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Knowledge Area Module 6: Investment and International Finance Student: Thomas P. FitzGibbon, III Student’s Email: [email protected] Student’s ID#: 0378491 Program: PhD in Applied Management and Decision Sciences Specialization: Finance KAM Assessor: Dr. Mohammad Sharifzadeh [email protected] Faculty Mentor: Dr. Mohammad Sharifzadeh [email protected] Walden University October 5, 2008

Jet Fuel Hedging Strategies - Thomas FitzGibbon

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Knowledge Area Module 6: Investment and International Finance

Student: Thomas P. FitzGibbon, III Student’s Email: [email protected]

Student’s ID#: 0378491 Program: PhD in Applied Management and Decision Sciences

Specialization: Finance

KAM Assessor: Dr. Mohammad Sharifzadeh [email protected] Faculty Mentor: Dr. Mohammad Sharifzadeh [email protected]

Walden University October 5, 2008

ABSTRACT

Breadth

The purpose of this KAM is to identify the theories associated with investments and international

finance with particular focus on the theories surrounding commodity market structures and

processes. The Breadth Component focuses specifically on the development of commodity

markets, the functions of commodity exchanges, the influence of cartels on commodity markets,

and finally the impact of nationalization of commodity producers. The market theories of

Adelman, Hartshorn, and Radetzki will be compared and contrasted on their perspectives on the

above topics.

ABSTRACT

Depth

In the Depth Section of this review, I will review and summarize the relevant issues related to

hedging strategies in commodity markets. Within that review, I will discuss the applicable United

States Government regulations and how they have applied to hedge funds, investors and creditors.

In addition, I will also discuss the applicable changes to previous regulations. Within the review, I

will examine the contemporary literature that discusses the hedge fund industry, relevancy of

government and investor oversight and the public perception of hedging practices. The intended

outcome of this review is to formulate a greater understanding of the hedging process and how

hedging may have an impact on end user commodity pricing.

ABSTRACT

Application

The Application Section will provide an overview of the potential strategies that airlines can use

to reduce operational costs. Within this review, we will focus the discussion on the strategies

related to jet fuel hedging and provide examples of successful hedging strategies of major

American airlines. Along with this, we will also discuss the other manageable airline costs, stock

and financial performance of the airlines, as well as the perceived impact of the September 11,

2001 terrorist attacks on the financial performance of the American airlines. The outcome of the

Application Section will be a review of strategies that are available for implementation, including

hedging, for use in the airline industry.

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TABLE OF CONTENTS

BREADTH………………………………………………………………………………………...1 Introduction………………………………………………………………………………..1 Overview of the Current Situation………………………………………………………...1 Historical Development of Commodity Markets………………………………………….3 Commodity Markets and Exchanges……………………………………………………...6 The Impact of Cartels…………………………………………………………………….16 Nationalization and Public Ownership of Commodity Markets………………………....20 Conclusion……………………………………………………………………………….27

DEPTH………………………………………………………………………………………...…3

0 Annotated Bibliography………………………………………………………………….30 Context of the Problem………………………………………………………………..…45 Government Regulation and Oversight of Commodity Markets………………………...57 Conclusion……………………………………………………………………………….68

APPLICATION…………………………………………………………………………………..7

1 Introduction………………………………………………………………………………71 Overview of the Current Situation……………………………………………………….71

Hedging or Speculation?....................................................................................................77

Implementing an Effective Hedging Strategy……………………………………………78 Which Airlines

Hedge?......................................................................................................81 The Impact of Hedging on the Value of an Airline………………………………………82 The Impact of the September 11th Terrorist Attacks……………………………………..87

Why did Southwest Succeed?............................................................................................91

Conclusion……………………………………………………………………………….92

REFERENCES………………………………………………………………………………..…96

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BREADTH

AMDS 8613: THEORY OF INVESTMENTS AND INTERNATIONAL FINANCE

Introduction The focus of this Breadth review will be on comparing and contrasting the theories of

Adelman, Radetzki, and Hartshorn as they relate to the theories associated with commodity

markets. Within the review, I will focus this analysis on the historical development of commodity

markets, the commodity exchanges, the impact of cartels on commodity markets, and the

nationalization and public ownership of commodity producers. Within the review, I will also

examine how the theoretical perspectives of Adelman, Radetzki, and Hartshorn apply to oil

markets.

Overview of the Current Situation When people think of commodities, they tend to focus on areas that are impacting their

daily lives. One of the most evident commodities in the news is that of oil and the significant

increases in oil prices over the past year. While many have their conclusions as to the cause of the

current increases, I will examine how there is likely no one specific answer to the question on

pricing in this or most commodity markets.

For the most part, the media, political pundits, and consumers have their own ideas as to

what the causes of the surge in oil pricing are. Some consider the basic theories of supply and

demand, blaming both consumers as well as the producers. Additionally, there is also a rise in

interest in the behavior of speculators or investors in the market, while others blame the federal

government for not acting in a more aggressive manner to manage the price or the markets. In

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the end, it is likely a combination of all of these factors that have lead to the increases over the

past year.

Furthermore, in reference to the consumers in the United States, it is clear that demand for

oil and gasoline has increased in recent years. This increase in demand is due to a number of

factors including the total number of vehicles in use as well as the average miles per gallon for

vehicles. Clearly, both factors are concerning, as vehicles have grown in both number and size,

the amount of gasoline needed to address demand is increasing, as such with supplies being

relatively constant, the equilibrium price for gasoline would increase.

In reference to producers, there are two distinct challenges they face. The first challenge

is the increase in global demand for oil from countries such as India and China. Secondly, as I

will discuss later, the need to focus on long term development of the market with the

understanding that oil is a limited resource and it can not last forever. Given the limitations of the

resource, the producers wish to focus more on creation of a long term revenue stream rather than

significantly increasing production now at the risk of using up the available resource much earlier

than planned.

Finally, in reference to the market, there is increasing focus on the performance of

speculators. Again, as I will discuss below, speculators focus on developing short term profit

between the time that the commodity is produced to the point that the commodity is delivered to

the consumer. The intent is to benefit from any changes in the commodity price in the timeframe

between production and delivery.

While oil is an example of a commodity in the news, the general theories of the commodity

markets are universally applicable regardless of the particular product being traded. Commodities

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are typically limited in their availability and there is normally a price difference between when the

commodity is agreed to be purchased and the time that the product is delivered. In addition,

commodities could generally be considered to be natural resources that have uniformity in quality

but are limited in their availability.

Historical Development of Commodity Markets Before we can effectively examine a specific commodity market like oil, we must first have

an understanding of the development of commodity markets in general. Commodity markets are

significantly different from a traditional market where the buyers and sellers immediately exchange

products or currency for products at a specific location. As mentioned above, one of the primary

differences between commodity markets and traditional markets is that there is typically a delay

between the agreement to purchase a product and the delivery of that product to the purchaser.

However, we must first understand the types of products that are exchanged in a

commodity market. As Radetzki (2008) states, the markets “supply unprocessed raw materials of

agricultural and mineral origin, along with fuels, electricity and potable water, for use by other

sectors of the economy” (Radetzki, p. 7). In other words, the intention of the market is to

provide an outlet for producers to exchange their goods that could then be used in another area

where the traded commodity is not readily available. Radetzki goes on to note that most

economies do not have access to all the necessary raw materials to sustain long term economic

growth (Radetzki, 2008) and must have reasonable access to acquire the raw materials that they

need in order to sustain and grow their individual economies.

Furthermore, once the market is established, the next step is the development of a

transportation process that would deliver the raw materials sold in the market to the consumers

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purchasing the goods. The issue of transportation was an early challenge for markets. The

markets could identify both the producer and the consumer of a particular raw material.

However, the challenge was in how to efficiently deliver those goods from the producers to the

consumers.

Clearly, markets have existed for centuries as a vehicle for the exchange of goods.

However, as producers began offering a wider range of products for sale, there was a need to

establish a larger market of consumers. While the market expansion is beneficial for both

producers and consumers, there was a need to develop a more effective transportation mechanism

to support efficient product delivery. With that, there were two periods of improvement to the

transportation process. The initial phase of this improvement took place in the latter half of the

nineteenth century and again later in the 1970’s (Radetzki, 2008). Furthermore, in reference to

the more recent improvements, the intention of the commodity producers was to create more of a

global market for their products. With the resulting improvements in transportation, this goal of

reaching a larger market was now achievable.

With an improved transportation process, commodity producers could begin a more

effective process of standardization of product and prices. Given the past history where markets

were either local or regional in scope, commodity prices were driven more by the dynamics of the

local economy rather than a global pricing model facilitated by the larger market available to

producers. However, this also required a need to effectively manage transportation costs within

the overall price of the delivered commodity.

As Radetzki (2008) notes, “shipping costs are akin to tariff barriers” (Radetzki, p. 12) in

that producers not only need to account for the production costs and profit, but they also must

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consider the shipping costs of the good in their final price to the consumer. While there were

efficiency gains over time in the transportation process which helped to alleviate the initial high

costs, there were still some things that the market must consider when determining prices.

Clearly, producers understood that to expand their markets they would need to provide efficient

transportation, but producers also needed to consider the impact those transportation costs would

have on the demand for their products. In the event that producers charged too high of a price,

accounting for transportation costs, they would likely find that there would be a very limited

market that would see the value for the produced good when such a significant percentage of the

final price was the result of transportation expenses (Radetzki, 2008).

Furthermore, along with efficiencies in transportation, producers also needed to consider

the technology used in the transportation process. Since many commodities are perishable goods,

improvements to food storage and refrigeration were also required. Without these improvements,

producers would run the risk of spoilage of the good prior to delivery resulting in the consumer

rejecting the shipment and the producer receiving no compensation for the product.

Finally, and this is particularly true in the oil markets, there was the vast increase in size of

the carriers over the past several years. In the discussion of the Suez Canal crisis, Radetzki

(2008) notes that, “the shipping industry’s response to the canal closure was to opt for specialized

huge bulk carriers, along with concomitant loading and unloading facilities, to permit economic

transport of low-value products” (Radetzki, p. 13). The intent with this is that while there was an

increased cost associated with larger carriers, that cost could be spread over significantly larger

quantities of goods resulting in a lower cost to market. Additionally, this provided an opportunity

for producers of lower value products to expand their market to a larger audience.

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With an understanding of the particular factors in product pricing, there is a need to

consider the competitive factors in pricing as well. Given that different regions or countries will

have varied costs of production, this factor should also be considered in overall commodity

pricing structure. Radetzki (2008) discusses this issue in examining the performance of European

food producers in the 1880’s, he notes that there was a significant reduction of consumption of

domestically produced goods since the market price of the imported good was much less in

comparison. In other words, even though the foreign producer had increased costs of

transportation, their final price was still less than the local competition. This difference in

production cost was primarily the result of lower labor costs of the foreign producer. As such,

the consumer focused on the price rather than the proximity of production when making their

buying decision. Ironically, this exists in most markets today where consumers are willing to

purchase foreign produced goods at a lower price and are rarely willing to pay a higher price

simply due to local production. This would be an example of Ricardo’s Theory of Comparative

Advantage in that countries will find a benefit in specializing in producing commodities that they

can do both efficiently and at a reasonable cost. By meaning, in the event that oil might prove too

expensive to produce, it would not be wise to produce them. Rather, it would be more effective

for that country to import oil and focus on other goods that could be used in trade or sale where

the proceeds would be used to produce goods not readily available (Radetzki, 2008).

Commodity Markets and Exchanges

Now that we have an understanding of the historical development of commodity markets,

we now need to examine the structure of commodity markets today. Commodity markets have

distinct differences when compared to more common markets reviewed above.

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First, there are a limited number of people that can participate in a commodity market.

Unlike traditional markets where anyone is welcome to buy and sell products, commodity markets

are limited in that both buyers and sellers must be approved by the market managers prior to

engagement. This approval process varies by exchange. However, at a minimum, the applicant

for membership must have an established business as well as the access to sufficient funds to meet

margin requirements as well as trade in the exchange. The result of this is that it can serve to

provide more consistency in the purchase and sale process and support more effective operational

standardization of the commodity market as well (Radetzki, 2008).

Secondly, most commodity markets conduct their negotiations electronically. Thus, both

buyers and sellers can negotiate the price for a product by electronic means rather than a face-to-

face negotiation. The benefit of this method is that both buyers and sellers gain a clear

understanding of the terms of the agreement as well as more efficient method of negotiating the

commodity price before closing a deal in comparison to an open market where buyers and sellers

meet in person to negotiate the price, without prior knowledge of the other side’s conditions.

Additionally, this also provides an opportunity for a wider variety of participants to engage in the

negotiating process. Therefore, with no requirement to be physically present to negotiate the

transaction, there is a broader market of participants who are able to buy or sell (Radetzki, 2008).

Thirdly, commodity markets are highly standardized in that there are specific quantities,

qualities, delivery dates, and payment terms that apply to particular commodities. When

examining how this standardization applies to the oil market, there are different types of oil such

as Texas Light Sweet Crude or North Sea Brent. Each type of oil has its own particular price

based in part on the end use of the product as well as any costs associated with the use of refined

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oil available for production of other products. In reference to payment and delivery terms, one

will often see the per barrel cost of oil discussed in terms of a ninety day delivery period. This

means that the agreed price of a barrel of oil is not for delivery of the product today, but is what

the buyer is willing to pay for that barrel once delivery ninety days from the date of the contract

(Radetzki, 2008).

Additionally, since nearly all commodity transactions are contract based, there is an ability

to transfer ownership of the contract prior to the actual delivery of the good to the purchaser.

Clearly, this is different when compared to most markets where the product delivery and the fund

transfer are done at the same or nearly the same time (Radetzki, 2008). I will discuss this

particular feature in later sections of both the Depth and Application reviews.

Finally, commodities’ markets also have a clearinghouse function attached to the market.

The clearinghouse provides a mechanism to settle transactions between the purchaser and seller.

Again, this would be different from a more traditional market where no clearinghouse exists as the

goods and compensation are exchanged at nearly the same time rather than with a delayed

delivery date that exists within commodity markets (Radetzki, 2008).

However, within this framework, there is an underlying process by which commodities

should be traded in commodity markets. There are certain criteria that are required of a product in

order for it not only to be considered to be a commodity, but to also meet the requirements of an

applicable commodity market. First, there must be a sufficient market of quantity of buyers and

sellers with adequate liquidity and product supply to sustain a continuous market. Secondly, the

producers must be able to tolerate and be adequately prepared for both hedging and speculation

functions. Thirdly, there should be sufficient price volatility in the market and prices should be

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reasonably elastic. Furthermore, the product under consideration must be easy to grade and be

homogeneous in quality so as to provide consistency in valuation. Finally, the product must be

storable so as to maintain its quality and grade from the point that the purchase is agreed upon

until the date the product is delivered to the purchaser (Radetzki, 2008).

For example, we could examine diamonds as a potential commodity for consideration for

sale in a commodity market. However, there are certain factors with diamonds that would meet

some requirements noted above, but fail on others. Clearly, diamonds would meet the test of

being easy and consistent to grade. There are grades on color, cut, and clarity that are generally

accepted. In addition, a diamond is easy to store and does not lose quality from the point of

production and sale to delivery. Additionally, diamond price could be considered fairly inelastic in

reference to supply or demand. But, diamonds fail on other requirements. First, the market for

diamonds is relatively small. There are very few producers of diamonds and very few buyers.

Typically, the buyers and sellers meet to negotiate a particular price on specific diamonds or a

price on a large quantity of similar stones. Second, since the market is tightly controlled by a

small number of producers, there is very little flexibility in supply.

This case of diamonds is quite in contrast to considering oil as a commodity. Clearly, oil

would meet all of the requirements noted by Radetzki (2008) in that there is a significant market

of buyers and sellers with the necessary liquidity to sustain a continuous market. Additionally,

especially today, the hedging and speculation process is very active. Thirdly, while crude oil is

reasonably managed from the supply side by cartels such as OPEC, demand for oil does have

significant variability both due to seasonal factors as well as due to increased demand from new

consumer groups. Moreover, oil does have a generally accepted grading system as discussed

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earlier. Finally, as highlighted above, oil is easy to store and ship to the buyer. As such, unlike

diamonds, oil would be a commodity that would be suitable for trade on a commodity market.

Furthermore, with the understanding of the commodity market and the products traded in

it, we must have an understanding of how transactions are processed in the market. There are

two different types of instruments used to conduct transactions in the commodity market, futures

contracts and options. A futures contract is an agreement to buy or sell a specific quantity of a

commodity for delivery at some specific point in the future. In addition to the structure of the

contract, it should also noted that when a buyer engages a seller with a futures contract it is not

necessary that the purchaser pay the purchase price in full at the time of the contract. However,

what is required is that the purchaser pays a margin or percentage of total price at the point of

agreement. This margin can differ based on the requirements of specific commodities or the

markets where the transaction occurs. However, in general, the purchaser is required to pay at

least 10% to 20% of the total price to the seller. Once the margin is agreed to, the margin

payment is then completed through the brokerage accounts of the parties in the contract.

Additionally, in event where there is a rise in the contract price, the buyer may be required to

provide an additional margin payment to maintain the percentage assigned. The intent is that the

percentage of the total value is maintained throughout the period. As with the initial margin

payment, any additional payments are settled through a brokerage account and maintained with

the clearinghouse of the market. (Radetzki, 2008).

On the other hand, options contracts are quite different. An options contract gives the

owner of the contract the right to buy or sell a contract at a given price. There are two types of

options contracts. The first type of options contract is a call option. The call option provides the

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owner of the contract with the right to purchase the commodity at the option exercise price at any

point prior to the expiration of the contract. This means that, the owner has the option to

purchase the commodity, but not the obligation. The other type of options contract is a put

option. A put option provides the owner of the contract with the right to sell a future contract a

future contract at a given price at any point prior to the expiration of the option. Regardless of

whether the contract is a put or a call option, the contract itself can also be sold to another party.

Ironically, the actual commodity is not necessarily traded at all. It is simply the right to buy

commodity or sell the futures at a given price that is traded. In effect, the contract itself could

also be considered a commodity as well (Radetzki, 2008).

As with any market transactions, there are risks involved. The primary risks that investors

wish to avoid are issues related to pricing. As with any commodity, price is based on supply and

demand of the commodity. If there is any shift in either factor, the price of the good will adjust as

well. For example, since there is a delay between the purchase of a commodity and its delivery to

the consumer, any price changes that occur during the production and delivery period need to be

considered when determining the risks associated with the transaction. This is where the idea of

hedging comes into play in the commodity market.

Even with this delay, some commodity producers will assume some of the downside risks

associated with price changes over the period of transporting the good to the consumer. For

example, in the early 1980’s, Saudi Arabia found that their exports of oil were steadily decreasing

to the world market. Realizing that they and the OPEC cartel were unwilling to consider price

discounts to spur demand, they were forced to consider alternatives to address the slumping

exports. Given that at the time it took over 45 days for their product to leave the gulf and get to

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markets in North America, Western Europe and, Asia, something needed to be done in order to

eliminate the price risk over the shipment period. With that, the Saudis elected to accept the risk

on their own. While there was an agreed price at the point of the contract, the Saudis decided

that it would be better to honor the price on delivery. As such, the actual price on delivery would

be the contracted price for purchase (Hartshorn, 1993). The result of this was that importers of

oil no longer had to bear the risk of price variations as this was now the responsibility of the

supplier.

While I will go into this in significantly more detail in the Application section of this

review, the primary goal of someone hedging is to mitigate the risks associated with price

changes. Typically, a hedger will take an opposite future position to that of the position of the

purchased contract. By meaning, the contract might call for a given quantity and price today, and

the hedged future contract will have that same quantity and delivery time of the original contract,

but will be at a different price. That price will then be an attempt to offset any changes that the

commodity contract might encounter prior to delivery (Radetzki, 2008).

Clearly, there are two different types of risk associated with price. First is that the price of

a commodity will go down, resulting in any remaining inventory going down in value as well. In

this event, the owner would execute a short hedge that would match up with the quantity and

delivery date that is currently in inventory. The idea with this tactic is that it serves to lock in a

current price that would safeguard against the risk of any additional downward trend in the

market price for the commodity (Radetzki, 2008).

The second type of risk is that the if the price of the commodity increases in the current

market, the price of the futures contracts associated with that commodity will also increase

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relative to the current market. In this case, the end user of the commodity may choose to execute

a long hedge of the commodity. As with the short hedge, the long hedge would also match the

quantity and delivery time of the original contract. Again, the intent with this tactic is to lock in a

specific price in the market today to offset any future changes in the value. However, one

particular issue with either a short or long hedge is that the purchaser also needs to consider the

margin expense associated with the transaction and whether that margin payment has any impact

on their overall decision to engage in this tactic (Radetzki, 2008).

Hartshorn (1993) also discussed the function of markets to address the risks associated

with price differences in oil. As mentioned earlier, as a commodity, oil markets function similarly

to most commodity markets. With that, the intent of hedging in the oil market is primarily

designed to “hedge trading risks between the time the deal is made and the time later than the

commodity has been delivered” (Hartshorn, p. 207). Again, the intention is to attempt to balance

any price changes over time and remove any risks associated with changes in the market price

between the time the contract is made and the time of the commodity delivery. Clearly, this is

less of an issue with shorter delivery times, but with all commodities, prices can have significant

adjustments even in short time periods.

However, one must also consider whether or not commodity markets are efficient. While

it is evident that there is nearly complete transparency in the market in reference to prices and

quantities (Hartshorn, 1993) what still remains unclear is whether the functions between the

contract agreement and delivery have any impact on the actual price of the commodity. As I

discussed above, commodity markets and traditional markets are quite different when it comes to

purchase and delivery.

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As an example, we can examine the significant increase in oil prices in 1979. While the

market did manage the overall price, Hartshorn (1993) and several other economists believe that

the price increase was due more to a perception of a lower supply than any objective factors in the

market. That misconception managed to drive prices even higher as speculators increased their

activities in the market hoping to gain a quick profit through the expected increases in prices for

oil even within the period of shipping the oil from producer to consumer (Hartshorn, 1993).

In a traditional market, the good and the purchase price are exchanged at the same time,

with that, there is no speculation on any future changes in the price. By meaning, one does not go

to a market such as a clothing retailer and agree to purchase an item, but get it delivered later.

Furthermore, one does not hold an option to purchase the item and then sell that option to a third

party at a different price. This would be akin to anticipating that the item will be discounted in the

future and paying the discounted price to the retailer today. If that was the case, there would be

one of two outcomes. The retailer would never sell the item at a discounted price or the retailer

would simply inflate the price much higher than needed today to account for the risks of a future

discounted price. Now, some would believe that the latter is what actually occurs in a retail

market. However, most large retailers will project what the market will demand and offer that

much for sale at full price, rather than offering too high a quantity knowing that they will always

have residual inventory that will be sold at a discount. In other words, the retailer will offer as

little as possible with the intent of selling all available inventories at the full price.

Furthermore, within an efficient market, information must be readily available and be of

reasonable quality. This is another area where Hartshorn (1993) questions the performance of the

oil market. There are very few places that oil can exist before it gets to the consumer: ships

15

transporting the material, storage tanks, or in the ground. It is the latter that is of highest

concern. As oil is not visible until it is pumped out of the ground, many question the validity of

the estimates of remaining quantity. Clearly, this would call into question the accuracy of supply

estimates. As with most traditional markets, quantity or inventories can be counted or at least

fairly estimated. The same can not be clearly said of commodity markets. Given that supply is a

key determinant of price, one would be justified in questioning whether or not the data used in the

market. In the end, as Hartshorn notes, “it is only on the average that open market prices, spot,

forward or futures, could be hoped to offer the best possible prediction of what will actually

happen” (Hartshorn, p. 219). Adelman comments on this as well in questioning that “future

scarcity cannot possibly explain the current price of oil on the international market” (Adelman, p.

373). Given this, both could conclude that with an inability to accurately predict what future

supply or demand will be and how the market should respond to these unknown variables.

Finally, it is also unclear as to whether a market system can even handle the complexities

in a commodity exchange. Notwithstanding the number of buyers, sellers and processes, many

would consider this to be well beyond the scope of what a market system could support.

However, there are just as many that would say that a market system is likely the only system that

would support the level of complexities in a commodity exchange with the inherent flexibility that

most market systems can efficiently accommodate (Adelman, 1993).

The Impact of Cartels

Now that we have an understanding of the structures and processes of commodity

markets, the next step in the discussion involves the impact of cartels on commodity markets.

Both Hartshorn (1993) and Adelman (1993) wrote extensively about the impact of cartels in the

16

oil market. As such, I will discuss the specific dynamics of the oil market and the actions of

cartels on the overall performance of this commodity market.

However, before I discuss the specifics of cartel practices, we must first understand what a

cartel is and how it functions. Cartels are typically formed by an agreement either between firms,

or in the case of oil, between countries to jointly manage the production, pricing, and distribution

of a commodity. As it relates to oil, the Organization of Petroleum Exporting Countries (OPEC)

is the most well known cartel. OPEC was formed by the major oil producing countries with the

intent of standardizing general production and pricing strategies and the resulting stabilization of

pricing that would result from the standardization. Prior to the existence of the cartel, prices and

processes were varied between countries. The result of the inconsistency was that prices were

different for different oil producing countries and there was limited collaboration on an overall

strategy to manage the oil market.

As such, one of the first steps upon the establishment of the cartel was to create a ceiling

and quota system to manage production and pricing (Hartshorn, 1993). The intent in this was

that while each country could produce a certain daily limit of oil, the focus of the cartel was to

examine the total production of oil both within and outside of the cartel so as to control the price

offered to the consumer. However, the existence of the quota system does not necessarily imply

that all cartel members will adhere to the requirement.

For example, during the first Gulf War, all country specific quotas were suspended.

Primarily the reason behind the action was to address any concerns in the market, but also to

compensate for the loss of production from Kuwait and to a limited extent, Iraq. While this was a

formal suspension of the quota by the cartel, the idea of imposing the quota system again after the

17

war was not initially successful. In fact, “even before that war several member countries had been

paying no more than lip service to the system, and most had been exceeding their quotas”

(Hartshorn, p. 169). As such, while there was a system in place to manage output, the actual

members were still performing to their own individual interests rather than those of the cartel.

Along with the need for quotas, the underlying intent in managing output was to tie the

perceived demand in the market to that of the actual volumes produced. The idea with this

strategy was that there would be very limited excess inventory and this could also serve to

manage the price as well. While there were several organizations who would publish their

estimates of demand, including OPEC, the key issue with those estimates is that they would often

times underestimate the actual demand in the market (Hartshorn, 1993). The result of that was

that even with the quotas, the actual demand was higher than the supply provided by the cartel

and other producers.

Ironically, even with this mismatch between lower supply and higher demand, prices

remained consistent immediately after the conclusion of the first Gulf War. However, what was

clear was that if there was a benefit to an individual country to produce more beyond their quota,

as was the case during the Gulf War, it was clear that individuals would continue to do this if it

served their individual economic benefit. What was of significant concern to most member

governments was a continued frustration in OPEC’s lack of ability to effectively manage the

overall production of individual cartel members (Hartshorn, 1993).

However, in order for a cartel to effectively function, the individual members must focus

on the needs of the group and not simply on their individual needs. Clearly, any supplier would

normally wish to sell what they have available to sell and not be restricted by a quota system

18

where they would be forced to keep in reserve any excess inventory that could be sold, but would

be restricted from sale by an existing quota determined by the leaders of the cartel. This leads to

the temptation to sell the inventory in spite of the cartel’s requirements which would then lead to

further erosion of the cartel and make the entire cartel weaker and less able to control market

price for the product (Adelman, 1993).

But, this is not meant to say that the cartel is solely dependent on member compliance to

manage available supply and price (Radtezki, 2008). The cartel still has several alternatives to

effectively test the market at a given price. For example, in the past, Saudi Arabia has taken steps

to raise the prices slightly to gauge market reactions. These slight increases provided insight into

whether demand could be sustained at a higher price. Once they were able to sustain demand,

they would then have an opportunity to set that tested price as the new price. In addition to

having a member of the cartel test the price, the cartel could also utilize pricing tactics instituted

by the multi-national oil companies. While the oil companies would follow a similar process of

testing demand, the cartel could then use this information and market response to in turn make

their own price adjustments as well. With either option, the intent is to ensure that supply of the

good does not exceed demand (Adelman, 1993).

Furthermore, what is ironic in the actions of OPEC as a cartel and their management of

supply and pricing is that there does not appear to be any policy of the cartel as it relates to

pricing. By meaning, most of the focus on the cartel has been on production of available supply

to the market, with the intent that controlling supply would then lead to management of overall

pricing. However, OPEC has not come to an agreement as to what they wish to do with pricing

in the future. While there have been discussions in the past about increasing pricing to the

19

market, those talks stalled and no agreement was made. As such, the cartel tends to focus on

managing supply to as to not provide more than demanded, but also to balance that supply against

the available reserves for future sale (Adelman, 1993).

Finally, one must also acknowledge the other non-revenue benefit that cartels receive.

That benefit is the political clout of controlling a resource. Clearly, OPEC is an example of the

amount of political benefit they receive (Adelman, 1993). Since OPEC controls a commodity in

high demand throughout the world, their control of the commodity as a resource has downstream

impacts on the world economy. Furthermore, many believe that the first Gulf War was less about

the sovereignty of Kuwait, but more about the control of oil that Iraq would possess had the

invasion of Kuwait gone without a response. Obviously, this outcome was not something that

consumers, primarily the United States, were willing to accept. Additionally, the other producers

within the cartel were also unwilling to accept the greater influence that the government of Iraq

would possess in the workings of the cartel.

In conclusion, Adelman, Hartshorn, and Radetzki would all agree that the most effective

way for the cartel to succeed is to not only manage prices and supply, but to maintain the

members compliance with those standards. While some would argue that OPEC as a cartel has

encountered many challenges in maintaining adherence to supply quotas specifically related to

non-compliance by certain member states, overall the cartel has been successful. They have

managed to maintain their long term reserves while meeting their projected market demand with a

price that has significantly increased over time allowing all members to benefit from the market

growth.

Nationalization and Public Ownership of Commodity Production

20

Now that we have an understanding of general market functions and the impact of cartels

on commodity markets, I will now focus on the impact that government ownership of commodity

producers has on the global market. In summary, nationalization occurs when a government

elects to assume ownership of production facilities that were at a time privately owned. In some

cases, the government will compensate the private owner for their investment while in others the

government simply takes over the property and strips the private owner of any equity in the

facility.

Furthermore, state ownership of commodity producers is not uncommon. In many

markets like oil, the majority of the producers are the governments. However, relative to

commodity producers in general, state ownership is prevalent in the developing world. While

many of these state owned producers began their operations in the 1960’s and 1970’s, the intent

was to tap into the natural resource and invest the revenues into the further development of the

country and benefit the citizens of that country (Radetzki, 2008).

Within the commodity producers owned by governments, there is a significant portion

related specifically to mineral and energy resources. Clearly, there are a number of reasons why

these particular commodity groups are more popular than others. First is the perception that

mineral wealth is sovereign to the country. In other words, there is a certain perceived value of

utilizing a natural resource that is part of the land that the country occupies. Secondly, that the

extraction and processing of the resource is seen as a strategically importance for the country and

its citizens (Radetzki, 2008). With that, the governments instill a sense of ownership among the

citizens, and consider private ownership to be ‘taking’ a resource away from the people of the

country.

21

Additionally, countries would also look at nationalization as a purely economic exercise in

that instead of a private entity gaining the revenues and profits from the resource, those profits

would in turn go to the government. Clearly the thought behind this is that with increased

revenues from other sources, the government owner could either take the revenues and invest in

items such as infrastructure improvements and education, or relieve the citizenry of tax

obligations originally payable to the government prior to nationalization of a commodity

producer. In either example, the intent was to gain a new revenue source that would be held and

managed by the government.

However, government ownership of a commodity producer can cause some conflicts of

interest as well. First, in nearly all situations, the government is not only the owner of the

production facilities but it is also the source of the laws governing the production of the

commodity. Clearly there is a conflict in that it would be difficult for a government to establish

laws or requirements that may limit their access to the resource or related revenues. Along with

that, the opposite would be true in that the government may also be lax on regulations to

encourage more revenues regardless of any external limits that may be necessary to have in place.

The result of this is that the government tends to focus its production management to align with

the social goals of the country rather than the need to maximize profit, like privately owned

companies (Radetzki, 2008).

Secondly, government ownership can also imply certain political influence on the industry.

This is evident by examining the recent nationalization of several oil facilities in Venezuela. In this

example, President Hugo Chavez was motivated by some of the manners discussed above. First,

he felt that it was in the people’s best interests that the oil revenues be maintained by the

22

government rather than foreign owned oil producing companies. Secondly, he was able to exert

perceived control over his political adversary, the United States Government and capitalize on the

general public support for his political perspectives. Finally, while President Chavez was willing

to negotiate a purchase price for the production facilities with the private owners, the companies

had little choice but to accept the terms offered or receive nothing at all. In addition, to make

matters worse, in situations where local governments offered little or no compensation for the

facilities, the previous managers were rarely willing to provide any technical assistance to the new

owners (Radetzki, 2008).

Furthermore, this also has significant implications for the efficiencies of the newly

nationalized organizations. As Radetzki (2008) discusses, there are two different types of

nationalized organizations, those that were founded by the local governments and those

organizations that were once private but are now controlled by the governments. While there are

differences, in either example, the initial operations of the organizations tended to be significantly

less efficient when compared to similar privately owned organizations. While there are several

reasons why this is the case, the most predominant appears to reside with the lack of expertise of

the managers or leaders of the organization. Ironically, this issue is still true where the operating

facilities already existed and there was far less need for start up costs or processes (Radetzki,

2008).

However, one would expect that most major corporations, especially those in commodity

industries, would hire managers who have relevant experience and education that is related to the

industry or function. However, the common practice in several nationalized commodity

producers was to hire employees that had the right political connections and not on skills or

23

experience. As such, positions were hired based on political favors or connections. Resulting in

placing individuals in leadership roles who did not possess any related skills to effectively run the

organization they were now responsible to manage (Radetzki, 2008).

The result of this lack of experience and focus on the nationalized organization resulted in

three negative impacts on the overall financial performance of the organization. The first, as

discussed above, is that the lack of experience will inherently lead to a lack of efficiency of the

operation. Secondly, with the new focus of the organization no longer on profit and reinvestment

but on social development, there is a risk that the production facilities may fall into disrepair.

Finally, with a lack of emphasis on cost management, over time, the organization will see a

reduction in overall profit and eventually find that they will need to charge a premium for the

commodity simply to break even against increased costs (Radetzki, 2008).

However, what is also troubling is that many nationalized organizations also risk losing

their motivation to be financially viable. When the organization is, in effect, absorbed into the

overall structure of the government, the managers of the organization would likely come to the

conclusion that whether they operate at a profit or loss is meaningless since they will always have

access to any additional funds from the government. Secondly, since the revenues gained are

transferred to the government’s overall budget, they will no longer have access to funds to

improve their product mix or expand into new markets. In the end, they no longer become an

income generator for continuous improvement, but an income generator for government

programs (Radetzki, 2008).

While not a completely nationalized organization, several members of OPEC are

government owned and operated. Hence, it would be appropriate to examine their performance

24

in detail to gain an understanding of the efficiencies of nationalized commodity producers. This is

especially evident when comparing the production of the nationalized oil producers against those

operated by private companies.

Throughout the global expansion between 1979 and 2005, the global capacity expansion

of the private enterprises resulted in a capacity increase of nearly sixty percent. However, in the

same period of time, the OPEC capacity as a group actually declined by three percent (Radetzki,

2008). Given this, there are two potential reasons why this lack of improved capacity resulted.

First is that this could actually be an intentional strategy by OPEC as I discussed above, in that the

strategy could be that OPEC is intentionally managing capacity to a lower level so as to sustain

their reserves farther in the future. Secondly, this lack of capacity growth could simply be a result

of an inefficient operation typical to that of other nationalized commodity producers.

However, what is interesting is the more recent trend where nationalized organizations are

now approaching private companies to establish partnership agreements. This is especially true of

OPEC. As OPEC went through a wave of nationalizations in the 1970’s, they quickly realized

that they no longer possessed the expertise in building their capacity to meet increasing demand in

the world markets. As such, several OPEC nations began to solicit assistance and partnership to

improve their performance to meet market needs. This need for outside expertise was mainly

driven by particular failures in the initial steps of nationalization. Furthermore, the most evident

failure was how the ownership of the oil industry was distributed shortly after nationalization

(Hartshorn, 1993).

However, this return to a limited partnership between the individual country and private

producers is not always beneficial. Clearly, there is a benefit to the specific member country that

25

sees a need to enhance the existing technical skills to increase future capacity. However, that

improved capacity from the nationalized company may not be beneficial to the performance of the

cartel (Adelman, 1993). As stated, the cartel operates within a quota system for the commodity

as well as for individual member countries. With that, the cartel as an entity would see little

benefit from the improved performance of the industry within a specific country. Additionally, in

the long term, the member country may not be able to gain any tangible benefit from the

operational improvements if they are still subject to capacity limits from the cartel.

Furthermore, while there is no law that forces a quota system on an individual nation, in

order for the cartel to succeed and control the market, adherence is key. Clearly, there is a benefit

that the cartel possesses when the members have a nationalized industry. That benefit is control.

Rather than the cartel being forced to work with a group of profit motivated private corporations

focused on their investors’ interest, nationalized organizations speak with one voice that

represents the member state. This leads to an opportunity within the cartel to manage the

production of the nationalized industries within the reigns of a smaller group when compared to

the influence and demands private owners may place on the cartel. This allows higher producing

members such as Saudi Arabia to exert more pressure on the other member states to further

control the available supply (Adelman, 1993). Given this, at least as it relates to the oil industry,

there is a reasonably complementary relationship between the nationalized producers and the

cartel as they both wield significant control of the industry both at the local level within a member

country and at the level of the cartel.

The failure in ownership distribution lies with the process of assigning ownership to

controlling families in many of the OPEC countries. As with the case with other nationalization

26

efforts, the level of expertise of the new owners was irrelevant in the assignment process. While

this is different than assigning management to those with more political influence than experience,

the result was nearly the same. The challenge the member states quickly faced was that the new

owners lacked any significant technical expertise to effectively manage oil production (Hartshorn,

1993).

This is not to imply that governments received no revenue prior to nationalization. As

with most commodities, governments still had the ability to levy for taxes and royalties against the

private producer. As such, there was still revenue to be had. However, what was clear is that if

the government actually owned the production and revenue of the commodity that revenue would

go from a percentage charged to a private owner to all the revenue associated with the

commodity sale. In addition to the full access to the revenue, they would also be able to fully

control the resource and its distribution to the market (Hartshorn, 1993).

Additionally, as discussed earlier, one of the primary strategies that OPEC possesses is its

need to manage their reserves so as to get a long term revenue stream. With that, there was more

incentive to nationalize the resource rather than let it remain in private hands. This is primarily

due to the structure of leases and licensing agreements the private companies had with

governments prior to nationalization. Within the structure of the agreements, there was a

specified time period that the agreement was in force. As a result, private companies would try to

not only quickly recover their infrastructure costs, but to also make as much money as possible

before the agreement expired (Hartshorn, 1993). Clearly, this is in contrast with the strategies of

OPEC. Likely, the individual member governments recognized that there was a greater

27

temptation for the private company to exploit the resource quickly rather than the member

government’s need to maintain a long term revenue stream.

Furthermore, especially as it relates to OPEC, most of the member countries receive a

significant portion of their operating revenue from the sale of a small set of commodities to the

market. When examining the economic structure of a majority of the Gulf state members of

OPEC, there is a heavy reliance on oil production and sale to support other government

investments. As such, any swings in oil prices can have a significant impact on the country’s

ability to effectively invest in other areas of need. With that, there is a tendency to have a higher

need to manage the resource not only as a cartel, but within the operations of the individual nation

as well. This further enhances the previous topics of member production compliance within the

OPEC cartel where individual members would often ignore quotas where local events drove the

need to increase production (Hartshorn, 1993).

Conclusion

There are very clear differentiating factors with commodity markets that one would not

readily see in a traditional market where consumers and producers meet. However, the

underlying theories associated with these markets are quite consistent between Hartshorn (1993),

Adelman (1993), and Radetzki (2008). The basis for commodity markets is similar to other

markets in that a produced good is exchanged for payment of that good.

However, where these markets differ is primarily related to their structures and controls.

Since commodities are considered natural resources, they are not readily available everywhere in

the world. As such, the commodity is controlled by those that possess access to exploit the

commodity and make it available for sale.

28

When examining the oil markets, there are many external influences on the industry. The

most evident of those influence lies with the control of production and pricing that is limited to a

small group of governments, cartels and private producers. This control allows the group to have

a broad influence on the global economy like no other commodity since the dependence on oil is

much higher in comparison to other commodities available for sale.

Additionally, an example of this economic influence is on producer nations such as Russia.

In the Soviet era, there was barely enough oil produced to sustain the needs of the Soviet Union,

let alone any outside consumer wishing to purchase from the country. Some may say this was

related to an inefficient state ownership of the industry, while others may conclude that there was

no interest on the part of the Soviet Union to sell oil to a global market or at least to non-Soviet

Bloc member states.

However, resulting from the fall of the Soviet Union, the oil producing companies were

converted to private ownership entities. While there is clear evidence that the initial private

offering was fraught with corruption forcing government action to take control of the industry

again, that does not necessarily imply that the result was not positive. However, by examining the

economy of Russia today, it is much stronger than it was less than ten years ago. There is a

significant wealthy class of citizens who are clearly benefiting from the economic improvements.

While there is still a poor population, the problems of the Soviet era appear to be abated by the

significant growth of the economy.

While there is growth, the concern of over-reliance on oil revenues as the driving force to

the economy still exists. This opportunity, if utilized to make other investments, may serve to be

a guide for other countries who are producers of limited commodities to further invest in long

29

term development. In the end, there are two paths a producer can implement: developing the

resource to benefit a limited group, or to make the investments in infrastructure or other

industries to prepare the country for the point where either the commodity as a resource is no

longer available, or the market of the commodity is no longer interested in its purchase.

As we continue with the Depth Section of this review, I will focus on the processes related

to hedging and speculation on the impact of markets in their overall function and pricing

strategies. Within that analysis, I will discuss some of the current areas of concern about the

impact of hedging and speculation in oil markets.

DEPTH

AMDS 8623: CURRENT RESEARCH IN INVESTMENTS AND INTERNATIONAL

FINANCE

Annotated Bibliography Preiserowicz, J. (2006). The new regulatory regime for hedge funds: has the SEC gone down the

wrong path? Fordham Journal of Corporate & Financial Law, 11(4), 807-49. In this review, Preiserowicz (2006) provides a summary of several regulatory changes as

well as proposed changes to govern individuals involved in both hedging and speculation practices

in commodities markets in the United States. In addition to the summary, the author also

provides a detailed historical summary of several issues that are now forcing the consideration of

stronger government oversight into the industry.

Additionally, the author also provides a detailed synopsis of the hedging process as well as

the strategies involved in considering hedging as an investment tool in the commodity markets.

Within that summary, he also discusses the structure and processes of hedge funds and how the

funds operate within the market.

Furthermore, the author provides a lengthy summary of some of the primary issues where

the existing regulations do not effectively meet the needs of hedgers and speculators. Specifically,

the issues surrounding off shore transactions and the lack of effective reporting were of high

concern. The primary issue with this challenge is that there is a lack of insight into the volume of

transactions for specific commodities. With that lack of insight, there is concern that the markets

have a risk for manipulation which has a downstream impact on the entire economy for several

commodities.

31

Given that lack of insight, the United States Government is examining a wide range of

steps, including regulations, that could serve to not only provide better control of the market, but

to also gain access to a greater amount of market information. The thought behind this is that

with a more informed investor and market, the pricing can better align with projected supply and

demand of commodities.

Abumustafa, N.I. (2007). Hybrid securities and commodity swaps; tools to hedge risk in emerging stock markets: theoretical approach. Journal of Derivatives and Hedge Funds, 13(1), 26-32.

In this review, Abumustafa (2007) discusses some of the factors in the trading of financial

derivatives. Along with this, he also discusses how derivatives are used in a similar process to

hedging in that they are used to attempt to mitigate price risk of the underlying security.

However, they are different in the aspect that they are not typically based on commodities,

but are focused more on financial instruments such as equities or bonds. However, they do have

certain similarities with commodities in that there is an option structure as well as the ability to

convert the derivative into equity at the holder’s discretion.

While financial instruments are a more common form of derivative, there are options for

commodities as well. As the author discusses the process of commodity swaps where the price

paid from the buyer to seller is based on the price of an underlying commodity. In this strategy,

an investor would use the commodity swap in areas where the investor wishes to utilize a hedging

strategy, but is unable to implement the strategy with a futures contract.

Additionally, the author discusses several examples of non-equity based derivatives in the

market, credit derivatives and credit default swaps. Like other derivatives, these instruments are

also used to mitigate risk. However, this is different in comparison to other instruments discussed

32

above. In the example of credit derivatives and credit default swaps, the buyers and sellers are

transacting the credit risk itself. Simply put, these instruments focus more on the risk of default

rather than the risk of a change in price. As such, the focus is more on assessing and pricing the

derivative on the risk of default of the portfolio itself.

Williams, O.M. (2008). Hedge funds: regulators and market participants are taking steps to strengthen market discipline, but continued attention is needed. GAO Reports.

In this summary and testimony to the House Committee on Financial Services, Williams

(2008) provides a summary of the growth of hedge funds since 2001 both in trading volume and

in value. Specifically, the author discusses some of the more recent performance indicators on

hedging strategies related to loans, credit derivatives and distressed debt trading that has

significantly increased.

Along with the summary, the author provides an overview of the general strategies for

hedging and how those strategies can impact the overall performance of the market as well as the

values of the underlying commodities or securities. In addition, the author also discusses several

opportunities for greater government oversight and the development of additional regulations

noting several examples where a lack of oversight led to failures among several brokers.

In addition, the author also examines examples of where a weak or ineffective risk

management strategy on the part of the investor may have also spurred on several failures.

Furthermore, there is also a discussion of the interconnection between investors and banks ay

have a downstream impact on bank performance as well. By meaning, hedge funds typically work

with banks to establish lines of credit which can then fund the investment strategy. However, in

the event where the investor fails, the investor defaults on the financing causing the bank’s

33

financial standing to deteriorate. As such, the author provides some insight into the risk

management oversight that lenders are beginning to implement that can better address their risk

management by closely monitoring the investments that the hedge fund is making.

Herbst, M. (2008, May 7). Hedging Against $200 Oil. Business Week Online, 2-2.

In this article, Herbst (2008) discusses some strategies that commodity consumers can use

to effectively address the risks of future price increases. While this article focuses on the

strategies used by Southwest Airlines to mitigate the risk of jet fuel, the strategies could be

applicable to other commodity consumers as well.

In addition to the strategy summary used by the airline, the author also provides a

summary where Southwest was not only able to mitigate the risks of a price increase, but actually

resulted in an operating profit to the airline. This was then compared to the strategies and

financial results of other airlines that did not effectively prepare for the price increases.

Furthermore, the author also provides an in depth summary of where the latest demand

trends for oil are progressing not only in reference to quantity, but also specific countries where

demand has increased. Specifically, the author notes that both China and India, while still

considering developing countries, have been responsible for a significant part of the new demand.

The result of this is that while supplies have not necessarily increased, the quantity demanded by

the market has increased significantly.

With that, organizations like Southwest executed their strategy of purchasing future

contracts for oil and jet fuel that were at a significantly lower price than the actual market value at

the time of delivery. While they were expected to pay a margin payment to secure the price, the

34

cost savings as well as future profit outweighed any risks associated with a reduction in price that

would have been less than their contracted price on the futures contract.

Thompson, S. (2004). Great Expectations. Rural Cooperatives. 71(4), 14-18.

In this article, Thompson (2004) discusses the impact of ethanol on gas and oil prices as

well as the impact ethanol production has on the cost of corn. Additionally, the author provides

an overview of the ethanol production process and how corn producers are managing production

at a local level.

Of the key challenges noted by the author is that while there is significant demand for

ethanol as a fuel substitute that does not necessarily imply that everyone who produces ethanol is

successful in the effort. In fact, as the author notes, there is a significant investment in production

facilities that are required in order to effectively produce sufficient quantities for purchase. It is

those larger facilities that seem to succeed where the smaller facilities have not received a benefit

from the surge in demand.

In addition, the author also discusses strategies where the corn producers are also

operating in hedge strategy with their resource. The hedge in this effort is that they see that they

can produce ethanol at a more profitable amount in comparison to producing corn for sale on the

commodity exchange. What is interesting is that, with the exception of variations in processing,

the input resource, corn, is the same in either aspect. However, the producers expect that there

will be more demand for ethanol rather than corn and focus their production on that commodity

rather than corn. That withstanding, there is still a balance that is necessary. This is primarily due

to the fact that on a cost per mile basis, ethanol is still more expensive than traditional gasoline,

and until that becomes closer to the same cost, the market for ethanol will be limited.

35

Kase, C.A. (2006). Preparing to manage energy costs: basics for small to mid size companies. American Ceramic Society Bulletin. 85(11), 31-33.

Kase (2006) provides an overview on the hedging process as well as the processes

associated with formulating a hedging strategy in commodities markets. As an introduction, the

author provides an overview of the basis for hedging, that is to formulate a prediction for the

future. However, as the author notes that while speculators may indicate that they based their

strategies on market fundamentals, the author questions how fundamentals could apply when a

hedger is betting on the future rather than basing that strategy on known items.

In reference to strategy formulation, the author first discusses the idea that the investor

must first decide how much exposure or risk they are willing to take in the process. While

investors do have the ability to purchase options and pay a margin, the investor should still have a

thorough understanding of their total risk of their strategy before executing the agreement with

the seller.

Along with that, the author also provides a summary of different investment strategies

such as ‘scaling in’ that allows investors with an opportunity to invest in increments over time

rather than investing everything at once. In addition, there are also options where the investor,

depending on the level of purchase they are making in the market, can also choose to invest on

their own, or potentially invest in a consortium of other investors.

Finally, the author provides an overview of different techniques that an investor can use to

determine their risk versus reward so as to guide them on certain investment opportunities. The

intent is that the investor then has access to fairly reliable information that will give them a fair

assessment of particular investment options that meet their individual income goals.

36

Hill, P. (2008). Speculators accused of dictating oil prices. Washington Times, The (DC). Hill (2008) provides an overview of the recent discussions involving the potential impact

that speculators and hedgers may be playing in artificially inflating the price of oil in the market.

Along with this, the author provides some selected statistics summarizing the growth of

speculation activities in exchange volume leading up to the current market.

Within this, the author also provides some comparative data indicating the change in the

price of oil in comparison to the changing price of the stock market. As noted in the text, while

the oil markets surged, the stock market was losing value over the same period of time.

Furthermore, the author also discusses some potential actions that the government could

take that might serve to lessen the influence of speculative activities in the market. The goal of

these potential regulations is not only designed to curb further growth of these activities, but also

to have an impact on the fluctuation of oil prices in general.

While many would consider this to be controlling a free market, the intent is that if the

majority of the price increase is due to speculative activities, then a curbing of those activities

should serve to bring prices more in line with the prices that the market, free of speculation

activities, would consider as the appropriate value for the commodity.

Herbst, M., Coy, P., & Palmeri, C. (2008, 9 June). Speculation but not manipulation. Business Week, 26-29.

In their article, Herbst, Coy, and Palmeri (2008) discuss the potential impact of increased

trading of oil futures on upward overall market price of oil over the last few years. Their

perspective is that the role of speculators could simply be to make a quick profit, but they also see

that effort as serving to sustain the continued upward growth of the oil price.

37

In addition, the authors also discuss some of the reaction from politicians in the federal

government and their quick judgment to assume that the increase in oil costs is solely the result of

speculators attempting to profit from the market. They go on to further comment that while this

perspective may have some merit, some of those speaking out may be attempting to use this for

political favor rather than to search out a specific reason or reasons for the increase.

As the authors discuss, speculation is likely a part of the process, but the intent of the

speculators is not simply to gain control of the market. As summarized, the intent among many

speculators is to hedge against inflation or loss in other areas that are not seeing the same level of

growth as oil.

Along with the role of speculators, the authors also identify other potential reasons for the

increase in oil costs. For example, they note the growing demand in developing countries as their

economies develop and demand for oil increases. In addition to new markets, they also discuss

the issues of limited growth in supply and the time that is needed to identify locations and extract

oil from new areas and that this can certainly adjust supply in the long term, it will not address the

significant increase in demand and the negligible increases in supply production. In conclusion, it

is more likely that it is a combination of several factors, including speculation that has led to the

current high oil price.

LIEBERMAN, J., CHAIRMAN, C., & AFFAIRS, C. (2008). COMMODITY SPECULATION AND RISING FOOD PRICES. FDCH Congressional Testimony

In his opening statement to the Senate Homeland Security and Government Affairs

Committee, Senator Joseph Lieberman (2008) focuses his remarks on introducing the need for

further research on whether food price increases have been driven by speculation in the

38

commodity markets. While it is clear that there are many factors that impact overall prices for

commodities including imbalances between supply and demand, the contention is that while this

may exist, the problem is made even worse by the activities of speculators attempting to benefit

from the price surge.

Additionally, Senator Lieberman also discusses that many new investors are participating

in trading activities in commodity markets. Clearly, there are individual investors and hedge

funds, but we are also seeing an increase in more traditional investors such as pension funds

investing in these markets. The concern is that with the significant increase in activity, there could

also be an artificial increase in market prices for the commodity.

Finally, Senator Lieberman also discusses some of the previous legislation and existing

regulations that are designed to manage the commodities markets so as to avoid any single

investor or group from having a controlling stake in a commodity. However, from his

perspective, it appears that while the regulations have some effectiveness, it is likely that they will

need to be updated to better address the current conditions of the market.

Farrell, D., & Lund, S. (2008). The world's new financial power brokers. McKinsey Quarterly, 2008(1), 82-97.

Farrell and Lund (2008) discuss the shift in wealth related to the performance of the oil

markets since the year 2000. The notion that the authors review is that there is has been a

significant shift in wealth to not only the oil producing countries primarily in the Middle East, but

there has also been significant growth in deposits for banks based in Asia.

The result of this shift is that investors in hedge funds are now finding a new source of

funds from outside of the United States. Given the high levels of liquidity now available in these

39

regions, hedge funds now have access to banks and individual investors that are willing to extend

credit to a higher degree in comparison to previous sources of funds. As such, not only do hedge

funds have a new funding stream, but the cost of that funding has dropped as well.

Along with the improved investment in commodities, these players are also becoming

involved in areas such as credit derivatives that the banks can use to mitigate existing risks in their

portfolios. Clearly, giving them access to a new investment tool that can serve to benefit their

overall risk profile. Ironically, several of the Middle East investors are taking their investment

gains from oil sales and investing those revenues in investment funds that do further commodity

investing. In other words, potentially taking their own profits and executing hedging strategies

that may actually be pushing the price of oil higher.

However, while the performance of hedge funds is generally improving, there continues to

be significant concern that as hedge funds grow in size, there could be a greater risk to the entire

market if prices should go down. This is not only due to the decrease in portfolio value, but also

due to the amount of borrowing that hedge funds use. In other words, the concern is that in the

event of a downturn, the creditors may call for the credit to be repaid, thus destabilizing the

market.

Williams, O.M. (2007). Energy derivatives: preliminary reviews on energy derivatives training and CFTC oversight. GAO Reports.

In testimony to the Subcommittee on General Farm Commodities and Risk Management,

Committee on Agriculture for the House of Representatives, Williams (2007) provides a summary

on the oversight activities of the Commodity Futures Trading Commission (CFTC) on the

commodity markets in the United States.

40

In the summary, Williams provides details as to the increase in participation from managed

money investors and hedge funds as seeing energy futures as a new investment option. This

resulted in increases in investment funds in areas such as oil, natural gas and ethanol. The intent

being that as demand for these commodities began to increase, that prospects for growth in the

value of these commodities as an investment was evident as well.

However, what was of significant concern was that these types of options transactions are

exempt from CFTC oversight in that the markets where the transactions occur are not subject to

any regulatory authority. Further, these transactions can take place outside of regular exchange

markets as well as in overseas exchanges that are not subject to government oversight. With that

lack of visibility, it was unclear as to the total impact that these transactions can have in the

establishment of a market price for the commodity.

Along with that, Wilson also discusses the lack of oversight on the trading of derivatives

not only for the reasons discussed above, but the fact that there is a lack of clarity on the value of

derivatives. While the value should be tied to that of the underlying assets of securities

composing the derivative, the issue of the variations in the underlying instruments can cause

difficulty in valuing the derivative itself. Additionally, since the commodity is rarely delivered to

the investor, Wilson questions the reasoning behind the investment. In other words, is the intent

to only make a short term profit off a growing market or does the investor truly wish to consume

the commodity.

Finally, Wilson also reviews some applicable hedging strategies related to energy markets.

From the consumer’s perspective, the intent of hedging is to lock in a price today rather than risk

a price increase if the commodity was purchased at delivery. This gives the consumer the

41

advantage of making a relatively low risk investment to offset the potential of a significant

increase in the future price of the commodity.

Velotti, J.P. (2006). Regulators seek to curb energy funds. Long Island Business News, 53(35), 1A-57A.

In this article, Velotti (2006) provides a summary of where the new demand in oil future

investment is coming from. Historically, it was the oil companies that would purchase oil futures

with the intent of taking delivery and refining the oil for use in other areas such as gasoline.

However, what is clear is that while there continues to be demand from oil and gas

companies as well as other end users, hedge funds are now increasing their participation in this

market. While the author does state that hedge funds are looking at this as an investment tool and

not as an end user, he also concludes that the activities from hedge funds may also be influencing

the final price that the end users pay.

Furthermore, at the time of publishing, the author notes that the role of speculators alone

could be driving the price of a barrel of oil by as much as $25 per barrel. Clearly, this is resulting

in a short term gain by investors making further increasing their participation.

The result of this activity is that oil becomes more expensive for the end users to purchase.

That increase in cost is then pushed to the consumers of the refined products on the market. In

other words, if there is an increase in cost to the oil company, they will then pass that increase to

the refiner. Therefore, when we examine the increase in costs of end products such as gasoline,

the author tasks us to consider that the role of speculators, in part, is causing the increase in

commodity costs to all users after the product is produced.

Willams, O.M. (2006). Futures markets: approach for examining oversight of energy futures. GAO Reports.

42

In his summary to the Committee on Energy and Commerce of the United States House of

Representatives, Williams (2006) provides his comments to address some of the concerns related

to the increase in the per barrel cost of oil as well as increases in the cost of natural gas. In his

conclusion, he notes that while market influences do have some impact, it is clear that this is no

longer the primary reason for the latest commodity price increases.

Furthermore, he notes the increased in the participation of hedgers, speculators and

brokers as having an impact on the commodity price. As he notes, the role of these investors is

causing downstream price increases for commodity distributors and end users of the commodity.

With that, the intent of the planned research by the General Accounting Office (GAO) is to

determine whether these investment activities are causing prices to increase, and if so, what the

extent to which those increases are impacting the overall market price for the commodity.

In addition to that effort, the GAO will also investigate whether any of these practices are

serving to potentially manipulate the market and control the overall price performance. While the

Commodity Futures Trading Commission (CFTC) does have oversight on certain markets, their

oversight is limited where the activities of hedgers and speculators are concerned. As such, the

results of the research may involved recommendations for policy and regulatory changes to more

effectively manage market activities.

Siddiqi, M.A. (2004). Swings and roundabouts. The Middle East, February 2004(342), 38-43.

In this summary, Siddiqi (2004) discusses some select strategies by the Organization of

Petroleum Exporting Countries (OPEC) in their efforts to manage supply of oil that may actually

be less than the quantity demanded by the market. In a strategy that applies to most commodity

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cartels, they find that the most effective tactic in managing price is to manage the supply of the

good available to the market. Along with this, the lack of insight into the true reserve quantities

provides an opportunity where the perception of scarcity of the commodity can artificially drive

up the price.

However, this perception of a lower supply as well as quota limits managed by OPEC is

not the only reason why the market price of oil is increasing. As Siddiqi discusses, there are other

external factors such as the roles of hedgers and speculators, as well as political conflicts in the

region that are also impacting market price.

In addition, the author also reviews how the deceasing exchange value of the United

States Dollar is also impacting the price. Since oil is traded in dollars, the value of the dollar has a

direct impact on the market price. By meaning, while producers are able to reasonably maintain

their costs, a lower value of the dollar will result in the producer spending more dollars for the

same expense. As such, the method of recovery of that cost increase is a higher cost to market.

Additionally, producers also need to consider the purchasing power of the declining dollar in

converted to their local currency. As we see, the recovery of the exchange rate loss is seen in an

increase in the per barrel cost of the commodity.

Finally, Siddiqi discusses the challenges that cartels such as OPEC have in managing

adherence to their quota scheme by individual countries. Clearly, as prices for a commodity

increase, it would be in an individual cartel member’s best interest to sell more and gain a benefit

from the increased price. However, in order for the cartel to succeed, compliance with quotas

will be key to that success. As such, OPEC will continually manage the overall quota and

underlying member adherence to meet long term revenue objectives.

44

Edwards, F.R. (2006). Hedge funds and investor protection regulation. Economic Review, 91(4), 35-48.

In this summary, Edwards (2006) discusses some of the potential regulatory actions to

address the changes in commodity markets. These proposed changes are designed to not only

better protect end users, but also to protect those investing in hedge funds.

The intent with this effort is designed to address incidents of fraudulent activity by some

hedge funds managers where there were concerns about the financial integrity of specific hedge

funds as well as concerns related to protecting investors. Furthermore, of specific note was the

lack of available or reliable information that was provided by hedge funds to their investors. In

some examples noted by the author, the information was often incorrect or in some cases,

inconsistently disseminated to investors. The result of this was that there was a greater risk of

investors making incorrect decisions based on questionable data from the hedge fund manager.

In addition, the author discusses potential conflicts of interest between the broker and

investor in the process. By meaning, the broker could be more concerned with his own or his

firm’s benefit and less on any risks that the customer may have in the opportunity. As such, the

broker becomes more of a sales person and less of an advisor to the investor as the investor’s

interest no longer carry the same weight as other factors.

Finally, of specific concern to the author is the fact that hedge funds have the ability to

operate with nearly no regulation or oversight. They can transact on foreign markets, they can

take concentrated positions on specific securities as well as have nearly unlimited access to credit

as well as leverage. The result of this is that there is a potential for a hedge fund to control

45

significant portions of a particular market or commodity. And, in the event of failure, can cause a

significant negative impact on market overall market performance.

DEPTH ESSAY

The idea of hedging and speculation in commodity markets has become a greater concern

in reference to the impact that these activities have on the price of particular commodities. With

that, in the Depth Section of this review, we will discuss in greater detail some of the primary

processes related to hedging and speculation. These topics will include a detailed discussion as to

the impact that hedging has on price, the general processes related to hedging along with existing

and potential United States Government regulations applied to commodities markets. In order to

provide some context to the discussion, I will focus on the performance of oil within the greater

context of hedging and speculation issues.

Context of the Problem

Since 2001, we have witnessed significant increases in commodity pricing for most

commodities in the energy sector. As examples of related commodities, we can consider different

varieties of oil, natural gas, ethanol, and diesel fuel. While there are many opinions that relate to

the cause of the recent increases in commodity pricing, the most common cause discussed appears

to be the impact of speculators and hedgers in the market.

Clearly, the debate on this issue has been contentious, with several parties blaming each

other for the increase. To make matters worse, there is a perception that speculators and hedgers

are simply involved in the process to make a quick profit and capitalize on a bad situation. While

that may be true in some cases, what should be considered is that there are likely a range of

reasons why we now see the significantly higher prices for energy commodities. Thus, it may be

46

more beneficial to take a more global approach to understand all of the market forces and

influences on the establishment of market price for these commodities.

Hedging Process and Strategy Development

First, to give some context of the process, the strategy of an investor executing a hedge is

to lower the risks associated with future changes in price of the commodity they are investing in.

Along with that, hedge funds are often willing to accept risks that other financial institutions may

not be willing to accept in their investment strategies, focusing instead on investment options such

as equities or bonds (Williams, 2008). For example, an investor might forecast that a particular

commodity will increase in value in the near future. With that, the investor would execute a

hedge strategy to fix the purchase price of the commodity to something less than they project the

future price to actually be. For example, a natural gas distributor might choose to fix the

contracted option price at the current market price if they feel that the market price will be higher

at the point of delivery. Then, when the delivery is scheduled to occur, the distributor will then

pay the price on the contract regardless of what the actual market price at delivery. As such, in

the event where the price actually does increase between the period of the agreement and delivery,

the distributor realizes a lower actual expense since they were able to purchase the commodity at

a lower price.

This does not make the assumption that the distributor will pass that savings on to the

customers purchasing their products. As with all businesses, there are two tactics that can be

applied in these situations. First, the company could simply take the benefit of the cost savings

and realize the improvement on their overall production costs. Secondly, the company could also

take the expense reduction and reinvest the funds in additional options for future delivery. In

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either example, the overall hedging strategy does not change. The goal is still to mitigate the risks

associated with potential near term commodity price increases rather than simply purchasing

goods for immediate delivery on the current market rates.

Furthermore, as I will discuss in greater detail in the Application section of this review,

there are also opportunities for end users to profit from these activities as well. As an example,

we can see some of the hedging tactics used by Southwest Airlines in their hedging strategy

related to jet fuel costs. Southwest was able to accurately predict that oil prices along with the

refined jet fuel would increase over time starting in the year 2000. Expecting this, Southwest

elected to invest some of their profits in purchasing options for jet fuel that now are priced slightly

less than one-third of the current price of oil. Clearly, they were able to save money by having the

opportunity to purchase the commodity at a much lower price than the market value at the time of

delivery. However, they were also able to report an additional profit of over thirty million dollars

as a result of their effective investment strategy (Herbst, 2008).

Hedging can also apply to those who are purchasers of a commodity that is then converted

to a secondary use by another party. An obvious example of this is the relationship of oil and

gasoline. Generally, a gasoline refiner will purchase oil from an oil producer and then refine that

oil into gasoline for sale to the market. Since the refiner is a customer of the oil producer, they

also want to gain a benefit from locking in a price. Much like the Southwest example I discussed

above, refiners also often attempt to lock in a potentially lower price by executing an option

contract to purchase oil at a fixed price for later delivery. In the event of an increase in the price

of oil, they would also benefit from the locked price in the option contract (Wilson, 2008) and

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either improve their profit margin with the lower oil price or potentially pass some of that savings

to their customers.

In addition to end users of commodities, commodity producers can also use hedging

strategies in their production. As an example, we can look at some of the more recent strategies

initiated by corn producers. As a commodity, corn has multiple uses, but it is primarily known as

either a food product, gasoline additive, or gasoline substitute. For years, most corn producers

focused on producing for the market that considered corn to be a food product as this was the

product in the most demand in the market. However, starting with some mid-western states in

the United States, local governments began requiring that the corn derivative ethanol be offered

to consumers as an additive to gasoline.

In order to address this new market demand, corn farmers began to form small

cooperatives that would take the corn and produce ethanol in limited quantities to meet the small,

regional demand. However, as the use of ethanol began to increase to a broader range of the

United States as well as globally, there was a need for many large corn producers to make a

choice between focusing production on ethanol as there was a much better profit potential in

comparison to food production. This is another form of a hedge strategy. The producers were

hedging their production with the belief that ethanol prices would continue to increase where corn

as a food product was stagnating in value (Thompson, 2004).

This is not meant to imply that all corn producers would be successful in the switch from

food production to ethanol production. What was not considered were the production costs

associated with ethanol production and how that would impact overall profits for the corn

producers. As a result, those cooperatives that were able to form large organizations turned out

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to be more successful in ethanol production. This is primarily due to the significant facilities costs

associated with the refining facilities. Those larger organizations could spread the operation costs

over a larger group of investors who were also high quantity producers of the product. As such,

while many organizations entered the market, the larger organizations were able succeed where

smaller organizations failed (Thompson, 2004).

While the market was growing, corn producers were not able to maintain their market

domination for long. The primary issue was that the market quickly realized that corn was not the

only option available for refined ethanol. As an example, we can consider the ethanol production

in Brazil as a viable substitute to ethanol produced in the United States. The Brazilians were able

to refine ethanol from a readily available commodity, sugar cane. Along with having relatively

easy access to harvest sugar cane, the Brazilians also had the advantage of lower labor costs along

with lower refining costs. The result of this was that ethanol was available from sugar cane at a

much lower cost than ethanol produced by corn farmers.

To make matters worse for the corn producers, even with the significant transportation

costs from Brazil to the United States, Brazilian produced ethanol was still cheaper in comparison

to the value corn producers were charging the market. Furthermore, since ethanol as a

commodity is not sensitive to the source of production, corn or sugar cane, the market identified a

much larger supply available resulting in a decline in value of the commodity. This decline

resulted in significant expense to the corn producers as their profits nearly evaporated as there

was much more supply available for purchase (Thompson, 2004).

Ironically, the shift from food production to ethanol production also had an impact on the

price of corn as a commodity. As the supply of corn was used in higher amounts for ethanol

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production, there was less supply of corn available for food production. What was not anticipated

though was that corn was not only used for human consumption, but was also used as livestock

feed as well. As such, as corn became more expensive, this also had an impact on livestock,

primarily hogs and cattle, on the market as well. Since it was now more expensive to feed

livestock, the cost of livestock production increased and that cost increase was passed to the

market. This also provided a profit opportunity for hedgers and speculators in other commodities

outside of oil, corn and ethanol (Lieberman, 2008).

As a result, hedgers and speculators began investing in options that would allow them to

short sell ethanol with the expectation that the value would continue to decline. In instances such

as this, the hedger still profits from the decline in value, but the producer continues to lose money

as the value of the commodity declines. As if this was not enough for the farmers, we are now

seeing that there is less acceptance of ethanol as a long term substitute for gasoline. In the

beginning ethanol was thought to be better for the environment and more efficient for use in

automobiles. However, as we now see, there is significant research that actually indicates the

opposite, that ethanol is less efficient, more expensive and has limited environmental benefit.

With that, it is likely that the long term demand for ethanol will continue to decline causing more

financial burden for the producers (Thompson, 2004).

In general, the role of speculators in the market is significantly different in comparison to

end users using wise financial planning to better manage future costs. Speculators focus more on

accessing the benefits of an increase in cost so as to make a profit based on changes in market

value for a commodity. Additionally, it is in the rare case that a speculator ever takes final

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delivery of the commodity. As such, their intent is simply to make a financial gain based on

market changes.

The volume of speculation continues to grow in significance in the performance of the

market. Specifically as it relates to the oil markets, speculators are now controlling over 40% of

the futures contract business (Hill, 2008). As a result of the increase in participation from

investors, it would be safe to conclude that those activities may have an impact on the final market

price of the good. In addition to the volume of oil contract participation, speculators are also

involved in other commodity markets which from 2007 to 2008, has grown by nearly one trillion

dollars (Hill, 2008). Again, not only is the contract volume increasing but the value of those

contracts has also grown significantly.

Clearly there is a reason behind this activity. As most equity markets began to lose value

as regional economic performance began to decline, investors needed to locate a new avenue for

their investment. As such, they turned to commodity markets as a new profit opportunity.

Furthermore, along with more funds, general trading volume also increased. As evidence of this

increase, trading volume in the year 2000 was approximately 500 million transactions, in 2007

that volume increased to over 3 billion transactions, a six-fold increase (Hill, 2008). The result of

this investment shift was that equity markets continued their decline while at the same time,

commodity prices began to increase.

However, this is not meant to imply that it is just a few Wall Street firms that are involved

in this process. Since the prices have continued to increase at a much stronger rate in comparison

to other investment opportunities, the variety of commodity investors has also increased. Along

with the institutional investors such as those found on Wall Street, we are now seeing pension

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funds, insurance companies and other financial investors entering the market to capitalize on the

performance (Lieberman, 2008). As I discussed above, the increase in new market participants,

especially participants with significant investment funds, this can also cause prices to increase as

demand for commodities increases.

Furthermore, as an indication of the investment trends, we have also seen a significant

increase in the ratio of long positions in the market. As I discussed in the Breadth Section of this

review, long positions enable investors to profit when prices rise in comparison to the option

price. Additionally, when comparing positions in long positions to those of actual commodity

traders, the long positions now compose nearly two-thirds of market activity in comparison to less

than one-quarter ten years ago (Lieberman, 2008).

What is interesting in this situation is that the commodities markets were originally

established to create a mechanism for commodity producers and consumers to meet and negotiate

a price and delivery date for the commodity. However, with these recent trends toward a higher

proportion of speculative practices, there is less interest among most market participants to

actually purchase and receive the produced good. As I mentioned above, the focus appears to be

more in line with the exchange of options to purchase or sell rather than actual exchange of the

commodity. Thus, it may be safe to conclude that the options are becoming the latest form of a

commodity in the commodity market.

From the consumers’ perspective, the increased expenses related to oil and gas purchases

are not necessarily going directly to the oil producers. With the heavy volume of speculative

investment, the higher costs paid by the end user are being funneled into hedge and other

investment funds (Farrell and Lund, 2008). This would be contrary to the markets prior to the

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onset of hedge activities in that the costs paid by the consumer were typically returned to the

producer of the commodity rather than the producer and a third-party hedge investor as we see in

the market today.

Along with the entry of new investors such as pension funds and Wall Street firms in the

commodities markets, we are now seeing an influx of money from outside of the United States in

the trading activities. As hedge funds continue to grow, they continue to need more credit to

invest in the markets. While in the past, most of that credit came from banks, the new funds are

being accessed from the major oil producing countries in the Middle East as well as several large

Asian banks (Farrell and Lund, 2008). Like other investors, these new participants follow a

strategy of investing in options that provide the most upward potential for profit. However, some

would consider it to be ironic that Middle East oil producers could be speculating in the oil

markets. In other words, they may be creating a situation where they are not only gaining a

significant profit from the point of production and contracting, but they also gain access to

additional profits resulting from their additional speculative investments.

However, this increase in the availability of credit may have a risk as well. As hedge fund

managers and firms find that they are depending on outside credit available from banks and other

investors, there may be a point in time where they will no longer have access to credit at the level

they currently possess. Additionally, as credit becomes more the norm for payment in options

markets, the market itself could become too leveraged on credit resulting in a higher risk of

collapse of a fund for non-payment of outstanding credit obligations (Farrell and Lund, 2008).

While banks and other investors have certainly improved their oversight of credit issuance to

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better refine their individual risk management strategies, the risk of default still remains and can

become a more predominant issue as access to credit increases.

As discussed above, the strategy of a hedger or speculator is to profit from price

fluctuations in markets. In general, prices are established by a balance of the available supply

against the quantity demanded by the market. What the speculator wishes to benefit from is to

project demand or supply changes and how those impact the price. The hedger profits either by

contracting to purchase the commodity at a lower price than the current market value at delivery,

or to sell the option at a higher price in comparison to a lower current market price.

Again, in examining oil as a commodity, we can see that there has been a significant surge

in demand while supplies have been consistent (Herbst, Coy and Palmeri, 2008). The result of

this is that with more demand, the prices will naturally increase. With that, even with no

speculative or hedging activities involved, there would be a price increase due to a mismatch of

available supply and quantity demanded. However, as external economic factors such as increases

in global inflation rates and the declining value of the United States Dollar, speculators looked at

other investment options for their funds that could hedge against their equity investments that

were either losing money or seeing minimal improvement in value (Siddiqi, 2004).

Given the economic conditions, hedgers identified the oil markets as an option to maintain

growth. Investors correctly forecasted the growth in global demand for oil specifically from

developing countries like China and India, and felt that futures options in oil would be a more

effective investment (Herbst, Coy and Palmeri, 2008). While many would consider this activity to

potentially be an effort to manipulate the market for a short term gain at the consumer’s expense,

the practice is generally legal as an option for investors (Herbst, Coy and Palmeri, 2008).

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Along with the variety of methods to trade commodities on the market, there are also

other types of instruments that can be used in hedging strategies. Financial derivatives are

instruments where the underlying security is not necessarily a commodity. For example,

optionally convertible securities provide owners with the opportunity to convert the security to a

specified number of shares of common stock within the company (Abumustafa, 2007). While

some would consider this to be nearly the same as a stock option that could be found as part of an

employee compensation plan. Stock options provide an opportunity for the holder of the option

to purchase shares at the option price after a pre-determined future date.

For example, an employee could receive the option to purchase one thousand shares of

company stock at $10 per share. In the event that the actual market price of the company stock is

more than $10 per share, it would be wise to execute the purchase as the holder would have the

ability to purchase the shares at a price that is lower than the market value. In the event that the

holder did execute the purchase at that price, they could choose to keep the shares, or

immediately sell the shares at the market price and receive the difference between option price and

market price as profit. Furthermore, if the market price is less than the option price, it would not

be a wise decision to execute the option as the option holder would be better served in purchasing

their shares on the open market at a lower price. However, unlike optionally convertible

securities, stock options can not be sold between the original owner and a third party.

Optionally convertible securities also provide increased flexibility for the issuer in

comparison to stock options as well. For example, in times of market sensitivity, investors

typically become quite concerned with a company’s performance when additional shares are

issued to the open market. Investors would likely get the impression that the finances of the

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company are not as strong and they need additional funds. Secondly, where company assets

remain the same and more shares are issued, the value of the shares on the open market would be

considered to be of lower value as there is a wider share of ownership (Abumustafa, 2007).

However, when a company issues optionally convertible securities, they receive the benefit

of additional access to funding without the risk of negative market perception. The reason behind

this is that since no additional stock is issued, the perceived value of the stock would not

necessarily change. As these securities are simply options to convert to actual shares at a later

date, the only risk the company has is that there is a risk of conversion at some point in the future

and they would need to address any changes in market perception at the time of conversion.

However, the issuer also has the option to call the securities after a set period of time that forces

the conversion to the underlying security. As such, the company receives the benefit of the

improved cash flow without the stigma of negative market perception (Abumustafa, 2007).

From the holder’s perspective, there are benefits as well. As discussed above, they have

the option to sell the security to a third party as well as convert the option to shares at their

discretion. Along with that, holder also has the option to collect dividend or interest income until

the point of conversion into company stock. This is especially beneficial to holders of optional

convertible securities that do not have a call option. In this case, the holder can collect dividend

or interest income into perpetuity without risk of the issuer calling the option (Abumustafa,

2007).

However, there are also derivative instruments that do have ties to commodities. An

example of this is a commodity swap. With a commodity swap there is an agreement between

two parties where one party agrees to make a series of payments to the second party where the

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payment is based on the value of a commodity. The payments are based on a fixed price that is

agreed to in the contract. Commodity swaps are typically used as a hedge when a futures

contract is not an available option for the investor (Abumustafa, 2007).

Government Regulation and Oversight in Commodity Markets

Now that we have an understanding of some of the complexities of options markets,

speculation and hedging strategies, I will now review some of the existing government regulation

and further discuss its impact on options markets and investment strategies.

Among the most well known regulations that govern the securities industry is the

Securities Act of 1933. In the act, the government is not only establishing the Securities and

Exchange Commission (SEC) as the regulatory and enforcement arm of the government, but also

serves to establish guidelines for market operations. Within the act, companies and investors have

a clear framework for the issuance and purchase of shares as investment options available to the

public. Additionally, the act defines the level and frequency of public disclosure of financial

performance of the company. Simply put, the SEC is attempting to “protect the average investor”

(Preiserowicz, p. 813).

However, in relation to hedge funds, the act does not specifically cover these activities.

The challenge that the act faces in situations with hedge funds is that the act focuses more on

individual investment of company shares available to the public. Hedge funds do not necessarily

provide this option. In addition, hedge funds are not subject to any disclosure requirements

typically found in a public company. As such, most hedge funds are considered private

investment partnerships where there is limited membership to those investors deemed to be

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accredited with sufficient funds to participate in the fund. Clearly, these accredited investors

would not be defined as average investors under protection from the SEC (Preiserowicz, 2006).

Along with the qualification requirements of investors, hedge funds are not necessarily

required to register with any government agency which provides them with an opportunity to

operate without any government regulation or risk of legal violations (Preiserowicz, 2006).

Clearly, there is a concern with this as without any government oversight investors could be

making very risky investments as there would be virtually no protection in the event of

inappropriate conduct of a hedge funds leadership. Beyond that, investors would have either very

limited or no access to the underlying performance of the fund as the fund managers would have

no obligation to disclose the information.

The Investment Company Act of 1940 was implemented to further regulate investment

markets. The primary purpose of this act was that it required companies with a primary purpose

in facilitating securities investment to register as an investment company with the SEC

(Preiserowicz, 2006). On its surface, this would appear to provide some level of regulation for

hedge funds as by definition, hedge funds facilitate security investment. However, even with this

regulation, there are still exceptions where hedge funds would not necessarily be subject to this

act.

However, if a hedge fund has no more than one hundred members and does not make

public offerings for investment, they are not required to register as an investment firm with the

SEC (Preiserowicz, 2006). Again, as is the case with the Securities Act of 1933, if a hedge fund

intentionally limits its membership, the rules would not apply. Thus, the results for an investor

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would be the same, a lack of required financial disclosure of the hedge fund and a potentially blind

investment from the investor.

As the regulations continued to evolve, the government made another attempt at market

regulation by the implementation of the Investment Advisors Act of 1940. While this act does not

regulate the investment company itself, it does regulate the individual advisors within a firm. In

the act, any individual who receives compensation for providing assistance or advice to investors

of securities is required to register with the SEC as an investment advisor (Preiserowicz, 2006).

However, hedge fund advisors have an exception under this rule as well. In the event that

an individual advisor has less than fifteen clients along with not offering to assist the general

public in their investment activities, the advisor is not subject to the act and not required to

register with the SEC (Preiserowicz, 2006). While with the acts discussed above, there is no

requirement for disclosure of fund performance, in this circumstance, there is no requirement for

the advisor to disclose their qualifications, historical performance or any other factor to a

potential investor. Clearly, this is quite risky from the investor’s perspective in that they could be

receiving advice from an advisor who is either in no informed position to provide the advice or

could very well have provided historically bad advice to previous investors.

Along with this exception, there is an underlying exception that could also apply to hedge

fund advisors. That exception is the definition of ‘client’ within the act. Normally, we would

consider an individual person to be a client. However, in the act, a client can also be a fund that

has underlying investors. Those underlying investors could be limitless as the act only defines the

fund as the client, and not any other beneficiaries of the fund. With that, as long as the advisor

manages no more than fifteen funds, regardless of the amount of total individual beneficiaries of a

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fund, in the eyes of the law, that advisor only has fifteen clients (Preiserowicz, 2006). This

exemption is significant in that the unregistered advisor could control the investments of a

limitless amount of individuals.

Among the well known investment market regulations is the Securities Exchange Act of

1934. While the government and the SEC implemented this Act to further regulate markets, this

Act still provided exceptions for hedge funds. Within the Act, there is a requirement that would

require firm registration in the event that there were more than five hundred clients and a value of

more than $10 million (Preiserowicz, 2006). However, even with this tighter regulation, there is

an obvious exemption for hedge funds. That exemption lies in the total amount of members

required for registration. In order to effectively avoid registration, a hedge fund could simply

limit membership to less than five hundred members. As such, regardless of the value of the

fund, as long as the membership was limited to less than the act requires, they would not be

subject to any registration requirements.

Given the continued attempts by the government and the SEC, there is clearly a need to

reassess the applicability of the existing regulations as they pertain to hedge funds. As such, the

SEC is now focusing on evaluating the specific concerns in discussion so that may serve as a basis

for the development of future oversight strategies. Along with this, the intention of the enhanced

regulations was to further protect investors in these funds as well as add financial stability to

hedge funds (Edwards, 2006).

The first concern from the SEC involves the significant growth of the hedge fund industry

and the related risks associated with continued growth to financial markets. As hedge funds

continue to grow, their dependence on available credit from outside investors continues to

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increase. With this reliance on credit, there is a risk that other non hedge fund investments may

find that there is less access to funding as hedge funds may be interpreted by the market as being a

better investment. Thus, we have a situation where the credit market could be focusing too much

on one particular investment opportunity and ignoring others that may be more reliable investment

instruments. Secondly, as the credit market invests more credit in hedge funds, there is an implied

risk where there could be a negative impact on the overall credit market in the event of failures of

hedge funds (Preiserowicz, 2006).

Secondly, there is significant concern about the lack of financial disclosure of hedge funds.

As I briefly mentioned earlier, as hedge funds are not subject to the existing SEC regulations for

investment firms or advisors, there is no requirement that either party disclose the valuation of the

hedge fund portfolio. While it is in their best interest to report some valuation information in the

process of soliciting new investors in the fund, there is no requirement of any sort of outside audit

of the portfolio or any validation of the conclusions of the fund managers (Preiserowicz, 2006).

For the individual investor, there is an inability to validate whether or not the information

provided by the fund manager is true or not. While the investor could certainly make some

assumptions about the validity of the valuation, but by no means does that imply that the

information is correct.

Additionally, there is also no requirement for fund managers to disclose their overall

investment strategy to investors. Again, it is likely in the best interest of the fund managers to

provide some level of detail when soliciting new investors, but that disclosure does not mean that

the stated strategy will be continued for any period of time in the future. As such, while a fund

manager may disclose the current investment strategy of the fund that does not imply that the

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manager may elect to change that strategy in the future. Since there is no requirement to disclose

the strategy at all, there is also no requirement to disclose change in the strategy (Preiserowicz,

2006). From an investor’s perspective, this would be challenging in that without the disclosure,

the investor would have difficulty in assessing whether or not the existing or future investment

strategies of the fund are in line with their personal investment strategies.

Along with the lack of disclosure requirements, there is also a significant risk of a conflict

of interest on the part of the fund manager. As an example, in the event that an individual

manager is responsible for multiple funds, they may choose to take a loss on one to the benefit of

another. Clearly, those investors only participating in the former fund would not benefit.

However, the fund manager could benefit as there would be improvement in the performance of

the latter fund. In addition to this example, hedge fund managers could also implement strategies

that may be in their own personal financial interest but are not in the interest of other investors.

By meaning, investment strategies would be based on what would drive income to the fund

manager instead of the fund investors (Preiserowicz, 2006).

Ironically, for the most part, the majority of a fund manager’s compensation is not tied to

the performance or profit of the fund. Generally, hedge fund managers receive two percent of the

value of the assets of the fund and an additional twenty percent of any profits received by the fund

within the assessment period (Williams, 2008). With this, in the event where a fund may lose

money in a period of time, the only risk for the fund manager is their loss of the share of the

profits as they would continue to be compensated on the overall value of the assets of the fund.

While there is clearly a risk of loss in overall asset value, the fact that the advisor could still have

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high compensation for managing a poorly performing fund could be difficult for investors to

comprehend.

Given these issues, the SEC is considering a wide range of new regulations that would be

directly related to the management of hedge funds and potentially address the existing exemptions

afforded to hedge funds. The first of those options is to consider hedge funds as private funds. In

order to effectively define a hedge fund as a private fund, the SEC provided guidance on how

hedge funds would be recognized under this response. First that hedge funds would otherwise be

considered to be investment companies as defined by the guidelines under the Investment

Company Act of 1940. Secondly, investors would not be permitted to withdraw their investment

within the first two years of the investment in the fund, and third that the investment is being

offered based on the skills of the fund manager. The intent behind these very specific definitions

of a private fund was to better tie the characteristics of a hedge fund and related processes and

avoid additional regulations for other investment entities such as banks, insurance companies or

venture capital pools that would not normally be registered with the SEC (Preiserowicz, 2006).

Additionally, as I discussed above regarding the Investment Advisors Act of 1940, hedge

fund advisors previously had an exemption related to the total number of clients in their fund. As

discussed above, hedge fund managers would simply be required to consider clients to be

something as simple as the total number of funds they managed. As long as that total number did

not exceed fourteen clients, they would be exempt from the regulation and not required to register

with the SEC as an investment advisor. As such, the SEC adjusted their regulations to consider

the sum total of all investors in all funds a hedge fund manager may have as a client. With that,

the fund manager would be required to register as an investment advisor based on the total

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number of individuals who were investors directly with the fund manager or investors in any

subordinate funds under the hedge fund manager’s control. This look-through provision was

previously an exemption for hedge fund managers in the Investment Advisors Act of 1940, the

response by the SEC was to remove this exemption and require that hedge fund managers register

as investment advisors with the SEC (Preiserowicz, 2006).

Additionally, the SEC developed the Recordkeeping Rule to address the lack of audit or

reporting requirements previously available to hedge funds. Given that hedge fund managers

would now be required to register as investment advisors, along with that requirement, they

would now also be required to keep and provide to their investors, their audited financial results

to their investors, but also disclose those results in any promotional materials that would be used

to market their fund to new investors (Preiserowicz, 2006).

Also within the requirements for all registered investment advisors, the hedge fund

managers are now required to adjust their performance fee processes under the new Performance

Fee Rule. In this rule, hedge fund advisors can only charge performance fees to qualified clients

as defined in the Investment Company Act of 1940 and could no longer charge performance fees

to investors that did not meet the criteria of a qualified investor. Previously, hedge fund managers

had the ability to charge performance fees to all of their clients under their previous exemptions.

While there is a grandfathering process that did apply to this rule, any new clients or new funds

would be subject to this requirement (Preiserowicz, 2006).

In tandem with the new Recordkeeping Rule, hedge fund managers will also be subject to

the Adviser Custody Rule that requires that all registered investment advisors provide third-party

audited financial results of their funds performance. However, hedge fund managers who have

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other funds as clients may have difficulty adhering to this rule. This is due to the requirement that

the financial disclosures must be made within 120 days of the end of the fiscal year. As such, in

the event that a hedge fund manager has other funds as clients, the manager may not get the

financial results of the underlying fund until the 120th day, which would then be quite difficult for

the fund manager to adhere to this requirement since they would also be subject to the 120 day

rule. However, the SEC recognized this and did provide an exception which would provide the

hedge fund manager an additional sixty days to provide their audited results (Preiserowicz, 2006).

Now that we have established the processes and regulations of hedge funds, I will now

examine the current strategies that hedge funds and their investors implement. First, prior to

discussing those strategies, it is appropriate to review some of the causes for several recent hedge

fund failures.

The most predominant reason for hedge fund failures was a lack of market discipline in

their operations as it relates to not only the risk management strategies of the funds, but the risk

management strategies of the investors and those firms providing credit to the hedge funds

(Wilson, 2008). In the fervor to enter the growing hedge fund market, many investors entered

blindly hoping to receive the same perceived benefit their peers received from participating in

these activities.

While initially many hedge funds were quite successful in their strategies, the lack insight

into a fund’s risk management strategies resulted in the eventual financial failure of several firms

as well as the investors and creditors of those firms. As I discussed earlier referencing the new

SEC regulations related to performance and recordkeeping disclosure requirements, there was a

risk that a hedge fund could be taking very risky investment opportunities with the hope of a

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financial gain, but in the event of a loss, there was limited ability for an investor to be aware of the

failure until it was too late to act.

As an example of this, we can review the issues related to the trading of Collateralized

Debt Obligations (CDOs) in the mortgage market. CDOs are packaged mortgages that are

available for purchase by an investor. The assumption prior to the mortgage crisis was that CDOs

were generally accepted to be of high quality as there was a perception that since there was a

minimal chance of borrower default, the risk related to the investment would be limited.

However, what was not known was the quality of the underlying mortgages within a CDO. By

meaning, a lender creating the CDO could package mortgages that were of high perceived quality,

low quality, or a mix of the two. Regardless of the mix, CDO investors had no insight into the

actual quality of the underlying mortgages as there was no expectation that this information be

disclosed to investors purchasing CDOs. Furthermore, to make matters worse, most CDOs

contained mortgages that did not have an opportunity to become delinquent, as these loans were

typically packaged and sold shortly after origination, often before the first payment was due.

This is nearly analogous to strategies related in commodity based hedge funds. In that,

investors and creditors had virtually no access to the underlying investments managed by the fund.

However, as I discussed above, for many investors, this did not appear to be of concern. The

primary motivation of many investors was to enter the market soon enough so as to not lose an

opportunity to profit from the surge in growth.

Now that the failures have occurred and the lessons are beginning to be learned, investors

and creditors are now revisiting their investment strategies related to hedge funds. While some

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investors and creditors have simply exited the hedge fund market completely, those that remain

are becoming much more conservative on their investment strategy.

As I discussed above, the first step in the process was to refine the risk management

strategies and the supporting systems and processes of the investors. As such, the SEC began a

process of identifying the appropriate risk management systems in their assessment of hedge

funds. Those systems included “market, credit, liquidity, operational, and legal and compliance”

(Wilson, p.19). The intent of this assessment was to gauge whether the hedge fund had the

appropriate systems in place to effectively determine whether an effective risk management

strategy existed as well as whether the managers had access to the systemic information to

determine adherence to the risk management strategy.

Along with the risk management strategies of hedge funds, investors also became more

risk averse as a result of several hedge fund failures. As such, investors significantly increased

their due diligence processes related to providing funds. These due diligence processes require

that the hedge fund under consideration provide adequate financial reports indicating historical

performance as well as insight into their current and future investment strategies. With this

information, investors and creditors could better understand whether the pending investment

would fit within their, now enhanced, risk management strategies. For example, if the disclosure

reported that a hedge fund appeared to rely to heavily on a specific commodity or other industry

within their strategy, the investor may consider this to be riskier as there would be a greater risk

associated with changes in a performance in a concentrated investment strategy (Wilson, 2008).

Building on the due diligence requirements, creditors also began requiring that hedge

funds post collateral to secure the credit in the event that the hedge fund defaulted (Wilson,

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2008). Clearly, this is contradictory with the past operation of creditors where collateral was not

required to secure the credit line as credit was simply extended to hedge funds with very limited

oversight. Furthermore, the collateral provided would also be required to meet certain standards

as well. For example, hedge funds would be required to provide cash or cash-equivalent

instruments or highly liquid securities that had minimal risk of loss and could be quickly liquidated

in the event of failure (Wilson, 2008).

Given the wealth of new regulations and the significant changes to credit requirements, the

remaining hedge funds were forced to re-evaluate their overall strategies. Prior to several failures,

hedge fund managers would insist that they were using market fundamentals to guide their

hedging strategies. However, as we are now aware, many fund managers were focusing less on

historic performance and market fundamentals, but were focused more on trying to speculate on

what the future fundamentals would be (Kase, 2006). Clearly, the concern about this was that

managers were nearly guessing the future. While many managers would insist that they based

their predictions on market performance, we can again consider the failure of the mortgage

market and hedge funds that were heavily invested in CDOs, that traditional fundamentals may

not have been applied and led to the failure of many funds.

Conclusion

While there is a lot of contention as to who is the blame for the recent hedge fund failures,

the general unease with hedge fund investments, and the surge in commodity prices, there are

many parties that share some of the responsibility for the crisis. First, the lack of applicable

government regulation on hedge funds and their managers that provided many exemptions that

the funds could easily access and avoid government oversight. Secondly, hedge managers and

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advisors for their apparent lack of foresight into the risks that they assumed in their strategies

which resulted in a downstream negative impact on the financial standing of their investors and

creditors. Finally, the oversight of investors and creditors in their limited application of realistic

risk management strategies and effective oversight of hedge fund performance and strategy. In

the end, it was likely a combination of all of these factors that led to the weakening of the hedge

fund market.

Finally, we also need to understand how the processes of hedge funds and speculators

have on consumers. As I discussed earlier, there were some consumers such as Southwest

Airlines who were able to execute an effective hedge strategy in oil that also provided a benefit to

their customers related to price stability. However, those consumers who directly purchase

gasoline are feeling the pain of significantly higher prices at the pump. While some analysts

consider that the activity of speculators is a primary reason for higher prices (Velotti, 2006) with

the perception that speculators are artificially increasing the price of oil to make a quick profit that

is paid by the consumer, there is clearly more to the picture than the act of speculators alone. As

I have discussed above, speculators likely have some influence, however, there are also other

instances of speculation through hedging that have provided a benefit to consumers as well.

In the Application Section of this KAM, I will focus on detailing effective hedging

strategies that airlines, like Southwest Airlines, can implement to better address potential future

increases in oil and jet fuel pricing.

APPLICATION

AMDS 8633: PROFESSIONAL PRACTICE: APPLICATION OF INVESTMENTS AND

INTERNATIONAL FINANCE

Introduction

As we see in the current financial crisis facing air carriers in the United States, the

significant increases in the price of oil is quickly having a downstream impact on the cost of jet

fuel for the airlines along with increases in costs passed down to consumers. Clearly, this has a

negative impact on the economy as a whole. Not only does this impact the regular business

traveler, but it also impacts business costs related to companies who operate at a national or

international level. As such, along with the costs consumers face when flying, they also see an

increase in cost of goods that are manufactured and shipped to the customer.

With this, we need to establish a thorough understanding of not only how oil and fuel

costs are directly tied to the economy, but what actions consumers can take to better address

future price changes. As such, I will focus this application review on first gaining a stronger

understanding of what the current situation is in oil and fuel markets and then identify particular

strategies used by airlines to effectively address price changes for their fuel expenses.

Overview of the Current Situation

As discussed above, many airlines in the United States have been plagued by significant

increases in the cost of oil and the impact that cost has on jet fuel. The result of this cost increase

has forced airlines to determine ways to recover the increased costs from their passengers. While

airlines could simply increase fares, which they did, that action alone was not effectively

addressing the continued increases in costs. Additionally, airlines also needed to consider the fact

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that continued increases in airfares would eventually result in lower passenger traffic resulting in

reductions in revenue against the continued cost structure.

While increases in fares were the first step that the airlines implemented to address cost

increases, they found that consumer tolerance for higher prices continued to decline as the

national economy began to suffer. The next step beyond fare increases was to determine other

sources of revenue that were clearly smaller in comparison to other options that appeared to be

more palatable to the consumer. One of the first tactics, and one that was well reported in the

media, was to begin charging customers for their second checked bag. The intent from the

airlines’ perspective was likely to test the market to determine whether customers would accept

this fee. This tactic had a dual benefit for airlines. They identified a new revenue stream as well as

addressing the impact that baggage has on the weight of the plane and the fuel usage related to

that weight.

As with many tactics related to any costs increases, once one airline implements the

change, the other major carriers quickly follow suit. While the tactic was initially set to charge a

fee for a second bag of checked luggage, leaving the first checked bag at no charge, this failed to

meet the increased cost burden of the airlines. As such, we find that, with the exception of one

major airline, all the airlines are charging a fee for every checked piece of luggage. While the cost

structure is different where the first piece of luggage is typically less expensive than the second or

subsequent checked items, consumers are now bearing, and are accepting this new fee.

Along with fees for baggage, airlines also began charging fees for options such as window

or aisle seats as well as upgrade fees for seating in the exit rows. Again, items that were

considered free in the past now had additional fees attached. Beyond the additional fees, several

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airlines began charging higher prices for items such as meals and beverages or in many

circumstances, dropping beverage service completely from certain flights.

However, the airlines could not simply focus on developing or enhancing new revenue

streams to address their growing operating costs. They also needed to examine how they

operated their flight schedules. For many years, it was common to board a plane and see plenty of

open seats that went unsold. Clearly, given that the operating costs were nearly the same, having

a half empty aircraft directly impacted the cost per passenger. With that, airlines also focused on

the efficiency of their schedule so as to improve their passenger capacity performance.

Given the capacity concerns, the first step that the major airlines took was to scale back

the amount of flights per day. By examining the peak capacity performance of certain flights, the

airlines could identify which particular flights could be suspended or permanently cancelled. The

projected result of this being that the remaining flights would have more passengers and the airline

could operate more efficiently. However, the airlines still needed to be conscious pushing

customer tolerance to a point that they would no longer travel. As such, the flight reduction was

done gradually to continually test customer demand to the level that we currently see with the

major carriers.

Along with improving their cost per passenger related to fuel consumption, the schedule

reduction also resulted in other operational costs reductions as well. Clearly, with fewer flights,

fewer employees were needed. With that, the airlines were able to reduce their staffing costs by

early retirement, layoffs and terminations. While this does not specifically impact the operating

costs of a particular flight, these reductions served to reduce overall salary and benefits costs of

the airline.

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However, even with the improved revenue streams related to increased fees and fares

along with the cost reductions in place, the major airlines are still struggling. As the cost of oil

and jet fuel continues to be a larger burden on the airlines, there continues to be an inability to

properly address what is now the largest single cost of operating a flight. For many of the major

airlines, the jet fuel cost is approaching forty-percent of the total operating cost of a flight. While

some long haul flights do not see this high of a ratio, the shorter flights which are the majority of

an airline’s schedule, continue to see excessive costs related to fuel consumption.

This puts the major airlines in a very precarious situation. They can not risk a negative

impact to customer retention by further increases in fees or fares nor can they continue to take on

more debt or financial losses related to jet fuel costs. With that, the airlines need to engage in a

strategy that can not only address the current situation related to fuel expenses, but to better

prepare for any future changes in fuel costs.

However, we also need to understand that the major airlines are not the only consumer of

jet fuel. In fact, there is another user who actually consumes more jet fuel than any individual

airline, that user is the United States Air Force. However, the Air Force does not have an

opportunity to recover additional fees or revenues like the airlines. As such, the Air Force needs

to consider methods of maintaining costs along with providing appropriate projections on

budgeting for future terms.

Given the restrictions the Air Force encounters when it relates to expense management,

they have proven to be unsuccessful in their attempts to effectively manage increasing jet fuel

costs. There are several reasons why this is the case. However, the most predominant reason for

the failure to manage fuel costs is the inability of the government to correctly predict what future

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prices will be. Since the past performance has shown that the government tends to underestimate

the actual fuel costs, the inaccuracies result in the Air Force either reducing or delaying expenses

or going back to the government to ask for supplemental funds to recover the costs (Spinetta,

2006).

Much of the discrepancy is due to the budgetary structure of the United States

Government as it relates to effective planning for changes in jet fuel pricing. In examining the

current structure of budgeting, the first stage of the process involves the Office of Management

and Budget determining the cost estimates for jet fuel consumption for a budget year. From there,

the OMB estimate will go through several stages to determine an estimated price per barrel of jet

fuel. Then that budget is sent to the Department of Defense for further adjustments with final

distribution to Air Force for their operational budgets. Beyond the fact that there are multiple

parties making adjustments and forecasts to the actual cost per barrel, what appears to be more

troubling is the focus of that estimate being based on oil futures pricing (Spinetta, 2006).

Furthermore, by focusing their price estimates on oil futures pricing, the OMB risks the

frequent price fluctuations related to activities outside of the market. For example, in the event of

war or other calamity that can not be forecasted by the markets or OMB. The result of this is that

more often than not, the OMB estimates for jet fuel pricing are significantly lower than the actual

cost at the time of purchase. As discussed above, this forces the Air Force to locate other funding

sources that could make up for the unexpected price adjustment.

Clearly, the intention of any commodity pricing strategy, for airlines or the government, is

to work towards establishing a stabilized price for the commodity. With both the airlines and the

Air Force attempting to better manage future costs, the need to stabilize this expense continues to

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be significantly relevant to their continued operations. With a stabilized price, the airlines can

better determine future expenses and have appropriate access to funding to manage their

operations. The same is true for the Air Force, in that they can better manage budget

expectations and meet their overall service objectives.

While from a financial perspective, there is clearly a benefit to establishing a stabilized

commodity price. However, that does not imply that this is something simple to determine. As

discussed above, the actions of the Department of Defense and the OMB clearly failed in the

attempt to determine what the stabilized price should be. While they did agree on what they

thought the stable price was, they were consistently inaccurate in that estimate. Thus, while the

intent existed to stabilize the price, the failure to do so accurately failed to effectively manage the

cost.

Given the inability for most airlines and other jet fuel users to develop an effective pricing

strategy, there is a need to implement a hedging strategy to better manage increasing jet fuel

costs. While the airlines have been hedging for many years with reasonable success, there is

significant concern that a government entity, the United States Department of Defense, in their

consideration of hedging to address jet fuel costs. While the Air Force is a significant user of jet

fuel in comparison to other major airlines, their usage is insignificant insofar as the total market

for jet fuel is concerned (Spinetta, 2006). With the projected lack of influence the government

could have on the commodity market, there would be little concern from the other market

participants on the government’s participation. However, that does not imply that the

government would then enter the market.

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Given the public perception of hedging and commodity markets, other members of the

government may see such actions as risky in that the investor may actually lose money in the

effort and it may still not address the Department of Defense’s need for a stabilized market price

for jet fuel. The general population may also see this action as a highly risky use of government

funds as well. This is where the perception of the market does not necessarily correlate with the

actual performance of the market (Spinetta, 2006).

As discussed above, the intention of a hedging strategy is not to necessarily make a profit,

but it is to provide some level of stability for the price over a period of time (Morrell and Swan,

2006). If we examine the performance of some of the airlines who did not implement a significant

hedging strategy, we would see examples where several major airlines were paying consistently

higher jet fuel prices in comparison to their competitor airlines. One specific example of note is

the hedging strategy of Southwest Airlines. Through 2003, Southwest hedged nearly forty-three

percent of its jet fuel needs for the following operating year. This was nearly three times the

average of all of the major airlines operating in the United States. Only one other airline, JetBlue

was hedging at a similar level. Clearly, when looking now at the level of profitability of the major

airlines, Southwest clearly used jet fuel hedging to its advantage when managing overall operating

costs (Spinetta, 2006). While other airlines entered and exited bankruptcy, Southwest has

maintained strong economic performance in a period where operational costs are increasing

significantly.

Hedging or Speculation?

Of the many ironies in the public perception of hedging by companies is the idea that

hedging and speculation go hand-in-hand. This could not be farther from the truth. In fact, if an

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airline does not hedge jet fuel to the best method possible, they are in fact speculating on the

future price of jet fuel (Spinetta, 2006). What we must first understand is that the act of hedging

makes solid business sense. It makes something as unpredictable as jet fuel pricing more

predictable and easier to manage from an operational perspective.

While the end result of hedging is not to make a profit or avoid a loss, as the long term

financial impact of a hedge is zero (Morrell and Swan, 2006). No gain or loss on the investment.

The benefit of being able to anticipate the future cost is the underlying benefit of a hedging

strategy. This is true even from a valuation perspective in that airlines who can establish an

accurate budget reportable to the investor will have the perception of being reliable and worthy of

future investment. Beyond that, investors appreciate consistency in operating costs and incomes.

We can see this with the consistent profitability of Southwest Airlines along with their consistent

stock performance in comparison to their peer airlines.

However, first we need to understand the impact that airlines have on the market. Again,

the intent is not to make a profit but to have a reliable cost stream into the future of the hedge.

While this is certainly a benefit to the operation, it does not mean that an airlines stock will surge

in value simply due to a hedging strategy. Investors consider a wide range of reasons which

involve costs, profit and operating strategies that continue to evolve with the needs of customers.

Thus, the purpose of the hedging strategy is to avoid a future risk of wild cost fluctuations and

provide financial stability to the operation.

Implementing an Effective Hedging Strategy

As discussed in the Depth and Breadth Sections of this review, there are several methods

of hedging the price of a commodity. As it relates to jet fuel, the typical strategy involves the

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setting of a forward contract for the purchase of jet fuel. The forward contract allows the airline

to purchase a certain quantity of jet fuel at a given price for delivery at some point in the future.

This agreement allows the airline to determine the cost well before delivery. This is also ideal

from the producer’s perspective in that they have a purchase commitment that allows them to

assume the income at the delivery date.

However, there is also risk associated with this type of transaction. As these contracts are

not set in an organized commodity market, there is a risk of failure to deliver at the time

designated in the contract. For example, in the event that the airline or the producer goes

bankrupt and fails to pay or deliver the jet fuel, there is no commodity market that would govern

the transaction. However, in reality, this is true of any direct contract between a buyer and seller.

There is always a risk that one of the parties will not fulfill their end of the contract.

In order to address this, some airlines may choose to simply enter into a futures contract

that is completed through a commodity exchange. By transacting through an organized

commodity exchange, third party investors can be involved in a transaction in the event either the

airline or producer does not fulfill the requirements of the contract. Ironically, only one percent

of the hedged oil in commodities markets are delivered to the initial futures purchaser. Since the

primary focus of the commodity investor is for the investment value of the contract, the existing

contracts are often reversed near the point of the scheduled delivery (Morrell and Swan, 2006).

On the other hand, airlines may also consider the use of derivatives in their fuel hedging

strategy. Unlike futures contracts that commit a buyer and seller to a particular quantity and price

with a stated delivery date, derivatives give the holder the right to purchase at a given price

(Morrell and Swan, 2006). The result of this is that there is a much lower financial commitment

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of the holder as they are not purchasing the actual commodity. Given that this is simply a right of

the holder, there is no obligation for the airline to actually purchase the fuel. In the event that the

airline wishes to execute the right to purchase, the agreement would then be converted to a

futures contract with the specific price and delivery terms (Morrell and Swan, 2006).

However, more recently airlines have engaged in a process where they use combinations

of put and call options in order to have a price that is in a range of available prices from the

producer. In this event, the airline would purchase a call option that would that would protect the

holder from a resulting price that could be above the strike price of the fuel. In addition to that

effort, the airline would also sell a put option that would provide protections where the market

price was actually lower than the strike price of the option. While there is a cost associated with

this, the option premium, the airlines see a benefit in this process as there will be a known price

range for the fuel when purchased (Morrell and Swan, 2006).

Finally, airlines will also engage in swap contracts that allow airlines to purchase fuel at a

specific price but with deliveries over a period of time. This is an ideal option for airlines in that

they are able to purchase the fuel based on projected need. In effect, a swap agreement is a set of

multiple futures contracts. For example, the airline could make a swap agreement where they

would receive a given quantity of fuel per month for a year or more. Within that agreement, there

would be a specific price for the fuel for delivery, much like futures contracts. However, where

swaps differ from futures contract is that the swap price and the market price are considered at

the point of delivery. In the event that the market price of the fuel is lower than the swap price,

the producer would pay the airline the variance multiplied by the quantity of fuel scheduled for

delivery. On the other hand, if the market price for the fuel is actually higher than the swap price,

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the airline would pay the producer the difference in price multiplied by the quantity for delivery

(Morrell and Swan, 2006).

Which Airlines Hedge?

Now that we have an understanding of the major hedging processes and options, I will

now discuss which airlines hedge their jet fuel acquisitions. As I discussed above, the major

categories of jet fuel users are the airlines and the military. In this discussion, I will examine the

non-military jet fuel users. As such, we can classify the airlines into two categories government

owned or sponsored airlines and publicly traded airlines.

First, I will examine those airlines that are either owned or funded by their home country

governments. In several cases, these government owned or operated airlines are faced with

similar restrictions as I mentioned earlier related to the fuel pricing strategies of the United States

Air Force. However, there are also examples, specifically the airlines operated by the People’s

Republic of China that are required to purchase their fuel from government owned producers.

Outside of the People’s Republic of China, other state owned airlines are permitted to hedge on a

limited basis if the airline can justify a hedging strategy to their government managers (Morrell

and Swann, 2006).

When examining the hedging strategies of some of the major American airlines, we can see

that there is a stark difference in planning. When referencing the hedging strategies through 2004,

the airline with the largest percentage of hedged jet fuel was Southwest Airlines with eighty-two

percent of their needs hedged. The next closest airline was Delta Airlines with thirty-two percent

of their fuel hedged with other airlines with no hedging strategy at all (Morrell and Swan, 2006).

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Clearly, hedging a majority of their fuel needs is a long term strategy of Southwest

Airlines. Additionally, it is evident that this strategy is paying off for them in that they remain the

only American airline that has maintained a profit over the past twenty years. While there are

likely some other reasons for Southwest’s financial success, it is clear that their effective cost

management is a major component of their success.

We can also see how a lack of a hedging strategy has a negative impact on some of the

other major American airlines. When we examine the strategy of the top two American airlines,

United and American, we see that a lack of a fuel hedging plan has impacted their financial

performance. Using United Airlines as an example, their lack of a hedging strategy has likely led

to their continual financial losses and subsequent bankruptcy filing.

The Impact of Hedging on the Value of an Airline

As I have discussed above, the ability for an airline to effectively manage their expenses

does have an impact on the financial performance of the company as well as the perceived value

of that company to investors and creditors. Even though the hedge itself is not designed to result

in any profit or loss, an airline’s exposure to fluctuations in cost does impact their ability to

stabilize costs. According to Carter, Rogers and Simkins (2006), their research shows that “the

airline firm value is positively related to hedging of future jet fuel requirements (Carter, Rogers

and Simkins, p. 54).” In other words, the market perceives a value premium when an airline

executes a hedging strategy.

Additionally, there is a negative relationship between increasing prices in jet fuel and stock

price (Carter, Rogers and Simkins, 2006). The result of this is that the behavior of the investor

market tends to hold that if there is a perception of profit decreases due to increased costs, the

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investors profit potential is limited. As such, they tend to sell off their investment in the airline.

Ironically, many investors stop short of examining an airline’s hedging strategy, if available, and

focus more on the perception that a commodity cost, regardless of airline, will result in lower

benefit to the investor.

As I have discussed before, a hedging strategy allows an airline to effectively lock in fuel

prices over a period of time. The additional benefit that the strategy has is that it also allows the

airline to also manage their long term investment strategy as well (Carter, Rogers and Simkins,

2006). For example, if an airline can predict their costs, they will also be able to budget for

acquiring new aircraft, routes or other resources that would be necessary for future expansion.

The same can not be said for those airlines that do not hedge in that they can not risk committing

to operational growth expenses with the risk of an increase in fuel expenses. Simply put, non-

hedging airlines can not commit a single source of funds to multiple needs.

Clearly, investors would have a negative perception of a company that can not manage its

expense nor invest in future growth. Instead, what results is that investors need to consider

whether they invest in an airline with sustained financial and operational growth or an airline that

is forced to restructure expenses as jet fuel costs increase. This is why we now see that investors

approach airlines like Southwest in comparison to other airlines like United and American who

either have limited or non-existent fuel hedging plans.

However, jet fuel risk is only one of several risks that airlines have in their operations.

Other risks include currency risks and interest rate risks. While currency risk only involves a

limited number of airlines that operate in multiple countries, interest rate risk occurs with any

airline that has any bank or bond debt in use to support their operations. While interest rate risk is

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a concern and can have an impact on the financial standing of an airline, that amount of risk is

negligible compared to jet fuel risk (Carter, Rogers and Simkins, 2006).

Additionally, there is also a positive market perception when an airline can hedge jet fuel

at a price that results in a lower price in comparison to the price available on the open market.

The market perceives this as a beneficial investment in that the airline would have the ability to

receive the jet fuel at a lower cost in comparison to not having the hedge in the first place. Again,

this could be considered counterintuitive in that a hedge should have a net present value of zero

dollars, the market clearly has a different interpretation of the meaning.

The typical result then is that if the market perceives a particular airline stock to be of

better value than a competitor, they will then invest more in that airline. This action then provides

the airline with more funds to invest in building their operation. Additionally, it also puts that

airline in a better position to efficiently compete against other airlines.

There are two primary tactics that an airline will use to utilize available funds to improve

its performance. First of those options is the purchase or lease of new aircraft. This tactic has the

benefit of not only modernizing their fleet but to lower maintenance costs associated with older

aircraft. The former reason is especially true in times where fuel costs are increasing.

When an airline has an opportunity to modernize their fleets, they have the option to either

purchase or lease new aircraft and retire older aircraft by means of sale to other airlines or if the

aircraft is beyond its useful life, airlines will simply sell the aircraft for dismantlement. In either

option, the benefit is a reduction in comparative operating costs from the old to the new aircraft.

In the event the airline chooses to lease aircraft instead of an outright purchase, nor the

lease expense or the value of the aircraft as an asset do not appear on the balance sheet of the

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airline. The benefit with this is that since the aircraft is not owned by the airline, the actual debt

the airline carries is understated thus appearing lower to investors (Carter, Rogers and Simkins,

2006). With that, investors will have the perception that the airline is carrying less debt and may

be perceived as a better investment. However, what is likely more tangible to investors is the

operational efficiency benefit of a newer fleet.

Along with the greater access to funds as a result of expense management and cash

inflows from investors, stronger airlines also have the opportunity to either acquire or consolidate

with other airlines (Carter, Rogers and Simkins, 2006). As an example, we can review the

acquisition of TWA by American Airlines in 2001. At the time, American was considered a

financially strong airline that was in need to grow to compete with United Airlines. American had

sufficient access to funds for the transaction as they were able to acquire TWA with their existing

cash on their balance sheet. The benefit that American received was the addition of a new hub in

St. Louis, Missouri as well as TWA’s existing aircraft fleet and their complementary routes that

would enhance American’s position as a competitive airline (Carter, Rogers and Simkins, 2006).

Currently, we are now seeing another increase in airline mergers and acquisitions.

However, the current environment is no longer focused on stronger airlines purchasing weaker

airlines. Nor are we seeing these mergers occurring on a cash basis either. In today’s market,

airlines are focusing more on options that will bring greater efficiency as well as complementary

route structures.

The first of these acquisitions was between US Airways and America West Airlines. In

this case, both airlines were struggling with increases in operating costs as well as loss of revenue.

However, there was clearly a complementary route structure. US Airways had a solid footing in

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the eastern portion of the United States with hubs in Pittsburgh, Pennsylvania and Charlotte,

North Carolina. America West Airlines had a solid presence in the southwestern portion of the

United States with their major hub in Phoenix, Arizona. However, since neither airline had

sufficient cash available to fund the merger, they turned to outside investors to purchase stock in

the new merged airline.

Another example of an airline merger in progress is between Northwest Airlines and Delta

Airlines. Again, this was an example of two airlines that were facing significant financial

problems. Both Delta and Northwest had recently emerged from bankruptcy and needed to take

drastic action to continue competing in the market. As was the case with the US Airways and

America West Airlines merger, there is a complementary route structure. Northwest maintains

hubs in Minneapolis, Minnesota, Memphis, Tennessee and Detroit, Michigan. Delta maintains

active hubs in Atlanta, Georgia as well as Salt Lake City, Utah. However, there is one additional

benefit in routes that provide an enhancement to this merger, that benefit being the significant

international route structure between the airlines. Northwest has historically maintained a strong

presence in Asia and Delta has a strong presence in Latin America and Europe. Additionally, both

airlines participate in the Skyteam loyalty program.

Along with the complementary route structure, the airlines also consider the benefit of

greater operational efficiencies after the merger. As with any merger of similar companies, the

merged companies have the ability to identify operational redundancies such as staff or routes.

While this should serve to solve some of the resulting company’s financial challenges, it will likely

be a significant period of time before the financial benefits of the merger will offset the current

financial challenges of either company.

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However, within all of these strategies, there is a perception that effective capital

investment by an airline will improve the airline’s value to the investor (Carter, Rogers and

Simkins, 2006). The theory behind this is that if an airline has funds available that are invested in

the operational growth of the airline by tactics such as jet fuel hedging, modernization of aircraft

and beneficial acquisitions, the market perceives these actions an enhancing their investment.

Along with that, the investor also perceives that by making these capital investments the company

is better positioned to address future changes in the industry and maintain financial growth.

The Impact of the September 11th Terrorist Attacks

Some may consider the events on September 11th to be the downfall of the major

American airlines. Notwithstanding the cessation of air travel for the week immediately following

the attacks, the reluctance of Americans to travel by air for the months after the attacks did not

improve the situation either.

However, while many thought that the attacks started the downturn in financial

performance of the major American airlines, the truth is that the financial challenges actually

began well before the attacks occurred. Along with quickly increasing fuel costs in the three years

prior to the attacks, the airlines also experienced increases in labor costs as well as reductions in

passengers (Kim and Gu, 2004). This resulted in nearly all of the major airlines reporting losses

prior to the attacks.

Along with the financial challenges of the airlines, the economy in the United States was

also on the decline prior to the attacks. As many economists would conclude, the United States

was already in a slight recession as early as March, 2001 after a significant period of economic

growth (Kim and Gu, 2004). Thus, the resulting decline in the financial performance of the

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airlines caused the recession to worsen shortly after the attacks and continued for well over a year

after the fact.

While the United States Government did take quick action to provide both loans and

direct compensation to airlines immediately following the attacks to provide some form of

stability, the funding did not have significant impact on correcting the financial downturn of the

airlines. Again, this was due to the direct losses of the attacks, but was also due to the poor

financial conditions of the airlines prior to the attacks. While the assistance certainly helped

mitigate some of the losses the airlines incurred, it did not satisfy all of the losses currently on the

books (Kim and Gu, 2004).

The result was that several airlines, including United Airlines and US Airways were forced

to file bankruptcy in order to reorganize their existing debt (Kim and Gu, 2004). While most of

these airlines did emerge from bankruptcy in better financial positions, it was only a short time

later when jet fuel prices surged, that the airlines found themselves in another predicament that

they were ill prepared to address.

In their analysis of weekly returns both sixty weeks before and after the attacks, Kim and

Gu (2004) provide clear evidence that there were few examples where an airline that had positive

returns prior to the attacks had negative returns after the attacks. While returns did drop for all

American airlines, the vast majority of the airlines that were losing money after the attacks were

losing money before as well. In fact, there were only three national carriers that swung to a loss

after the attacks. Those airlines were American Airlines, Frontier Airlines and Southwest Airlines.

The remaining national airlines simply saw increases in their existing losses in the sixty months

after the attacks. Ironically, if we examine the hedging strategy of American and Southwest, we

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would also see that these airlines hedged much higher proportions of their fuel needs in

comparison to the other major carriers (Carter, Rogers and Simkins, 2004). This might also serve

as a validation that there is a link between an effective hedging strategy and positive financial

returns.

Along with the analysis of changes in return for the major airlines, Kim and Gu (2004)

also reviewed the stock price fluctuation in the sixty months prior to and after the attacks. Here

we see similar indications of financial concern among the major carriers. While all of the major

airlines did see a significant increase in the standard deviation of the stock price, two carriers,

United Airlines and US Airways saw their standard deviations nearly triple in the sixty months

after the attacks. This would be compared to Southwest Airlines that witnessed an increase of

0.0072 in the standard deviation of their stock price. What this means is that the stock price of

most of the major American airlines was much more volatile after the attacks in comparison to

Southwest Airlines whose stock was hardly volatile prior to the attacks saw little change in that

volatility afterwards. Again, this could be based on the market’s perception that Southwest was a

wise investment both prior to and after the attacks.

Along with the perception that Southwest Airlines was considered a less risky investment,

we should also consider what was driving the higher volatility in stock price for the other major

American airlines. Clearly, investor behavior would indicate that if uncertainty in a company

exists, an increase in the price volatility of the stock will also exist. As it pertains to airlines,

investors pay close attention to fluctuations in the market itself and deteriorating financial

performance of the airlines (Kim and Gu, 2004). Thus, we see much higher volatility in stock

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price for airlines that were further weakened as a result of the attacks along with the deterioration

of their financial condition before and after the attacks.

Secondly, as I mentioned before, the increases in labor and fuel costs served to further

deteriorate the financial condition of the major carriers. To make matters worse, when several

airlines began to improve their financial performance, the price of jet fuel began to surge

significantly. Thus, limiting their potential to build upon the improving performance in the years

after the attacks (Kim and Gu, 2004).

Finally, we also need to examine the level of debt that airlines have assumed to address

their mounting financial losses. Since the attacks, most of the major airlines have continued to see

significant financial losses and have been forced to take on additional debt in order to cover their

mounting financial losses over the past few years. As Kim and Gu (2004) note in their research

that the average debt to capitalization ratio of the major airlines is now in excess of ninety percent

with a total debt approaching $90 billion. This has also had an impact on the Standard & Poor’s

credit ratings of the major airlines in that, with the exception of Southwest Airlines, the remaining

national carriers now have a debt rating that is considered speculative. Furthermore, this poor

rating makes a bad situation even worse as those with lower credit ratings are forced to pay

higher interest rates on new debt due to the increased risk associated with repayment.

Why did Southwest Airlines Succeed?

Now that we have an understanding of the financial performance of the airlines prior to

and after the September 11th terrorist attacks, I will examine the major reasons why Southwest

Airlines appears to have effectively remained ahead of other national airlines in financial

performance.

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First, Southwest was able to easily control their operational costs. The airline has

consistently hedged at least a majority of its overall jet fuel needs at a significantly lower price in

comparison to the market (Kim and Gu, 2004). This has allowed the airline to effectively lock in

their future fuel costs for anywhere between one to two years ahead of their current needs. As I

have discussed above, this stability in pricing allows Southwest to better predict future expenses

and accurately budget future expenditures with little risk of unforeseen increases in operational

costs.

Additionally, Southwest has also efficiently managed labor costs. While most of

Southwest’s employees are unionized, the airline maintains a strong relationship with the unions

and their employees. The result of that positive relationship is that the airline has never faced a

strike or lengthy disputes with the unions. This has allowed the airline and the unions to quickly

negotiate new contracts with its unions. While there have been disagreements in the past, the

strong working relationship between the airline and the unions has allowed the airline to run more

efficiently in comparison to other major carriers.

Furthermore, Southwest Airlines is one of the few airlines that offer a route structure that

is referred to as point-to-point. In this model, Southwest focuses their routes from city to city

rather than a hub-and-spoke model followed by most of the major airlines that centers their

operations on regional hubs that serve specific regions of the country. The benefit with

Southwest’s model is that they are able to better serve custom needs by focusing their routes on

high demand destinations rather than forcing customers to fly through and change planes at a hub

that can serve to lengthen travel time. From the customer’s perspective, this can be seen as more

convenient in comparison to major carriers.

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Along with this model, Southwest typically operates at secondary airports in the United

States. A clear example of this is Chicago’s Midway Airport. While nearly the same distance

from downtown Chicago as O’Hare Airport, Midway airport offers airlines significantly lower

gate and operating fees in comparison. Southwest can then utilize that savings for investment in

other areas of their operation.

Finally, Southwest Airlines operates only one type of aircraft, the Boeing 737. This allows

the airline to maintain lower costs for maintenance and training as they do not have a need to

service multiple types of aircraft. This would be in comparison to United Airlines which operates

nine types of aircraft from two manufacturers and American Airlines which operates eight types of

aircraft from three manufacturers. This allows Southwest to maintain a much lower parts

inventory as well as staff that are focused on maintaining a single type of aircraft.

Conclusion

As I have discussed, the options that American airlines have are limited in reference to

attempting to address the deteriorating financial condition that most face. Those two options

would be to lower their labor costs and hedge fuel costs for the future. By lowering the labor

costs, the airlines can trim one of their largest expenses further. However, there is a point where

the labor unions and employees will not accept any additional decreases. We are already seeing

this today where labor unions are simply striking, slowing down their work or calling in sick and

forcing the airline to take further action. Even with reductions in labor costs, there is a minimum

amount of labor that is needed for a flight to commence. There are minimum requirements on the

amount of flight attendants on a flight as well as the requirement to have a full flight crew.

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While there is also non-flight crew related labor such as customer service representatives

and baggage handlers, reductions in that labor expense can have a direct impact on customer

retention. By meaning, continued cut backs in customer service staff mean that customers will

have to wait longer to purchase a ticket or make any changes to an existing reservation. The

result of that is that customers would have the perception that the airlines are not providing

proper service and would then consider doing business with another airline. Secondly, in

reference to baggage handlers, any reduction in that labor cost would have a relative increase in

the amount of lost or delayed baggage or longer waits at the airport to retrieve luggage from an

arrived flight.

In both of these situations, there will likely be a reduction in customer retention where

customers will simply fly with another airline on their next trip. In a highly competitive industry

like the airlines, the risk of losing a customer to a competitor results in the need to increase other

expenses such as marketing or enhancements to existing reward programs to encourage high

volume customers to maintain their relationship with the airline. Thus, airlines need to examine

how those potential labor related costs reductions would be offset by other operational expenses

that would be related to maintaining the existing customers of the airline and attempting to grow

business where possible.

Thus, this leaves us with the only remaining option that airlines have to address their

increasing costs. That tactic is jet fuel hedging. As I have discussed above, the benefits to jet fuel

hedging are quite clear. While hedging is not designed to create a profit for the airline, it does

give them an avenue to effectively manage costs into the future rather than simply paying the spot

price for jet fuel on the open market. We can see this clearly in the discussion of Southwest

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Airlines. Southwest is able to accurately predict future jet fuel expenses which directly reduces

business risk.

However, this does not imply that airlines should simply start purchasing futures contracts

for jet fuel. The best option for airlines would be to enter into a collar that would at least provide

a specific and predictable range of prices. While the airline would not be able to predict the exact

price of the future delivery of fuel, they would at least have a set range of prices that would be

accurately predictable. Again, much better than simply purchasing jet fuel on the spot market

where the market is determining an airline’s fuel expenses.

However, regardless of the strategy, the national carriers need to implement a strategy that

balances continued operations with customer expectations. Clearly, the airlines have nearly

tapped the existing market on additional fees in an attempt shore up revenues. Additionally, given

the customer response to those fees, continued customer retention is starting to be a concerned as

the tolerance for more fees is near an end. Given this, the only remaining option for airlines is to

address their operating costs that they have the ability to reduce quickly. Without this effort, we

will see airlines continue to struggle.

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