hedgewould 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 thedifferential between the cash price of a given commodity and the price of the nearest futurescontract 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: productbasis risk, time basis risk, and locational basis risk. Product basis risk occurs when there is amismatch in the quality, consistency, weight, or underlying product. For example, airlinesfrequently use crude oil contacts to hedge jet fuel, but obviously crude oil and jet fuel are twodifferent commodities and hence have large product basis risk. Even within the samecommodity category, such as crude oil, product basis risk occurs because there are many types ofcrude oil varying in viscosity (such as heavy versus light crude) and sulfur content (sweet versussour crude). Time basis risk occurs when there is a mismatch in the time of the hedge. Forexample, if a hedger wishes to hedge long-term but only has short dated contracts available, timebasis risk is very significant.

    10 Locational basis risk, one of the most common types of basis risk,

    8Gas oil is the European designation for No. 2 heating oil and diesel fuel.9Refer 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, andchemicals conglomerate. In 1992, MGRM implemented what it believed to be a profitable marketing strategy. Thecompany agreed to sell specified amounts of petroleum products every month, for up to ten years, at fixed prices that

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    6/33

    occurs when there is a mismatch in the price of the product from one location to another, amismatch 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 jetkerosene 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 oilquickly 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% increaserelative to the average spread (i.e. (28.5 3.5)/ 3.5). It is important to note that since this periodof 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 MiddleEast now, which places less price pressure on jet fuel in periods of higher demand due to militaryconflict.

    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 moreexotic swap contracts) is an agreement whereby a floating price is exchanged for a fixed priceover a certain period of time. It is an off-balance-sheet financial arrangement, which involves notransfer of the physical item. Both parties settle their contractual obligations by means of atransfer 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 sometimesquarterly, semi-annually, or annually).

    Figure 4 illustrates fuel hedging using two types of swap contracts. Example 1 in the figuredescribes how a plain vanilla jet fuel swap arranged in the OTC market is used. Example 2illustrates fuel hedging on the organized exchanges using a highly liquid contract -- the NYMEX

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    7/33

    While a plain vanilla swap is based on the difference between the fixed and floating prices forthe 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 beused by companies to manage the basis risk from other hedging activities. For instance, assumean airline prefers to hedge its jet fuel exposure using a heating oil plain vanilla swap. The airlinecan used an additional swap contract, the differential swap for jet fuel versus heating oil, tohedge basis risk assumed from the heating oil swap. The net result is that the airline caneliminate the risk that jet fuel prices will increase more than heating oil prices. Basis risk can bean 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 atime up until the maturity date. OTC options in the oil industry are usually cash settled whileexchange-traded oil options on the NYMEX are exercised into futures contracts. OTC optionsettlement 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, theytypically 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 whenmarket liquidity is a concern. For example, an airline might buy an option on heating oil as across-market hedge against a rise in the price of jet fuel. Of course, cross-market hedges shouldonly be used if the prices are highly correlated.

    Airlines such as Southwest value the flexibility that energy options provide, but energy optionscan be seen as expensive relative to other options. The reason is the high volatility of energycommodities, which causes the option to have a higher premium. For this reason, zero-costcollars (discussed next) are often used. Figure 5 provides a conceptual illustration for hedginggains or losses using swaps, call options, and premium collars when locking into a 60-cent/gallonprice 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 acommodity, a collar is created by selling a put option with a strike price below the currentcommodity price and purchasing a call option with a strike price above the current commodityprice. The purchase of a call option provides protection during the life of the option against

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    8/33

    prices drop. A collar can be structured so that the premium received from the sale of the putoption 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 optionstrike price) or more benefit from declining prices is desired (i.e., selling a put with a lower strikeprice), a premium collar is used. With a premium collar, the cost of the call option is onlypartially offset by the premium received from selling a put option. Refer to Figure 5 for aconceptual illustration of the premium collar strategy.

    Using a zero-cost collar or premium collar may appear to be a reasonable hedging strategy for anairline 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 morefor jet fuel than its competitors who did not employ the collar strategy. Competitors may lowertheir airfares aggressively as a result. Accordingly, the zero-cost collar should be moreaccurately 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 commodityfor a certain price at a designated time in the future. The buyer has a long position, which meanshe/she agrees to make delivery of the commodity (i.e., purchase the commodity). The seller hasa short position, which means he/she agrees to make delivery of the commodity (i.e., sell thecommodity). Futures contracts are traded on an exchange, which specifies standard terms for thecontracts (e.g., quantity, quality, delivery, etc.) and guarantees their performance (removingcounterparty risk). Only a small percentage of futures contracts traded result in delivery of thecommodity (less than one percent in the case of energy contract). Instead, buyers and sellers offutures 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 contractsare typically customized and not traded on an exchange; and (2) Futures contracts are marked tomarket 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 dependingon the current value of the commodity being hedged. The NYMEX exchange trades futures oncrude oil, heating oil, and gasoline (among other commodities).

    Table 5 illustrates how a fuel hedger can use the NYMEX heating oil futures contract to hedgejet fuel price risk. As shown, the hedger purchases a futures contract at 66.28 cents per gallon

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    9/33

    hedgers net cost of jet fuel is 71.29 cents per gallon (i.e., 103.6 spot price in August minus thefutures 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 companysexposure to its derivative positions more transparent. Prior to SFAS 133, most derivatives werecarried off-balance sheet and reported only in footnotes to the financial statements. Under SFAS133, depending on the reason for holding the derivative position and the derivativeseffectiveness 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, fairvalue hedges, and speculative transactions under SFAS 133. Under SFAS 133, managers such asScott Topping that want their hedge to receive hedge accounting treatment, must be certain theirhedge will pass the effectiveness measure. To qualify, the manager must measure theeffectiveness of the hedge at least each reporting period for the entire duration of the hedge. Anyineffective 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 historicalperformance (retrospective test) and anticipated future performance (prospective test). TheFASB has provided only broad guidelines for testing hedge effectiveness. The FASB has twosuggested approaches to measure historical performance: the 80-125 rule and the correlationmethod. According to the 80-125 rule (also referred to as the dollar-value-offset method), ahedge is deemed effective if the ratio of the change in value of the derivative to the change invalue of the hedged item falls between 80 % and 125%. Shown in equation form:

    Effectiveness measure = n

    i=2(PH)ini=2(PD)i

    Where: (PH)i = (PH)i - (PH)i-1(PD)i = (PD)i- (PD)i-1PH= the daily price of the hedged item

    PD= the daily price of the derivativei = trading day in = total number of trading days in the period

    According to the correlation measure, a hedge is deemed effective if the correlation between thechanges in the value of the hedged item and the derivative is high. In other words, a hedge

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    10/33

    June 12, 2001

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

    Southwests average fuel cost per gallon in 2000 was $0.7869, which was the highest annualaverage 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 percentincrease in the average jet fuel cost per gallon. (Refer to Table 1: The average price per gallon ofjet 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 MiddleEast 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 theother hand, if the cost of jet fuel declines, the cost of fuel would drop if Southwest wereunhedged.

    To deal with these risks, Scott identified the following 5 alternatives. Scott estimatedSouthwests 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), therewere two different possibilities:

    11

    (1) Enron offered Scott an over-the-counter plain vanilla jet fuel swap with a 1-year

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    11/33

    enter into as many of these swap contracts as Southwest Airlines wanted. This swap wassimilar to that explained in Example 1 of Figure 4.

    (2) Scott also considered a NYMEX New York Heating Oil Calendar Swap (1-yearduration). The contract size was 42,000 gallons. The contract guaranteed a fixed rate forSouthwest Airlines of 73 cents/gallon for heating oil. The variable rate was based (perNYMEX regulations) on the arithmetic average of the NYMEX New York Harborheating 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 similarto Figure 4 (see Example 2).

    Appendix 3 (see the first figure) contains information on the relation between jet fuel costs andairline 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 variessignificantly 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 forjet fuel (spot), heating oil (spot and futures), and crude oil (spot and futures).

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    12/33

    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 thisquestion, use the information in the Excel spreadsheet.

    3. (a) Evaluate each of the five proposed hedging strategies. What are the benefits of eachhedge 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 eachscenario incorporating the hedging strategies used. (Note: you can analyze the hedgesunder as many price scenarios as you wish, but be certain to include the following twoscenarios.) 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 forheating oil, or $14.10 per barrel spot price for crude oil, andSCENARIO 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, 2004Wall Street Journalarticle titled Outside Audit: Jet-Fuel Bets Are Risky Business byMelanie 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 timeof 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 orcontango? (Note: Backwardation is the market situation when futures prices are

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    13/33

    References

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

    Carter, David A., Dan Rogers, and Betty J. Simkins, 2004, Does Fuel Hedging Make EconomicSense? 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, RiskPublications (London).

    Kalotay, Andrew and Leslie Abreo, 2001, Testing Hedge Effectiveness for FAS 133: TheVolatility 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 2001Outlook, 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 StreetJournal, February 24, page C3.

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    14/33

    13

    Table 1

    Fuel Usage and Hedging Data for Southwest Airlines

    Exposure variablesHedging variables

    Fiscalyearends Year

    HedgeFuel?

    FuelUsed

    (MillionGallons)

    Fuel Cost($million)

    Cost ofFuel

    ($ pergallon)

    AvailableSeatMiles(ASM)

    (millions)

    Cost/ASM

    TotalExpenses($ Millions)

    Fuel as a% of

    Expenses

    TotalRevenue

    ($Millions)

    Fuel Cost(% of

    Revenue)

    GallonsHedged(millions)

    % ofNextYear

    Hedged

    LongestMaturity

    ofHedges

    (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

    materialnot

    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

    materialnot

    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%

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    15/33

    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 1,285,942Fuel 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 EFFECTOF 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

    =========== =========== ===========

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    16/33

    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

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    17/33

    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) inPanel B. Major airlines are defined as airlines with annual revenues of more than $1 billion, and regionalairlines are those carriers with annual revenues less than $1 billion. ASM stands for available seat milesand represents one seat flown one mile. Average revenues are calculated as the average over 1994-2000and 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%

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    18/33

    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 Airlines2,205.1

    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 arecargo-only carriers. The other firms listed are primarily passengerairlines.

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    19/33

    Table 5Example 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 Septemberjet fuel consumption at current prices. He buys a September New York Harborheating oil futures contract on the NYMEX at 66.28 cents per gallon (contractsize is for 42,000 gallons). On the same day, the New York jet fuel spot priceis 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 hasmade a profit of 32.31 cents per gallon (98.59 minus 66.28) on the futurescontract. In essence, the hedger bought a futures contract (a long hedge) inJanuary and then sold back the futures contract in August. The spot price ofNY jet fuel on August 29th is 103.6 cents per gallon. Without the futureshedge, 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 spotmarket, 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 pergallon (i.e. 103.6 spot price in August minus the futures hedging gain of 32.31cents/gallon).

    Cash Price

    (i.e. Spot Price)

    Futures Price Basis

    (Cash price minus futures

    price)

    January 6 cash price80.28 cents/gallon

    66.28 cents/gallon 14.00 cents/gallon

    August 29 cash price103.6 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/gallonMinus heating oil futures gain - 32.31 cents/gallonNet purchase price of jet fuel 71 29 cents/gallon

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    20/33

    Table 6

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

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

    Type of Derivative Balance Sheet Impact Income Statement ImpactCash Flow Hedge Derivative (asset or liability) is

    reported at fair value. Changes in fairvalue of derivative are reported ascomponents of Other ComprehensiveIncome (balance sheet)

    No immediate income statement

    impact. Changes in fair value ofderivatives are reclassified into theincome statement (from OtherComprehensive Income in the balancesheet) when the expected (hedged)transaction affects the net income.Derivative must qualify for hedgeaccounting treatment.

    Fair Value Hedge Derivative (asset or liability) is

    reported at fair value. Hedged item isalso reported at fair value.

    Changes in fair value are reported as

    income/loss in the income statement.Offsetting changes in fair value of thehedged item are also reported as anincome/loss in the income statement

    Speculative Transaction Derivative (asset or liability) isreported at fair value

    Changes in the fair value are reportedas income/loss in the incomestatement.

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    21/33

    Table 7

    Disclosures on Hedging From Southwest Airlines 2000 Annual Report

    FINANCIAL DERIVATIVE INSTRUMENTS The Company utilizes a variety ofderivative instruments, including both crude oil and heating oil based derivatives, tohedge a portion of its exposure to jet fuel price increases. These instruments consistprimarily 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 swapagreements, 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 isused. 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 AccountingStandards No. 133 (SFAS 133), Accounting for Derivative Instruments and HedgingActivities 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 beadopted in fiscal years beginning after June 15, 2000. The Company will adopt SFAS 133effective January 1, 2001. SFAS 133 will require the Company to record all derivativeson its balance sheet at fair value. Derivatives that are not designated as hedges must beadjusted 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 areconsidered to be effective, as defined, will either offset the change in fair value of thehedged assets, liabilities, or firm commitments through earnings or will be recorded in

    other comprehensive income until the hedged item is recorded in earnings. Any portionof a change in a derivative's fair value that is considered to be ineffective, as defined, mayhave to be immediately recorded in earnings. Any portion of a change in a derivative'sfair 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 fluctuatesdaily, as of January 1, 2001, the fair value of the Company's fuel hedge derivativeinstruments was approximately $98.3 million, of which approximately $75.8 million wasnot recorded in the Consolidated Balance Sheet. The $75.8 million will be recorded as anasset on the Company's balance sheet as part of the transition adjustment related to theCompany's adoption of SFAS 133. The offset to this balance sheet adjustment will be an

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    22/33

    21

    Figure 1

    OPIS Regional Jet Fuel Prices

    25

    45

    65

    85

    105

    125

    1/3/1994

    4/3/1994

    7/3/1994

    10/3/1994

    1/3/1995

    4/3/1995

    7/3/1995

    10/3/1995

    1/3/1996

    4/3/1996

    7/3/1996

    10/3/1996

    1/3/1997

    4/3/1997

    7/3/1997

    10/3/1997

    1/3/1998

    4/3/1998

    7/3/1998

    10/3/1998

    1/3/1999

    4/3/1999

    7/3/1999

    10/3/1999

    1/3/2000

    4/3/2000

    7/3/2000

    10/3/2000

    1/3/2001

    4/3/2001

    Date

    U.S.C

    ents/Gallon

    OPIS Chicago Jet 54

    OPIS Gulf Coast Jet 54OPIS Los Angeles Jet 54

    OPIS N.Y. Harbor Jet 54

    OPIS San Francisco Jet 54

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    23/33

    Figure 2

    Historical Gulf Coast Spot Jet Fuel Price Volatility

    COMPUTING VOLATILITY (Standard Deviation)

    Results: Periodic AnnualizedVariance 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% 0.0037413 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% 0.0019426 1/9/2001 79.98 -2.62% -2.65% 0.0007047 1/10/2001 86 7.53% 7.26% 0.005267

    8 1/11/2001 84.43 -1.83% -1.84% 0.0003399 1/12/2001 85.4 1.15% 1.14% 0.000130

    10 1/16/2001 87.75 2.75% 2.71% 0.00073711 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% 0.00127318 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

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    24/33

    23

    Figure 3

    Price Spread Between Jet Fuel and Heating Oil for Gulf Coast Prompt

    0

    5

    10

    15

    20

    25

    30

    Mar

    -90

    Jul-9

    0

    Nov-90

    Mar

    -91

    Jul-9

    1

    Nov-91

    Mar

    -92

    Jul-9

    2

    Nov-92

    Mar

    -93

    Jul-9

    3

    Nov-93

    Mar

    -94

    Jul-9

    4

    Nov-94

    Mar

    -95

    Jul-9

    5

    Nov-95

    Mar

    -96

    Jul-9

    6

    Nov-96

    Mar

    -97

    Jul-9

    7

    Nov-97

    Mar

    -98

    Jul-9

    8

    Nov-98

    Mar

    -99

    Jul-9

    9

    Nov-99

    Mar

    -00

    Jul-0

    0

    Nov-00

    Date

    Spread(JetFuel-Hea

    tingOil)inCents/Gallon

    Source: Bloomberg

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    25/33

    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 jetfuel 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 jetfuel in the cash market, as usual, but the swap contract makes up the difference when prices riseand removes the difference when prices decline. The result for the airline is a fixed price for theperiod covered. The fixed rate payment is set based on market conditions when the swap contractis initiated. The floating price of jet fuel is commonly based on Platts New York Harbor jetfuel 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 thefloating 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 thesize of the contract is 100,000 gallons, a payment of $10,000 is made to the airline (i.e. $0.10 x100,000).

    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 heatingoil market as far forward as 36 months. The price settlement of the contract is based on thearithmetic average of the NYMEX New York Harbor heating oil futures nearby monthsettlement price for each business day during the contract month. The swap contract is for42,000-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 futuresaverage daily price for the month was 0.5900. The hedger who is long the futures contract (such

    Counterparty isFloating-rate

    payer

    Pay fixed rate of $X per gallon

    per the swap contract

    Airline receives floating rate based onmonthly average jet fuel price

    Airline isFixed-rate payer

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    26/33

    Figure 5

    Swap, Call Option, and Premium Collar Illustration

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    27/33

    26

    Figure 6

    Net Cost of Jet Fuel Using a Collar Strategy (Buy 80 Cent/Gallon Call and Sell 60 Cent/Gallon Put)

    0

    10

    20

    30

    40

    50

    60

    70

    80

    90

    30

    33

    36

    39

    42

    45

    48

    51

    54

    57

    60

    63

    66

    69

    72

    75

    78

    81

    84

    87

    90

    93

    96

    99

    102

    105

    108

    111

    114

    117

    120

    123

    126

    129

    132

    135

    138

    Price of Jet Fuel in Cents per Gallon

    NetCostofJetFuelUsingaCollarStrategy

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    28/33

    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 thetotal fleet of aircraft.

    Available seat miles (ASMs): The number of seats available for scheduled passengers multiplied by the number ofmiles 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 thedestination.

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

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

    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.

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    29/33

    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 PremiumJul-01 $27.50 706 $1.05 Jul-01 $24.00 1,792 $0.01Jul-01 $28.00 3,610 $0.71 Jul-01 $25.00 1,274 $0.02Jul-01 $28.50 3,085 $0.47 Jul-01 $25.50 881 $0.03Jul-01 $29.00 5,122 $0.29 Jul-01 $26.00 2,145 $0.04Jul-01 $29.50 2,659 $0.18 Jul-01 $26.50 750 $0.07Jul-01 $30.00 8,575 $0.10 Jul-01 $27.00 4,005 $0.12Jul-01 $30.50 708 $0.06 Jul-01 $27.50 1,583 $0.22Jul-01 $31.00 2,463 $0.04 Jul-01 $28.00 5,128 $0.38Jul-01 $32.00 4,086 $0.02Jul-01 $36.00 506 $0.01

    Aug-01 $28.00 1,966 $1.43 Aug-01 $23.00 535 $0.05Aug-01 $28.50 4,054 $1.16 Aug-01 $24.00 761 $0.07Aug-01 $29.00 2,930 $0.91 Aug-01 $25.00 1,022 $0.12Aug-01 $29.50 4,892 $0.73 Aug-01 $26.00 2,957 $0.24Aug-01 $30.00 6,127 $0.58 Aug-01 $26.50 1,003 $0.33Aug-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 $0.62Aug-01 $32.00 7,880 $0.19 Aug-01 $28.00 5,064 $0.80Aug-01 $33.00 1,880 $0.13Aug-01 $35.00 2,309 $0.09Aug-01 $40.00 1,161 $0.02Aug-01 $45.00 1,000 $0.01Sep-01 $28.00 750 $1.75 Sep-01 $24.00 733 $0.16Sep-01 $28.50 921 $1.48 Sep-01 $25.00 921 $0.28Sep-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 $0.92Sep-01 $33.00 1,371 $0.26 Sep-01 $28.00 1,708 $1.12Sep-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 $0.06Oct-01 $33.00 945 $0.39 Oct-01 $24.00 520 $0.27Oct-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 $0.10Nov-01 $24.00 3,325 $0.40

    Dec-01 $27.50 568 $2.24 Dec-01 $22.00 1,055 $0.22Dec-01 $28.00 602 $1.89 Dec-01 $23.00 5,850 $0.34Dec-01 $29.00 500 $1.46 Dec-01 $25.00 2,750 $0.77D 01 $30 00 579 $1 14 D 01 $26 00 3 151 $1 08

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    30/33

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    31/33

    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 5,999Dec 05 22.17 5,302

    Dec 06 21.82 1,996

    Dec 07 21.77 375

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    32/33

    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%

    -20.00%

    -15.00%

    -10.00%

    -5.00%

    0.00%

    5.00%

    10.00%

    15.00%

    20.00%

    25.00%

    30.00%

    Jan-94

    May-94

    Sep

    -94

    Jan-95

    May-95

    Sep

    -95

    Jan-96

    May-96

    Sep

    -96

    Jan-97

    May-97

    Sep

    -97

    Jan-98

    May-98

    Sep

    -98

    Jan-99

    May-99

    Sep

    -99

    Date

    Return

    Airline Portfolio Return Change in Jet Fuel Costs

  • 8/10/2019 2004 - Fuel Hedging in the Airline Industry

    33/33

    32

    Appendix 4

    50

    55

    60

    65

    70

    75

    80

    LoadFacto

    r(RPM/ASM)%

    Jan-00

    Feb-00

    Mar-0

    0

    Apr-0

    0

    May-0

    0

    Jun-00

    Jul-0

    0

    Aug-00

    Sep-00

    Oct-0

    0

    Nov-0

    0

    Dec-00

    Jan-01

    Feb-01

    Mar-0

    1

    Apr-0

    1

    May-0

    1

    Date

    Monthly Load Factors for U.S. Airline Domestic Flights

    Source: Bloomberg