Why American Airlines is Brilliant Not to Hedge Fuel

In this week’s “Tell Me Why” podcast for American Airlines employees, airline CFO Derek Kerr explains why they do not hedge fuel.

Kerr explains that fuel hedges don’t just pre-purchase fuel at a certain price. They also come at a cost for that insurance policy. He says fuel is running American 20% – 25% of their total costs. It’s the second largest expense after payroll.

Right now they’d have to hedge at $70 a barrel with a $10 cost to do so, so they wouldn’t be in the money on a hedge unless oil goes from $60 (or closer to $62) to $80 a barrel.

In contrast some modern airlines are really part transportation system, part financial trading firm. And sometimes they’re more of the latter than the former. As Kerr says they weren’t just insuring against major swings in one of their largest costs, they were betting on where they thought fuel prices would go (deciding what a ‘good price’ would be, that prices would only rise).

Three years ago I described Delta as being as much a complex derivatives firm as an airline. They’ve lost billions of dollars on commodities futures. US airline losses on these financial products totaled as much as $2.3 billion in a single year. Delta’s Vice President of Fuel was even caught front running his own trades and pocketing $3 million in his wife’s account.


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The airline industry is “notorious for bad trading decisions” and has “a reputation for being comically bereft of any trading savvy.”

Southwest long benefited from its fuel hedges, until they didn’t, and when they didn’t it was evil GAAP accounting’s fault. Southwest has lost up to a billion dollars on fuel hedges in a year.

When United lost over half a billion dollars in a single quarter on fuel hedges in 2008 they decried the evils of oil speculation with no irony whatsoever. And they continued their fuel hedging – badly.

I’ve written that the airlines should stay out of fuel hedging and many readers commented that I simply didn’t know as much as the airline executives losing hundreds of millions of dollars.

Since fuel is a huge part of the cost structure of an airline, and one that’s highly variable, one can make the case for locking in a price. But that’s another way of saying gambling that the price of fuel is likely to rise rather than fall. And if you bet wrong, you’ve forgone profits. In fact United and Delta no longer run the fuel hedging operations that they used to.

US Airways management has stayed out of the hedging game since 2008 and brought the same philosophy to American. Instead of ‘locking in the price of fuel’ they’ve separately said they believe ticket prices move in tandem with fuel prices so when fuel prices rise they’re best able to meet that expense. To be sure they’d be better off with a good hedge, but that begs the question. Not hedging avoids the bad hedges.

The relevant question is does any given airline have a strong commodities trading capability? Or do they just think that they do? There are real expert traders who do nothing else who get killed on this as often as they don’t.

American Airlines is brilliant not to hedge fuel because they don’t have a true capability in doing so. The question isn’t to hedge or not hedge. Many airlines have hedged fuel, done it badly, and lost billions of dollars because of it. If they aren’t going to build a world class capability they shouldn’t play in the space.

About Gary Leff

Gary Leff is one of the foremost experts in the field of miles, points, and frequent business travel - a topic he has covered since 2002. Co-founder of frequent flyer community InsideFlyer.com, emcee of the Freddie Awards, and named one of the "World's Top Travel Experts" by Conde' Nast Traveler (2010-Present) Gary has been a guest on most major news media, profiled in several top print publications, and published broadly on the topic of consumer loyalty. More About Gary »

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Comments

  1. The one airline that continues to hedge in good and bad times…sometimes with larger positions than others is Southwest. Take a look at their history and profitability. Even if there isn’t a perfect way to hedge, it’s smart to at least limit potential disaster. Fuel has to go up only a moderate % before AA and UAL don’t generate enough CF to cover fixed charges.

  2. I live in northern New England and heat my home with #2 home heating oil as most in this region do. Every September I am presented with a decision to hedge or not for the following heating season.

    I haven’t done it for the past 5 years and went with Market pricing and it worked out for me. This year, I would have saved 50¢ a gallon had I had a contract.

    Oh well, I can’t predict the future and neither can airlines.

  3. Agree that using derivatives to hedge a 15% price move is dumb, and nothing but speculation. But shouldn’t they still consider using way out of the money contracts to hedge against a massive move against them? I don’t know what the number is, but a 50%+ move would probably necessitate structural changes that ticket prices couldn’t make up for.

  4. You’d think that with given over-supply of oi(for myriad reasons)l that hedging is no longer necessary. Sure the price may bounce around but given the huge hedging premiums it no longer makes sense.
    Now a huge shock(invasion of Saudi Arabia etc…) to the system and all bets are off(or on in this case).
    Given AA’s savings on hedges maybe they can take a few seats out their 737Max:)

  5. Why would the VP of fuel for an airline based in Atlanta trade the same contract that Robert does? What was Delta supposedly hedging? Terminal A in Logan?

  6. A lot of CX’s issues stem from bad hedging choices.
    I don’t think FR hedge either and they make plenty of money

  7. If the airlines are having to mark to market, they are not hedging. It would be a hedge if they always held the contracts to maturity and took physical delivery. If they did so, there would be no derivatives losses, there would only be fuel expenses at whatever the cost they locked in. They also would not need to be trading geniuses. Hedging is not inherently bad or good, it is strictly risk transference, but the kind of speculation that the airlines engaged in is not hedging.
    American is also not entirely correct in suggesting that ticket prices could move with fuel prices. While this is true to a certain extent as some demand is inelastic, demand at the margin is quite elastic and would fall with increased ticket prices. Also, in the event of rising fuel prices, the hedged airline would have a competitive advantage over the one buying at spot, either being able to be more profitable at equal ticket prices or being able to undercut the spot airline.
    If I ran an airline, I would likely hedge at least some of my future fuel costs. While it will cost you small amounts over time, it will save you from large losses if the cost of your second largest expense doubles or triples in a short time, which potentially saves you from bankruptcy. Unfortunately, the compensation for airline executives encourages short term thinking over long term and the US corporate bankruptcy process further encourages risk taking and marginal thinking over long term viability.

  8. This is an okay explanation of hedging overall (mainly that Delta doesn’t have an unusual talent at anticipating oil prices), but Kerr is only really explaining the strategy of buying calls outright.

    The more common trading strategy (at least for oil producers) is using collars. For an airline, that would be buying protection against price increases (buying oil calls) by selling the benefit of price declines (selling puts). Could also use futures instead of derivatives. There’s still a cost of course – the loss of potential savings, but they;d have a much lower upfront premium (or no premium at all), so no real penalty if prices stay flat.

  9. @Evan of course they /should/ use collars if they really just wanted to hedge. But underlying it is the airline CEO’s dream of having their cake and eating it too.

    In any strategy, though, they would be tying up capital needed as collateral. I suspect, given how much capital airlines suck up as it is, that this is as much a consideration as the relatively expensive costs for the one-sided hedging they want to undertake.

  10. Hedging can lose money yes, but the company may prefer the cost certainty that hedging allows.

    And a $10 cost to hedge is high, they should be around $4. I am thinking where they hedge is the issue.

  11. Most successful (profitable) businesses are such because they do what they do best. Simple. If airlines wish to become so, I suggest they do flying and customer service well, and leave speculation, commodity trading, and financial corkscrews to others.

  12. Gary,

    There’s nothing inherently brilliant about not hedging fuel because hedging is neither good nor bad in and of itself. A consumer of commodities (e.g. an airline) or a producer of them can be successful whether or not they hedge.

    They key is that there should be an underlying business rationale for the hedges and the hedging program should be designed to match that rationale. For example, given that airlines don’t sell tickets more than a year in advance, one could argue that it’s hard to come up with a good business rationale for airlines to hedge more than a year in advance – if fuel prices rise in the interim, future tickets can likely be priced higher to account for the increased fuel cost (going by AA’s logic, with which I mostly agree).

    The other thing that’s important when it comes to hedging is to stay consistent – hedges are just that and not positions to be traded in and out of in the hopes of outsmarting the market. Wild changes or complete reversals in strategy should also be avoided.

    When these criteria are not met is when things tend to go badly. For example, many oil producers bought out their hedges, at great expense, near the peak of oil prices in 2008, when many of those hedges would have been significantly in the money only a short time later after oil crashed. Likewise, Barrick, the world’s largest gold producer, shifted overnight from hedging gold production up to 10 years out to going nearly unhedged (which cost billions). It benefitted for a short time, then gold prices crashed. At least one airline also spun up a huge fuel hedging program just before the 2008 peak in oil prices, having never hedged before.

    So yes, hedging is often badly executed, and not hedging may be better than hedging stupidly, but that doesn’t make not hedging brilliant.

    There are many different ways to implement a successful hedging program. Unlike what Andy 11235 said, purchasing calls is a perfectly legitimate type of hedging. So are collars and so are swaps as well as other structures. It depends on the business rationale and the risk tolerance of the business. Purchasing calls provides the most potential upside, but the price is the premium (upfront payment) paid to acquire the option. A collar simply involves selling another option that offsets (if it’s a costless collar) the premium paid for the call, but it caps the upside.

    @farnorthtrader, you’re incorrect about mark-to-market. A physically settled contract does not automatically qualify for hedge accounting (which eliminates mark-to-market swings from the income statement). On the flip side, financial hedges can qualify for hedge accounting. Hedge accounting is something made up by accountants and does not necessarily reflect whether a hedge is a good economic hedge. It is also a hassle from a reporting and audit perspective and many companies choose not to use hedge accounting for certain derivatives, even if they could, to avoid the hassle and expense.

  13. Airlines hedge for one reason and one reason only: to reduce earnings volatility which they have been conditioned to believe will please their investors. Since, as others have pointed out, they can’t (like most of the rest of us) reliably predict oil prices, whether any particular hedge works out or not is close to a random game. The only known is the cost of the hedges, which over time will, in exchange for reducing earnings volatility, reduce the airline’s total profits.

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