Jan. 5, 2001, 12:48AM
Houston Chronicle
Contracts to ease blow of rise in fuel prices helping airlines 
Hedging your jets 
By LAURA GOLDBERG 
Copyright 2001 Houston Chronicle 
Faced with higher gasoline prices in the past year, consumers lamented the 
bite that rising oil prices were taking from their wallets. 
Other than driving less or buying cars that use less gas, there wasn't much 
they could do. 
Airlines, which consume billions of gallons of jet fuel a year, also felt the 
sting as prices fluctuated. 
But airlines, unlike drivers, can use financial tools to ease the pain of 
volatile fuel prices. 
As airlines begin rolling out their fourth-quarter earnings reports in the 
next few weeks, those that "hedged" on fuel are likely to show better profits 
than those that didn't. 
Not only was that the case last year, but it will continue to be the case if 
jet-fuel and oil prices remain high. 
Gary Kelly, chief financial officer at low-fare Southwest Airlines in Dallas, 
says hedging is "insurance against a catastrophic rise in fuel prices that 
would put us at unacceptable earnings levels." 
Hedges aren't agreements to buy fuel. They are financial contracts pegged to 
the prices of oil and oil products, such as heating oil and jet fuel. 
If airlines buy the contracts at the right prices, they can collect cash to 
compensate them when jet fuel goes up. 
Successful hedging didn't stop airlines from raising ticket prices last year 
to help cover rising fuel costs. But, airlines say, the increases might have 
been higher without hedging. 
When the industry's fuel bill for 2000 is tallied, it is expected to be $13 
billion -- 50 percent higher than the previous year's $8.5 billion, according 
to a recent report from airline stock analysts at Merrill Lynch. At the same 
time, the airlines used only 4 percent more fuel. 
If the industry hadn't hedged, fuel expenses would have been $2 billion to $3 
billion higher, the analysts wrote. AMR Corp., the parent of Fort Worth-based 
American Airlines, the No. 2 domestic carrier, is expected to save $550 
million alone because of its hedging, they noted. 
Airlines don't like wild spikes in fuel prices because they make it difficult 
to plan and they jeopardize profits. 
A consumer would face the same dilemma if one month's apartment rent was 
$600, the next it jumped to $1,200 and the next it fell to $800. 
That's similar to what airlines faced the past year as the benchmark price of 
jet fuel, which is made from crude oil, fluctuated widely on the spot market. 
It was above 88 cents a gallon in March, dipped below 66 cents in April, rose 
to almost $1.10 in September and was just over 78 cents the last week in 
December. 
Airlines hedge to help smooth out such ups and downs. 
Greg Hartford, vice president for fuel at Houston-based Continental Airlines, 
looks to hedging "to take volatility out of the market, not to second-guess 
it." 
There are a variety of hedging tools. Some, just like car or home insurance, 
require upfront premiums. 
Hedging can be done through futures exchanges, such as the New York 
Mercantile Exchange, or through institutions, including banks, investment 
houses and energy traders such as Houston-based Enron Corp. 
Hedging is about managing risk, said Bill Berkeland, manager of trading for 
Enron North America, an Enron Corp. subsidiary. Techniques to cope with fuel 
price risks have been around probably 20 years, he said, but airlines didn't 
adopt them until the last decade. 
Airline hedging has gained more attention recently because of jet-fuel price 
spikes, he said. Some carriers will be able to take victory laps for being 
smart enough to hedge, he added, while others will simply blame fuel prices 
for their earnings problems. 
Hedges are bought for specific amounts of product and time: 2 million barrels 
a month for the next three months, for example. They can be pegged to the 
prices of crude oil, heating oil or jet fuel. 
Continental generally sticks to three basic types of hedges -- swaps, caps 
and collars. Hartford outlined the way each works: 
? Swap: A swap is one of the simplest types. It essentially locks in the cost 
of energy at a specific price for a certain time. No upfront payments are 
required. 
For example, an airline takes out a swap for 1 million barrels of crude oil 
at $25 a barrel for February. If the price averages $28 during February, the 
airline is paid $3 million -- the difference between $28 and $25 a barrel for 
the million barrels. 
But if the cost averages $22 a barrel, the airline must pay $3 million. 
? Cap: With caps, airlines purchase "call options" that protect them when 
prices rise but don't penalize them if prices drop. Caps, however, require 
upfront premium costs, which are based on a variety of factors. 
For example, an airline buys a crude-oil cap at $25 a barrel for 1 million 
barrels for February. If at month's end, oil averaged $28 a barrel, the 
airline collects $3 million. 
If it averaged $22, the airline gains nothing but loses nothing. Its cost: 
the upfront price-per-gallon premium. 
? Collar: A collar is more complex. It involves buying two different tools 
that create a price range -- essentially a minimum and maximum. The airline 
benefits if fuel goes above the range's high end but pays if it goes below 
the minimum. It can be set up so no premium is paid. 
Intuitively, it would seem to make sense for airlines to hedge on jet fuel. 
But the market for trading jet fuel isn't as liquid, or as strong, as the one 
for crude oil. 
So airlines look for something that correlates to jet-fuel prices. Heating 
oil is often best, followed by crude oil. 
There are trade-offs. Premiums for jet-fuel hedges are more expensive than 
those for heating oil. In turn, heating-oil hedges are more expensive than 
crude. But using crude oil as a hedge may not smooth volatility as much 
because of fluctuations in the relationship between crude and jet fuel. 
In the first part of 1999, when crude oil traded for around $12 a barrel, 
Atlanta-based Delta Air Lines started buying hedging contracts pegged to 
heating oil as far as 36 months out, said Joe Kolshak, director of investor 
relations at the third-largest U.S. airline. 
Delta's strategy has served it well. For the quarter that ended Sept. 30, 
hedging, including premium costs, saved the Atlanta-based carrier from paying 
an extra $160 million in fuel costs, he said. Even with that gain, Delta 
still paid 37 percent more for fuel over the same period than the year 
before. 
For the Sept. 30 quarter and the four preceding it, Delta had net hedging 
gains of $600 million. 
Hedging gains also helped balance sheets at other airlines, including No. 5 
Continental and No. 7 Southwest. 
Southwest's Kelly said the airline's hedging last year met its goal of 
protecting against catastrophic fuel-price rises. In the third quarter, 
operating profits rose $43.1 million because of hedging. 
During the same quarter, Continental gained $27 million from hedging. For 
1999, it was $105 million. 
Hedging isn't without risk. Airlines can predict the wrong way and lose 
millions. And when prices are already sky-high, certain hedging contracts 
won't be attractive because they, too, are pegged to higher prices. 
"Hedging is not a panacea, and it's not the golden elixir that people might 
consider it to be," Continental's Hartford said.