Why fuel expenses have to be hedged?
Fuel cost, the largest cost component for airlines is subject to risks of volatility in crude oil prices. Southwest’s estimated fuel price per gallon for different levels of Brent crude prices are shown in the table below. The changes in fuel prices depends on market forces of demand and supply and cannot be controlled by companies. However most airline companies try to reduce the effect of fluctuating crude prices by hedging their fuel risks using derivatives instruments.
Volume of fuel hedges
Southwest had fuel derivative instruments in place to hedge the fluctuations in jet fuel prices for 33% of its fuel consumption in 2Q14 and as of June 2014, had derivatives to cover up to 35% of its estimated fuel consumption for 3Q14, 25% for the full year, 40% each for the next three years and 5% for 2018. As per the management, opportunities to hedge directly in jet fuel is limited since jet fuel is not widely traded on an organized futures exchange for time horizons longer than 24 months. Hence hedges are based on related commodities such as WTI crude, Brent crude, Gulf coast jet fuel and refined products such as heating oil and gasoline. These instruments are held purely for hedging purpose and the company recorded net gain of $19 million as part of the fuel hedging program in 2Q14 and $37 million for 1H14 compared to net loss of $99 million in 1H13.
Fuel price per gallon
Among its competitors, Delta (DAL) had the least fuel price per gallon of $2.93 and fuel expense per available seat mile (ASM) of $3.93 cents in 2Q14 followed by Southwest’s (LUV) fuel price per gallon of $3.02 and fuel expense per available seat mile (or ASM) of 4.16 cents. Apart from fuel hedging, Delta could lower its fuel prices through the investment in refinery operations. For more details on Delta’s fuel cost in 2Q14 refer the article: Must-know: Delta kept its fuel cost lower than its peers. Fuel price and expense per ASM are higher for its other peers including, American (AAL), United (UAL) and JetBlue (JBLU). For more details on fuel prices of these companies in 2Q14 refer the article: American Airlines reports higher fuel expense in 2Q14.