Why Airlines Should Stop Hedging Fuel Costs

Modern airlines are really transportation system, and part financial trading firm. And sometimes they’re more of the latter than the former.

As Delta lost billions of dollars last year on commodities futures (‘fuel hedges’) I wrote that they’re as much a complex derivatives trading firm as an airline.

Their 2015 losses on these financial products totaled $2.3 billion. They continue to rack them up, announcing on Tuesday that they would take a $450 million loss. The airline’s cumulative hedging losses total $4 billion over the last 8 years. It didn’t help that Delta’s former Vice President of Fuel was front-running his own trades.

Delta’s financial gambling challenges, then, aren’t new. They lost nearly $1.5 billion on fuel hedges in 2009. And they kept at it.

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 expects a billion dollars in losses on fuel hedges this year.

United faced $100 million in losses for each $1 change in the price of oil early last year year. The airline lost over half a billion dollars in a single quarter in 2008 on its fuel hedges. And that’s after decrying the evils of oil speculation. The irony was completely lost on most observers.

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 on that the price of fuel is likely to rise rather than fall. And if you bet wrong, you’ve forgone profits.

The airlines have attempted to build capabilities here for many years without much success, so it may be time to learn some humility in the space.

US Airways management has stayed out of the hedging game and brought the same philosophy to American. Instead of ‘locking in the price of fuel’ they believe ticket prices and move in tandem with fuel prices so they don’t see the need. They’d be better off with a good hedge, of course, but avoid the bad ones.

That’s really the issue here: does any given airline have a strong commodities trading capability? Or do they just think that they do?

Air India and Thai were in the oil futures market in 2015, and it seems to me that when Thai Airways goes all-in on oil futures and Air India wants a seat at the trading table too that the smart money has already been made.

I’m not an expert commodities investor. My own guess is that the price of oil recovers when the Chinese economy does. But that’s just a guess, and why I invest primarily in low cost equity index funds. An airline could be expert at this. But there are real expert traders who do nothing else who get killed on this as often as they don’t.

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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  1. And who predicted $30/$40 oil two year’s ago when it was trading at $100 a barrel? IIRC the experts were forecasting $150 oil. So I guess you made a few million shorting oil futures with your prescience? Two years ago, airlines that didn’t hedge a portion of their fuel supply were dissed on Wall Street. Then came along the Saudis who were hell bent on destroying the shale oil boom going on in the US to ensure their hold on the largest consumer of oil in the world. That act decimated the fracking boom and oil sands high cost North American oil producers, but it has also crippled the economies of the Gulf oil producers like Saudi and the Emirates. Good hedge vs Bad hedge is the silliest thing I’ve read this morning. If there were such a thing, we’d all be rich! It’s the airline industry’s second biggest operating expense after salaries and the one item that will always be a cost that can never accurately be budgeted for unless it’s hedged.

  2. “Does any given airline have a strong commodities trading capability?”

    I think we’re missing the point. They’re hedging, not speculating. Hedge losses are expected and accepted because they’re intended to smooth out gains/losses due to swing in fuel prices, not provide an income stream. Hedging is great until it’s not – but that’s where people get caught… if you stop hedging when it’s working against you, you don’t get the benefit on the upswing. If they stop now and oil goes to $70… oops.

  3. Hedging for charter airlines is a necessity. They sell their seats/flights about a year in advance to touroperators and travel agencies. At that time they need to know the full cost of the seat to sell, so they hedge the charter flight fuel. The airline I work for does it this way. Then a percentage of fuel for the scheduled flights is hedged so you have sort of a base line price. The rest is up to the fuelprice at that time. If prices skyrocket you will get those dreaded fuel surcharges on tickets. The best way of saving cost in fuel is to tanker; fueling more at airports that have low fuel price than you need for the actual flight.

  4. No @Rob they’re not. While there’s a fine line between the two, airlines don’t seem to find themselves even in a grey area between the two.

  5. @DavidB – you’re missing the point. I don’t have prescience about the future prices of oil, and airlines have demonstrated over and over for years as oil has risen and fallen that they don’t either. It isn’t that I know more about where oil is going than the airlines do. Quite the opposite. My call is for humility and a recognition that they don’t know where it’s going.

  6. Boy, the crystal ball syndrome is strong this morning. Looking backwards is easy.

  7. I enjoy when travel bloggers are giving financial advice to multibillion companies. One day, giving restaurant recommendations. Next day, hedging advice.

  8. We did a case on this in business school with Southwest and their fuel hedging. It doesn’t really make sense for airlines to do this unless their main concern is marketing and keeping the perception of being a low cost carrier. If you have oil options at $51 but the market is pricing oil at $150 then you should just be selling that oil and making a profit… Not subsidizing your low margin airline business.

  9. @ Gary ….”My call is for humility and a recognition that they don’t know where it’s going.”

    They don’t know where it is going, which is exactly why they hedge. They are operating an airline and not trading energy, which is why they have hedges. A portion of their revenue is sold/booked in advance and tickets are priced partially based on the forward curve of fuel price at any given time, so they have to lock in part of that exposure.

    You mentioned DAL lost $2.3B this year on fuel hedges, but also failed to mention fuel expense decreased by ~$6B, so that’s $4B benefit net of losses on hedges.

    Had they not hedged and oil went the other way, you would probably write an article saying airlines should be smarted an hedge.

  10. @Another Dude – their track record suggests otherwise. And no, a $2.3b loss on hedges is not a $4b net benefit on hedges, it’s a $4b year-over-year benefit on fuel which is still more than a $2b loss relative to market/if they hadn’t hedged. But don’t look at just one year or one airline. Look at cumulative and repeat losses.

  11. Looks to me like the the $2.3B realized loss is accompanied by a $2.3B unrealized MTM adjustment, no?

    In one of your linked articles you say:

    “(1) Southwest’s earnings from operations number mentions that it includes fuel hedge gains on contracts that closed during the quarter. But if you include the upside of hedging, is it really fair to exclude fuel hedge investments that appear to be under water?”

    Does the opposite not apply? Not trying to be confrontational – just pointing out that a long-term hedging program will include both gains and losses. If they truly are speculating then I agree with you that it’s a problem. I just don’t see how we can prove that.

  12. @Eric V: Exactly right. Southwest thought they were geniuses using their fuel hedging gains to grow market share, but they could have done much better financially to price fares higher and just pocket the hedging gains. Southwest ended up at higher fares anyway, as soon as the hedging gains turned to losses.

  13. It seems Gary Leff has no idea why airlines are hedging in the first place and what is the objective of hedging which is surprising for a Chief Financial Officer of a university.

    Goes on to say about who manage Universities and why tuition and fees skyrockets everywhere in the USA…

  14. @Ced I understand what hedging is, calling what the airlines are doing ‘hedging’ at consistent multibillion dollar net losses is silly.

  15. I’m no expert here. Then again, the experts are often wrong. Just looking at the price of oil as being a product of supply as well as demand, hedging against a significant rise in oil prices seems risky. Low oil prices are a check on US oil production and limiting US market share is a goal of the Saudis. If prices rise, US production will ramp up. Iran is producing more, and Iraq may get its act together in the not too distant future. Russia and Venezuela are producing as much as possible. More oil means lower prices or at least no sharp increases. Simple, right? 🙂

  16. @ Gary…I didn’t say $4B net benefit on hedges…I said $4B benefit from lower fuel, net of losses on hedges. Hedging by definition is foregoing some upside to protect the downside.

    They could have had a $6B benefit on lower fuel, but chose to forego $2.3B of that in case fuel costs went up. Gains and losses in the current period or cumulatively are a fact of hedging. But it also means you have a offset somewhere else (ie you cost of fuel).

  17. It is not consistent losses since SWA made billions out of it. Get your facts right before calling other silly. You seem to have no understanding what a hedge is and why airlines are doing that. Whether it is profitable (great) or not (too bad) is not the question. Hedging is not made to make profit. Not understanding that is silly. Cannot believe I see that from a CFO.

  18. Most corporates hedge with forwards. When you buy something forward and the price decreases, you lose. Oil is low.

    We’ll be having a different discussion if/when oil increases. It’s only hedging if you do it when prices go in both directions.

  19. Just another “no it all” post. Feel free to ignore. Along the same lines as Gary’s posts on TSA. While TSA is a whipping boy and not perfect for sure, it’s easy to complain and cite USA today articles from the peanut gallery.

  20. The main benefit is predictability. The fact that sometimes they win and sometimes they lose is expected. But smoothing out the variability and better knowing your costs for a period of time is the win for the business. And having that sometimes costs money.

  21. You are missing the point of hedging as a risk management tool. They aren’t trying to time the market or make investment profits. They are trying to reduce business volatility, which inherently means reducing profits in “good times” so that the firm can continue to operate and grow in “bad times”.

  22. “@Ced I understand what hedging is, calling what the airlines are doing ‘hedging’ at consistent multibillion dollar net losses is silly.”

    No, no, no.

    Hedging is “spending some money to make sure you don’t get burned.”

    If they thing you’re hedging against doesn’t happen, you are guaranteed to “lose money.”

    Life insurance is a hedge against dying. Every year you don’t die, you’re “losing money”. But that doesn’t make life insurance a bad idea.

    Same is true for health insurance, and any year you don’t have a significant medical bill.

    In all the above cases, you’re buying “peace of mind”.

    Thank’s to Delta’s hedging operation, they paid $2.4 billion for fuel more than they other wise would have.

    So? How many tickets were they able to sell because they’d hedged the price of the fuel for those tickets? How much less would they have been burned if prices had gone the other way, because of those hedges?

    Your complaint makes as much sense as bashing Boeing for doing currency hedging when they get a big contract from a non-US buyer. The goal isn’t to “win”, the goal is to make sure that, if the market goes against you, you don’t get crushed

  23. The real problem with fuel hedging is that the cost is too high for the benefit received. Doug Parker figured this out many years ago and has saved his airlines several billion dollars. Anyone who follows oil prices knows they’re not predictable. You could be the world’s leading expert on oil fundamentals and still be wrong at least 50% of the time on oil price movements. (It has to do with “financialization,” which is a very interesting topic for those who are interested.) Because of this unpredictability, nobody wants to take the other side of a fuel hedge bet without extracting an enormous premium: it’s basically insurance that’s only available at a sky-high cost. So the net result is you lose a ton of money on your hedge when oil prices are stable, you lose billions when they drop, you lose a little money when they go up, and you only recoup your expenses when oil prices skyrocket. It’s a terrible bet. It is much better to simple “self insure” and try to raise your ticket prices if, in fact, “the worst happens.”

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