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.
Copyright vanbeets / 123RF Stock Photo
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.