Southwest Airlines and Fuel Options

Reporters and analysts aren't gods. They have their own prejudices, motivations and short comings. Often they provide great insight. Other times they leave me wondering if they know what they're talking about.

This last fall a bunch of business articles popped up in the news about Southwest Airlines and fuel hedging. It was frustrating reading some of them. I had looked into options trading as a means of getting decent returns when the stock market. I felt the basics were, well, pretty basic. Yet I would see articles that were clearly written by people who didn't know the basics of the trade. How do you report on news as a journalist when you don't understand what you're reporting on. You don't need to be an expert but surely one needs to know some of the fundamental ways in which it works. Some of the articles were written in a way that had it been about a murder case it appeared the reporter didn't understand that there were defense lawyers, the prosecution and a judge and/or jury.

Unfortunately I didn't tag any of those nor can find a good example of them right now. You will know them when you read them because they imply that an option is a fixed-price. That is, if I buy an option for fuel at $100 for 2008, I will have to buy it at that price when it's due. The problem is that options for commodities do not work like that. One should know that just by looking at SWA's annual report. As it stated in 2006, "The financial derivative instruments utilized by the Company primarily are a combination of collars, purchased call options, fixed price swap agreements."

How does one write about the company without looking at their financial reports? And at that without coming across that? If you did you would see that there are different types of financial derivative instruments.

I would define the main types this way :

Call options - The right to buy but not the obligation to buy (hence the name OPTION).
Fixed Swap - An obligation to buy at a fixed price.
Collar - A means to make money if there are large fluctuations in price up or down.

They're more complex than that and there are more specific options. For example flex price swaps don't have fixed price. But the point of this is not to get into the details of options but to point out that Southwest has various choices when it comes to options.

Gambling?

Once you better understand that there are different types of options that help address different situations, you can better understand what Southwest Airlines is doing. The problem is that even articles where they don't seem to understand what it is SWA is trying to do. An example is this column from the USA Today :

Hedging is a gamble; a hedged airline could pay more for fuel if prices drop, but I think Southwest is safe as the possibility of oil prices dropping below $40 or $50 a barrel is highly unlikely.

Hedging is a gamble? No, it is not. Go to dictionary.com and look the word up for yourself. Hedging is not a gamble. It is something you do to reduce risk. Which would you say "I went to Las Vegas to hedge" or "I hedged my bet..."? A hedged airline will have higher fuel costs than other airlines at some points in time. However, as I just pointed out it's not 100%. Not all of their options are an obligation to buy. If prices drop sharply enough, they will simply not exercise their options. They will have the cost of the fixed price swaps. But if that's only 30% of their fuel needs, than the other 70% will be at market costs + the price of the options. When I say the price of the options I mean the price of purchasing the contract itself. The contract will specify the cost and the time but there is also a cost to that contract. But in such a case where the market would unexpectedly swing in one direction, in this case prices drop much lower than anticipated, SWA also has it's collars to help take the sting out of the situation.

Why would they use a financial instrument like a collar if they didn't think prices were going up very much or dropping very much? Because they don't approach their projections as absolutes. They know there are chances of them being wrong. They know about probabilities. They're using the collars as a way of insuring themselves in the event that they are very wrong either way.

Once you realize the different choices Southwest has and why they use things like collars, the light bulb should go off. They are in fact not hedging their fuel to make money off of the investments. They do it because they're hedging against the risk of fuel prices changing in ways that they don't foresee or aren't able to cope with. That is, it's an insurance policy. Just as we have insurance in case we cause a car accident or someone burglarized our home, Southwest uses this hedging as insurance for fuel prices.