Fuel Hedging in Southwest Airlines

Fuel Hedging in the Airline Industry: The Case of Southwest Airlines
By Dave Carter a, Dan Rogers b, and Betty Simkins c

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College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-5104, Email: [email protected]
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School of Business Administration, Portland State University, Portland, OR 97207-0751, Phone: (503) 725-3790, Email: [email protected]
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CONTACT AUTHOR: College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011, Phone: (405) 744-8625, Fax: (405) 744-5180, Email: [email protected]

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Fuel Hedging in the Airline Industry: The Case of Southwest Airlines
By Dave Carter, Dan Rogers, and Betty Simkins

“If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and hedge this risk.”
Scott Topping, Director of Corporate Finance for Southwest Airlines

June 12, 2001: Scott Topping, the Director of Corporate Finance for Southwest Airlines (hereafter referred to as “Southwest”), was concerned about the cost of fuel for Southwest. High jet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew that since the industry was deregulated in 1978, airline profitability and survival depended on controlling costs.1 After labor, jet fuel is the second largest operating expense for airlines. If airlines can control the cost of fuel, they can more accurately estimate budgets and forecast earnings. It was Scott’s job to hedge fuel costs, however, he knows that jet fuel prices are largely unpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overall upward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. On September 11, 2000, the Gulf Coast jet fuel spot price was 101.25 cents/gallon – a whopping increase of 255 % in the spot price since the low in 1998. The prior day’s (June 11, 2001) spot price for Gulf Coast jet fuel closed at a price of 79.45 cents/gallon. While this price was lower than the highest level, Scott knew that future jet fuel prices would be uncertain. Figure 2 illustrates the high volatility of jet fuel prices. As shown, historical daily volatility over a recent 25-day period for Gulf Coast has averaged 58.7 percent.2 Clearly, fuel price risk is an important concern for airlines.
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One of the most important events in the history of the airline industry was the Deregulation Act passed by U.S. Congress in 1978. This act removed all government controls over fares and domestic routes for the first time and gave airlines the opportunity to operate as true businesses.

For example, at the price of 79.45 cents/gallon for jet fuel, there is a 68% probability that the price will change by as much as +/-46.63 cents/gallon (i.e. 79.45 x 0.587). This means that there is a 68 percent probability that the price will range from 32.8 to 126.0 cents/gallon. Using a recent 10-week average volatility of 30.5% (data not shown),

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As a result of fuel price increases during the later half of 1999 and throughout 2000, Southwest’s fuel and oil expense per available seat-mile (ASM) for the year 2000 increased 44.1 percent over that for 1999.3 As shown in Table 1, Southwest’s average price per gallon of jet fuel in 2000 was $0.7869 compared to $0.5271 in 1999.4 About Southwest Airlines Southwest was formed in 1971 by Rollin King and Herb Kelleher and the airline began with three Boeing 737 aircraft serving the Texas cities -- Dallas, Houston, and San Antonio. The airline began with one simple strategy: “If you get your passengers to their destinations when they want to get there, on time, at the lowest possible fares, and make darn sure they have a good time doing it, people will fly your airline.”5 This strategy has been the key to Southwest’s success. The airline realized early on that air travel would become a commodity business. In May 1988, Southwest became the first airline to win the coveted Triple Crown for a month – Best On-time Record, Best Baggage Handling, and Fewest Customer Complaints. Since then, the airline has won five annual Triple Crowns: 1992, 1993, 1994, 1995, and 1996. In addition to being a top quality airline, Southwest was also innovative. They were the first airline with a frequent flyer program to give credit for the number of trips taken and not the number of miles flown. Additionally, they pioneered senior discounts, same-day airfreight delivery service, ticketless travel, and many other unique programs. By the year 2000, the small Texas airline had evolved to become the 4th largest U.S. carrier based on domestic passengers boarded and the largest U.S. carrier based on scheduled domestic departures. At year-end 2000, Southwest operated 344 Boeing 737 aircraft and provided service to 58 airports in 57 cities in 29 states throughout the U.S. In 2000, Southwest commenced service to Albany and Buffalo, New York, and in January 2001, to West Palm Beach, Florida. Tables 2 and 3 provide Southwest Airlines’ consolidated statement of income and consolidated balance sheet, respectively, for the years 1999 and 2000. Historically, Southwest has experienced some seasonality in their business. For example, quarterly operating income and, to a lesser extent, revenues tend to be lower in the first quarter. In 2000, quarterly operating income represented 22 percent of annual operating income. Fuel Hedging in the Airline Industry

there is a 68% probability that the price will change by as much as 24.23 cents/gallon. Given that Southwest spent $484.7 million on jet fuel in the year 2000, there is a 68 % change that jet fuel can fluctuate by as much as $ 147.8 million using the 10 week volatility average (i.e. 0.303 x $484.7 million). 3 See the appendix for a glossary of airline terms. 4 These prices are net of the following gains from hedging -- approximately $113.5 million in 2000 and $14.8 million in 1999. 5 Refer to “We Weren’t Just Airborne Yesterday”, Southwest Airlines – A Brief History, http://www.southwest.com/.

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. Airlines executives know that it is often impossible to pass higher fuel prices on to passengers by raising ticket prices due to the highly competitive nature of the industry. Because large airlines compete with one another on most of the routes they serve, they have little power to raise prices in response to higher fuel costs. For example, Continental Airlines rescinded a fare hike after trying a number of times to boost overall fares. The airline said the airfare increases were due to high fuel costs, but intense airline competition has left the firm unable to pass along fuel costs to customers.6 Table 4 provides information on competition in the airline industry for both passenger airlines (Panel A) and airfreight carriers (Panel B). As shown in Panel A, Southwest Airlines holds a 5.51% market share based on total available seat miles flown over the period 1994-2000. Over the same period, Southwest holds a much smaller share of the freight market (see Panel B). By 2000, Southwest was the fourth largest carrier in the US based on passengers flown and the largest based on departures (see previous section). Obviously, competition is a top concern for Southwest. With air travel becoming a commodity business, being competitive on price is the key to survival and success. As Warren Buffett states: “You cannot be the high-cost producer in a commodity business. Sometimes it’s not even any good to be the low-cost producer.” (McCartney, Michaels, and Rogers, 2002). Airlines that want to prevent huge swings in operating expenses and bottom line profitability choose to hedge fuel prices. In fact, Raymond Neidl (see Neidl and Chiprich, 2001) points out that “the carriers that produced an adequate return, especially in the second half of 2000, tended to be those that had good fuel hedge positions in place.” Airlines without hedges in place had disappointing earnings or losses. For example, in the fourth quarter 2000, US Airways, which was unhedged, estimated that its $88 million net loss would have been a profit of $38 million if their fuel costs had not increased. Airlines are different from most commodity users or producers in that it usually the airline company’s treasury department (rather than the fuel purchasers) that handles fuel hedging. Fuel price risk management techniques were adopted by airlines around 1989 (Clubley, 1999). Airlines use derivative instruments based on crude oil, heating oil, or jet fuel to hedge their fuel cost risk. The majority of airlines rely on plain vanilla instruments to hedge their jet fuel costs, including swaps, futures, call options (including average price options which are a type of call option), and collars (including zero-cost collars). There are two main reasons why several fuels other than jet fuel are used in jet fuel hedging by airlines. The first reason requires a brief explanation of refining. When refiners process crude oil, the main products are gasoline, middle distillates (heating oil, diesel fuel, and jet kerosene) and residual fuel oil. Refiners often refer to these products as top, middle, or bottom of the barrel, respectively. Products from the same part of the barrel share similar characteristics, and as a result, the prices are highly correlated.7 Hence, heating oil, which shares similar

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See “Continental Raises Domestic Fares, Cites Fuel Costs” (Reuters, February 27, 2004) and “Continental Airlines Resends Latest Fare Hike” (Reuters, June 7, 2004). 7 Jet fuel is a essentially pure kerosene with some additives. Two products from the barrel not mentioned above are the gas liquids like butane at the very top and asphalt at the very bottom.

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. characteristics to jet fuel, is frequently used in hedging by airlines. Also, since jet fuel is refined from crude oil, crude oil is also used in hedging by airlines due to high price correlation. The second reason why airlines use several fuels in hedging is because jet fuel is not a sufficiently liquid market to warrant a futures contract or other type of exchanged-traded contract. As a result, derivative contracts for jet fuel must be arranged on the over-the-counter (OTC) markets. However, there are active and liquid markets for exchange-traded contracts on crude oil and heating oil in New York (the New York Mercantile Exchange, NYMEX) and for gasoil in London (the International Petroleum Exchange, IPE).8 While exchange-traded products offer high liquidity and low credit risk, typically these contracts are standardized and inflexible, meaning that users often face large basis risk. The term “basis risk” is used to describe the risk that the value of the commodity being hedged may not change in tandem with the value of the derivative contract used to hedge the price risk. While crude oil, heating oil, and jet fuel prices are highly correlated, significant basis risk can emerge if the relationship between the commodities breaks down. In an ideal hedge, the hedge would match the underlying position in every respect, removing any change of basis risk. However, in actuality, basis risk is a high concern, even if the derivatives contract is for the exact same commodity being hedge. More specifically, in the futures markets, basis is defined as the differential between the cash price of a given commodity and the price of the nearest futures contract for the same, or a related commodity.9 Hence, basis risk when hedging using futures contracts refers to the risk of the differential changing over the life of the hedge. Why does basis risk occur? The following three basis risks occur frequently in hedging: product basis risk, time basis risk, and locational basis risk. Product basis risk occurs when there is a mismatch in the quality, consistency, weight, or underlying product. For example, airlines frequently use crude oil contacts to hedge jet fuel, but obviously crude oil and jet fuel are two different commodities and hence have large product basis risk. Even within the same commodity category, such as crude oil, product basis risk occurs because there are many types of crude oil varying in viscosity (such as heavy versus light crude) and sulfur content (sweet versus sour crude). Time basis risk occurs when there is a mismatch in the time of the hedge. For example, if a hedger wishes to hedge long-term but only has short dated contracts available, time basis risk is very significant.10 Locational basis risk, one of the most common types of basis risk,
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Gas oil is the European designation for No. 2 heating oil and diesel fuel. Refer to “A Guide to Energy Hedging” published by the New York Mercantile Exchange. 10 For one of the most famous examples of time basis risk, refer to Metallgesellschaft Refining and Marketing (MGRM), which was an American subsidiary of Metallgesellschaft (MG), an international trading, engineering, and chemicals conglomerate. In 1992, MGRM implemented what it believed to be a profitable marketing strategy. The company agreed to sell specified amounts of petroleum products every month, for up to ten years, at fixed prices that were higher than the current market price. MGRM then purchased short-term energy futures to hedge the long-term commitments - a "stack" hedging strategy. This timing mismatch caused MGRM to go bankrupt. The MGRM hedge also illustrates another type of hedging risk: "funding risk" - the risk that positions which may be profitable in the long run can bankrupt a company in the short run if negative cash flows are mismatched with positive cash flows. For a short summary of the MGRM hedging disaster, refer to http://www.erisk.com/Learning/CaseStudies/ref_case_mg.asp.

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. occurs when there is a mismatch in the price of the product from one location to another, a mismatch in the delivery point for the derivatives contract, among others. While such extreme breakdowns in correlations are rare, hedgers should be aware of basis risk. Julian Barrowcliffe, director of global commodity swaps at Merrill Lynch (Schap, 1993) stated: “Some of the largest hedging losses have resulted from the assumption that heating oil and jet kerosene were essentially the same product and heating oil futures could hedge jet. At times, they haven’t tracked each other at all.” For example, in late 1990 when Iraq invaded Kuwait (which precipitated the first Gulf War), the differential between European jet fuel and heating oil quickly increased to more than five times the usual margin. As shown in Figure 3, the spread between jet fuel and heating oil for the Gulf Coast location increased to 28.5 cents per gallon. This is 8.1 times the average spread of 3.5 cents per gallon and represents a 714% increase relative to the average spread (i.e. (28.5 – 3.5)/ 3.5). It is important to note that since this period of time, basis risk fundamentals between jet fuel and heating oil or crude oil have improved. This is due primarily to the fact that there is significantly more storage of jet fuel in the Middle East now, which places less price pressure on jet fuel in periods of higher demand due to military conflict. Frequently Used Fuel Hedging Instruments by Airlines This section describes the most commonly used hedging contracts by airlines: swap contracts (including plain vanilla, differential, and basis swaps), call options (including caps), collars (including zero-cost and premium collars), futures contracts and forwards contracts. Plain Vanilla Swap The plain vanilla energy swap (called this because it is simple and basic when compared to more exotic swap contracts) is an agreement whereby a floating price is exchanged for a fixed price over a certain period of time. It is an off-balance-sheet financial arrangement, which involves no transfer of the physical item. Both parties settle their contractual obligations by means of a transfer of cash. In a fuel swap, the swap contract specifies the volume of fuel, the duration (i.e., the maturity of the swap), and the fixed and floating prices for fuel. The differences between fixed and floating prices are settled in cash for specific periods (usually monthly, but sometimes quarterly, semi-annually, or annually). Figure 4 illustrates fuel hedging using two types of swap contracts. Example 1 in the figure describes how a plain vanilla jet fuel swap arranged in the OTC market is used. Example 2 illustrates fuel hedging on the organized exchanges using a highly liquid contract -- the NYMEX New York Heating Oil Calendar Swap contract. In all swap contracts, the airline is usually the fixed-price payer, thus allowing the airline to hedge fuel price risk. For more information on these contracts, refer to the NYMEX website at http://www.NYMEX.com. Differential Swaps and Basis Risk

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. While a plain vanilla swap is based on the difference between the fixed and floating prices for the same commodity, a differential swap is based on the difference between a fixed differential for two different commodities and their actual differential over time. Differential swaps can be used by companies to manage the basis risk from other hedging activities. For instance, assume an airline prefers to hedge its jet fuel exposure using a heating oil plain vanilla swap. The airline can used an additional swap contract, the differential swap for jet fuel versus heating oil, to hedge basis risk assumed from the heating oil swap. The net result is that the airline can eliminate the risk that jet fuel prices will increase more than heating oil prices. Basis risk can be an important concern for cross-hedges of this type. For more information on differential swaps, refer to Chapter 1 of Falloon and Turner (1999). Call Options (Caps) A call option is the right to buy a particular asset at a predetermined fixed price (the strike) at a time up until the maturity date. OTC options in the oil industry are usually cash settled while exchange-traded oil options on the NYMEX are exercised into futures contracts. OTC option settlement is normally based on the average price for a period, commonly a calendar month. Airlines like settlement against average prices because an airline usually refuels its aircraft several times a day. Since the airline is effectively paying an average price over the month, they typically prefer to settle hedges against an average price (called average price options). In the energy industry, options are often used to hedge cross-market risks, especially when market liquidity is a concern. For example, an airline might buy an option on heating oil as a cross-market hedge against a rise in the price of jet fuel. Of course, cross-market hedges should only be used if the prices are highly correlated. Airlines such as Southwest value the flexibility that energy options provide, but energy options can be seen as expensive relative to other options. The reason is the high volatility of energy commodities, which causes the option to have a higher premium. For this reason, zero-cost collars (discussed next) are often used. Figure 5 provides a conceptual illustration for hedging gains or losses using swaps, call options, and premium collars when locking into a 60-cent/gallon price of jet fuel. Collars, Including Zero-Cost and Premium Collars A collar is a combination of a put option and a call option. For a hedger planning to purchase a commodity, a collar is created by selling a put option with a strike price below the current commodity price and purchasing a call option with a strike price above the current commodity price. The purchase of a call option provides protection during the life of the option against upward commodity price movements above the call strike price. The premium received from selling the put option helps offset the cost of the call option. By establishing a collar strategy, a minimum and maximum commodity price is created around a hedger’s position until the expiration of the options. Figure 6 provides an example of the net cost of jet fuel in $/gallon using a collar where a call option is purchased with a $0.80 strike price and a put option is sold with $0.60 strike price. As shown, the airline will never pay more than $0.80 for jet fuel no matter how high prices rise, yet will never pay less than $0.60 regardless of how low jet fuel

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. prices drop. A collar can be structured so that the premium received from the sale of the put option completely offsets the purchase price of the call option. This type of collar is called a “zero cost collar.” If more protection against upward price movements is desired (i.e., having a lower call option strike price) or more benefit from declining prices is desired (i.e., selling a put with a lower strike price), a premium collar is used. With a premium collar, the cost of the call option is only partially offset by the premium received from selling a put option. Refer to Figure 5 for a conceptual illustration of the premium collar strategy. Using a zero-cost collar or premium collar may appear to be a reasonable hedging strategy for an airline since it involves no upfront cost (or low upfront cost) and involves no speculative return. However, if jet fuel prices fall significantly, as illustrated in Figure 6, the airline may pay more for jet fuel than its competitors who did not employ the collar strategy. Competitors may lower their airfares aggressively as a result. Accordingly, the zero-cost collar should be more accurately called a “zero-upfront cost” collar. Futures and Forward Contracts A futures contract is an agreement to buy or sell a specified quantity and quality of a commodity for a certain price at a designated time in the future. The buyer has a long position, which means he/she agrees to make delivery of the commodity (i.e., purchase the commodity). The seller has a short position, which means he/she agrees to make delivery of the commodity (i.e., sell the commodity). Futures contracts are traded on an exchange, which specifies standard terms for the contracts (e.g., quantity, quality, delivery, etc.) and guarantees their performance (removing counterparty risk). Only a small percentage of futures contracts traded result in delivery of the commodity (less than one percent in the case of energy contract). Instead, buyers and sellers of futures contracts generally offset their position. A forward contract is the same as a futures contract except for two important distinctions: (1) Futures contracts are standardized and traded on organized exchanges, whereas forward contracts are typically customized and not traded on an exchange; and (2) Futures contracts are marked to market daily, whereas forward contracts are settled at maturity only. For the futures contract, this means that each day during the life of the contract, there is a daily cash settlement depending on the current value of the commodity being hedged. The NYMEX exchange trades futures on crude oil, heating oil, and gasoline (among other commodities). Table 5 illustrates how a fuel hedger can use the NYMEX heating oil futures contract to hedge jet fuel price risk. As shown, the hedger purchases a futures contract at 66.28 cents per gallon (futures contract size is 42,000 gallons) in January. On the same day, the New York jet fuel spot price is 80.28 cents per gallon. If the hedger closes out this futures contract for 42,000 gallons on August 29, 2000 at 98.59 cents per gallon, he/she has made a profit of 32.31 cents per gallon (98.59 minus 66.28). The spot price of NY jet fuel on August 29th is 103.6 cents per gallon. (Note: If the hedger had not hedged, he would have paid 23.32 cents/gallon more for the fuel.) However, by using the futures contract and purchasing jet fuel in the spot market, the gain of 32.31 on the futures more than offsets the 23.32 increase in jet fuel prices. In essence, the

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. hedger’s net cost of jet fuel is 71.29 cents per gallon (i.e., 103.6 spot price in August minus the futures hedging gain of 32.31 cents/gallon). Accounting for Derivatives According to SFAS 133 The Financial Accounting Standards Board (FASB) issued Statement 133 to make a company’s exposure to its derivative positions more transparent. Prior to SFAS 133, most derivatives were carried off-balance sheet and reported only in footnotes to the financial statements. Under SFAS 133, depending on the reason for holding the derivative position and the derivative’s effectiveness in hedging, changes in the derivatives’ fair value is recorded either in the income statement or in a component of equity known as other comprehensive income. Table 6 summarizes the balance sheet and income statement impacts of cash flow hedges, fair value hedges, and speculative transactions under SFAS 133. Under SFAS 133, managers such as Scott Topping that want their hedge to receive hedge accounting treatment, must be certain their hedge will pass the effectiveness measure. To qualify, the manager must measure the effectiveness of the hedge at least each reporting period for the entire duration of the hedge. Any ineffective portion or excluded portion of the change in derivative value must be reported directly to earnings. According to the FASB, hedge effectiveness should take into account both historical performance (retrospective test) and anticipated future performance (prospective test). The FASB has provided only broad guidelines for testing hedge effectiveness. The FASB has two suggested approaches to measure historical performance: the “80-125 rule” and the correlation method. According to the “80-125 rule” (also referred to as the dollar-value-offset method), a hedge is deemed effective if the ratio of the change in value of the derivative to the change in value of the hedged item falls between 80 % and 125%. Shown in equation form: Effectiveness measure = Σni=2(∆PH)i ⁄ Σ ni=2(∆PD)i Where: (∆PH)i = (PH)i - (PH)i-1 (∆PD)i = (PD)i - (PD)i-1 PH = the daily price of the hedged item PD = the daily price of the derivative i = trading day i n = total number of trading days in the period

According to the correlation measure, a hedge is deemed effective if the correlation between the changes in the value of the hedged item and the derivative is high. In other words, a hedge should be considered effective if the R-squared of the regression of this relation is around 80 percent. Furthermore, the slope of the regression line should be close to 1.0 (but this is not explicitly referred to in SFAS 133). For more information on measuring hedge effectiveness, refer to Kalotay and Abreo (2001), Risk Books (1999), and Energy Information Administration (2002), among others.

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. June 12, 2001 Senior management asked Scott to propose Southwest’s hedging strategy for the next one to three years. Because of the current high price of jet fuel, Scott was unsure of the best hedging strategy to employ. Table 7 provides Southwest’s hedging practices at year-end 2000 as discussed in their annual report. Because Southwest adopted SFAS 133 in 2001, Scott needed to consider this in his hedging strategy. Southwest’s average fuel cost per gallon in 2000 was $0.7869, which was the highest annual average fuel cost per gallon experienced by the company since 1984. As discussed previously, fuel and oil expense per ASM increased 44.1 percent in 2000, primarily due to the 49.3 percent increase in the average jet fuel cost per gallon. (Refer to Table 1: The average price per gallon of jet fuel in 2000 was $0.7869 compared to $0.5271 in 1999.) Although Scott thought the price of jet fuel would decrease over the next year, he cannot be sure – energy prices are notoriously hard to predict. Scott knew that: “Predicting is very difficult, especially as it concerns the future” (Chinese Proverb). Any political instability in the Middle East could cause energy prices to rise dramatically without much warning. If the cost of jet fuel continued to rise, the cost of fuel for Southwest would rise accordingly without hedging. On the other hand, if the cost of jet fuel declines, the cost of fuel would drop if Southwest were unhedged. To deal with these risks, Scott identified the following 5 alternatives. Scott estimated Southwest’s jet fuel usage to be approximately 1,100 million gallons for next year. 1. 2. 3. 4. 5. Do nothing. Hedge using a plain vanilla jet fuel or heating oil swap. Hedging using options. Hedge using a zero-cost collar strategy. Hedge using a crude oil or heating oil futures contract.

Appendix 2 contains information on NYMEX futures contracts and futures options contracts, both for crude oil and heating oil. For alternative 2 above (i.e. hedging using a plain vanilla crude oil or heating oil swap), there were two different possibilities: 11 (1) Enron offered Scott an over-the-counter plain vanilla jet fuel swap with a 1-year maturity. The offer stipulated a fixed rate for Southwest Airlines of 76 cents/gallon. The variable rate was based on the monthly average price for Gulf Coast jet fuel. Contract payments would be made monthly during the life of the contract. The size of the swap contract was one million gallons and for simplicity, assume that Enron was willing to
For the swap contract, use 1/12th of the hedge volume since the contracts are settled monthly over the one-year period. In other words, for the 100% hedging, use swap contracts for a total of 1,100 million gallons divided by 12 = 91.67 swap contracts (or round to 92 contracts).
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Review copy for use of the Case Research Journal. Not for reproduction or distribution. enter into as many of these swap contracts as Southwest Airlines wanted. This swap was similar to that explained in Example 1 of Figure 4. (2) Scott also considered a NYMEX New York Heating Oil Calendar Swap (1-year duration). The contract size was 42,000 gallons. The contract guaranteed a fixed rate for Southwest Airlines of 73 cents/gallon for heating oil. The variable rate was based (per NYMEX regulations) on the arithmetic average of the NYMEX New York Harbor heating oil futures nearby month settle price for each business day during the month. Contract payments would be made monthly during the life of the contract. This is similar to Figure 4 (see Example 2). Appendix 3 (see the first figure) contains information on the relation between jet fuel costs and airline stock prices (11 major airlines). Note the negative correlation between the two lines. Appendix 4 illustrates monthly load factors for U.S. domestic flights. As shown, demand varies significantly by month and demand is highest in the summer months. The Excel file (Jet Fuel Hedging Case Excel Data for Students.xls) contains historical prices for jet fuel (spot), heating oil (spot and futures), and crude oil (spot and futures).

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. Case Questions 1. 2. 3. Why do firms like Southwest hedge? What are the benefits of hedging? (Suggestion: refer to Carter, Rogers, and Simkins (2004) for assistance in answering this question.) Does heating oil or crude oil more closely follow the price of jet fuel? To answer this question, use the information in the Excel spreadsheet. (a) Evaluate each of the five proposed hedging strategies. What are the benefits of each hedge based on two fuel price scenarios in one year? In other words, assume in June 2002 that one of these scenarios occurs. Calculate your net cost of jet fuel under each scenario incorporating the hedging strategies used. (Note: you can analyze the hedges under as many price scenarios as you wish, but be certain to include the following two scenarios.) For both scenarios, consider full hedging and a 50% hedge strategy. SCENARIO 1: 39.3 cents/gallon spot price for jet fuel; 38.8 cents/gallon spot price for heating oil, or $14.10 per barrel spot price for crude oil, and SCENARIO 2: 119.6 cents/gallon spot price for jet fuel; 118.6 cents/gallon spot price for heating oil, and $40,00 per barrel spot price for crude oil. (b) Discuss the pros and cons of each hedging strategy. (c) Describe how a combination of the hedging strategies can be used. 4. What are the risks of being unhedged? Totally hedged? (Note: the February 24, 2004 Wall Street Journal article titled “Outside Audit: Jet-Fuel Bets Are Risky Business” by Melanie Trottman may be useful.) (a) What is basis risk and how is it different from price risk? (b) What are the implications of a changing basis? (c) Does basis risk exist for Southwest Airlines in their fuel hedging program? (a) What is FAS 133 and how does it impact a firm’s hedging strategy? (b) Using the effectiveness measure on page 6, calculate the effectiveness of hedges using heating oil futures and crude oil futures for the period 2000-2001 (up until the time of the case). How does the effectiveness measure impact a firm’s hedging decision. Describe how a market in backwardation or contango (i.e. shape of the forward curve) might impact hedging strategies. Are current crude oil markets in backwardation or contango? (Note: Backwardation is the market situation when futures prices are progressively lower in the distant delivery months when compared to the nearest (prompt) month. Contango, the opposite of backwardation, is a market situation in which prices in later delivery months are progressively higher than in the nearest delivery (prompt) month.) What do you recommend to Scott Topping? Why?

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. References Clubley, Sally, 1999, “An Early Take Off”, Risk (May), (see pg. 7 of Commodity Risk Special Report in the issue). Carter, David A., Dan Rogers, and Betty J. Simkins, 2004, “Does Fuel Hedging Make Economic Sense? The Case of the U.S. Airline Industry”, Oklahoma State University working paper. Energy Information Administration, 2002, Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries (October), U.S. Department of Energy. Falloon, William and David Turner, editors, 1999, Managing Energy Price Risk, Risk Publications (London). Kalotay, Andrew and Leslie Abreo, 2001, “Testing Hedge Effectiveness for FAS 133: The Volatility Reduction Measure”, Journal of Applied Corporate Finance Vol. 13 (No. 4), 93-99. McCartney, Scott, Daniel Michaels, and David Rogers, 2002, “Airlines Seek More Government Aid”, The Wall Street Journal, September 23, 2002, (pages A1, A10). Neidl, Raymond E. and Erik C. Chiprich, 2001, Major U.S. Carriers 2000 Results and 2001 Outlook, Global Research, Ing-Barings. Reuters, 2004, “Soaring Jet Fuel Prices Threaten Airlines’ Bottom Lines”, March 10. Schap, Keith, 1993, “Jet Fuel Swaps Ground Risk”, Futures (February), 44-46. Trottman, Melanie, 2004, “Outside Audit: Jet-Fuel Bets Are Risky Business”, Wall Street Journal, February 24, page C3.

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Table 1 Fuel Usage and Hedging Data for Southwest Airlines
Hedging variables Exposure variables Fiscal year ends 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec 31-Dec Fuel Hedge Used Fuel? (Million Fuel Cost Year Gallons) ($million) $ 2000 Yes 1022.2 804.4 $ 1999 Yes 939.1 495.0 $ 1998 Yes 850.3 388.3 $ 1997 Yes 792.4 495.0 $ 1996 Yes 740.3 484.7 $ 1995 Yes 662.2 365.7 $ 1994 Yes 592.6 319.6 Cost of Fuel ($ per gallon) $ 0.7869 $ 0.5271 $ 0.4567 $ 0.6246 $ 0.6547 $ 0.5522 $ 0.5392 Available Seat Miles (ASM) (millions) 59,910 52,855 47,544 44,487 40,727 36,180 32,124 $ $ $ $ $ $ $ Total Total Fuel as a Revenue Fuel Cost Expenses % of (% of ($ ($ Millions) Expenses Millions) Revenue) $ 4,628 $ 3,954 $ 3,480 $ 3,293 $ 3,055 $ 2,559 $ 2,275 10.5% 12.5% 11.2% 15.0% 15.9% 14.3% 14.0% $ 5,649 $ 4,736 $ 4,164 $ 3,817 $ 3,406 $ 2,873 $ 2,592 8.6% 10.5% 9.3% 13.0% 14.2% 12.7% 12.3% Longest % of Maturity Gallons Next of Hedged Year Hedges (millions) Hedged (yrs) N/A 126.10 290.00 not material not material 1.05 2.10 80.00% 86.00% 33.00% not material not material 2.00% 5.00% 3.00 >1 0.50 N/A N/A <1 <1

Cost/ ASM 0.0081 0.0094 0.0082 0.0111 0.0119 0.0101 0.0099

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Table 2 SOUTHWEST AIRLINES CO. CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts) OPERATING REVENUES: Passenger Freight Other Total operating revenues OPERATING EXPENSES: Salaries, wages, and benefits (Note 10) Fuel and oil Maintenance materials and repairs Agency commissions Aircraft rentals Landing fees and other rentals Depreciation (Note 2) Other operating expenses Total operating expenses OPERATING INCOME OTHER EXPENSES (INCOME): Interest expense Capitalized interest Interest income Other (gains) losses, net Total other expenses (income) INCOME BEFORE TAXES AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE PROVISION FOR INCOME TAXES (NOTE 11) INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, NET OF INCOME TAXES (NOTE 2) NET INCOME NET INCOME PER SHARE, BASIC BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE NET INCOME PER SHARE, BASIC YEARS ENDED DECEMBER 31, 2000 1999 1998 ------------------------------$ 5,467,965 110,742 70,853 ----------5,649,560 1,683,689 804,426 378,470 159,309 196,328 265,106 281,276 859,811 ----------4,628,415 ----------1,021,145 69,889 (27,551) (40,072) 1,515 ----------3,781 ----------1,017,364 392,140 ----------625,224 (22,131) ----------$ 603,093 =========== $ 1.25 $ 4,562,616 102,990 69,981 ----------4,735,587 1,455,237 492,415 367,606 156,419 199,740 242,002 248,660 791,932 ----------3,954,011 ----------781,576 54,145 (31,262) (25,200) 10,282 ----------7,965 ----------773,611 299,233 ----------474,378 -----------$ 474,378 =========== $ .94 $ 4,010,029 98,500 55,451 ----------4,163,980 1,285,942 388,348 302,431 157,766 202,160 214,907 225,212 703,603 ----------3,480,369 ----------683,611 56,276 (25,588) (31,083) (21,106) ----------(21,501) ----------705,112 271,681 ----------433,431 -----------$ 433,431 =========== $ .87

(.04) ----------$ 1.21 ===========

-----------$ .94 ===========

-----------$ .87 ===========

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Table 3

SOUTHWEST AIRLINES CO. CONSOLIDATED BALANCE SHEETS (In thousands, except per share amounts) DECEMBER 31, 2000 1999 ----------------------ASSETS Current assets: Cash and cash equivalents $ 522,995 $ 418,819 Accounts and other receivables (Note 7) 138,070 75,038 Inventories of parts and supplies, at cost 80,564 65,152 Deferred income taxes (Note 11) 28,005 20,929 Prepaid expenses and other current assets 61,902 52,657 --------------------Total current assets 831,536 632,595 Property and equipment, at cost (Notes 3, 5, and 6): Flight equipment Ground property and equipment Deposits on flight equipment purchase contracts Less allowance for depreciation Other assets 6,831,913 800,718 335,164 ----------7,967,795 2,148,070 ----------5,819,725 18,311 ----------$ 6,669,572 =========== 5,768,506 742,230 338,229 ----------6,848,965 1,840,799 ----------5,008,166 12,942 ----------$ 5,653,703 ===========

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable Accrued liabilities (Note 4) Air traffic liability Current maturities of long-term debt (Note 5) Total current liabilities Long-term debt less current maturities (Note 5) Deferred income taxes (Note 11) Deferred gains from sale and leaseback of aircraft Other deferred liabilities Stockholders' equity (Notes 8 and 9): Common stock, $1.00 par value: 1,300,000 shares authorized; 507,897 and 505,005 shares issued in 2000 and 1999, respectively Capital in excess of par value Retained earnings Treasury stock, at cost: 3,735 and 5,579 shares in 2000 and 1999, respectively Total stockholders' equity

$

312,716 499,874 377,061 108,752 ----------1,298,403 760,992 852,865 207,522 98,470

$

266,735 430,506 256,942 7,873 ----------962,056 871,717 692,342 222,700 69,100

507,897 103,780 2,902,007 (62,364) ----------3,451,320 ----------$ 6,669,572

505,005 35,436 2,385,854 (90,507) ----------2,835,788 ----------$ 5,653,703

===========

===========

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Table 4 Market Share of US Airlines
This table presents the market share of passenger-only or combined passenger and cargo carriers (designated as passenger airlines) in Panel A and cargo-only carriers (designated as airfreight carriers) in Panel B. Major airlines are defined as airlines with annual revenues of more than $1 billion, and regional airlines are those carriers with annual revenues less than $1 billion. ASM stands for available seat miles and represents one seat flown one mile. Average revenues are calculated as the average over 1994-2000 and market share in Panel A is calculated as the percentage of total ASM for the period 1994-2000. Panel A: Market Share of Passenger Carriers Based on Available Seat Miles. Average Total Available Revenue Seat Miles Airline ($ Millions) (1994-2000) Major Airlines 16,796 United Airlines 1,168,894.0 16,913 American Airlines 1,126,177.0 13,528 Delta Air Lines 966,188.0 9,750 Northwest Airlines 657,477.6 7,356 Continental Airlines 498,731.0 8,240 US Airways Group 418,607.0 3,891 Southwest Airlines 313,827.9 1,879 America West Holdings 160,005.0 1,746 Alaska Air Group 119,565.0 Regional Airlines Amtran Hawaiian Airlines Airtran Holdings Midwest Express Holdings Mesa Air Group Comair Holdings Frontier Airlines SkyWest Mesaba Holdings Midway Airlines Atlantic Coast Airlines Total

Market Share Based on ASM 20.52% 19.77% 16.96% 11.54% 8.75% 7.35% 5.51% 2.81% 2.10%

880 423 360 347 452 517 151 291 235 200 253

94,232.6 38,455.1 27,787.1 17,603.5 16,966.4 15,113.9 14,992.8 12,147.6 12,054.7 9,775.3 8,642.7 5,697,244.20

1.65% 0.67% 0.49% 0.31% 0.30% 0.27% 0.26% 0.21% 0.21% 0.17% 0.15% 100.00%

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Review copy for use of the Case Research Journal. Not for reproduction or distribution. Table 4. Continued
Panel B: Market Share of Cargo Carriers based on Freight Ton-miles (in Millions) Freight Ton-miles Market Share Based (in Millions) on Freight Ton-miles 7,401.9 FedEx 31.71% 4,339.1 United Parcel Service 18.59% 2,529.9 United Airlines 10.84% 2,205.1 Northwest Airlines 9.45% 1,916.7 American Airlines 8.21% 1,435.0 Delta Airlines 6.15% 1,048.3 Atlas Air 4.49% 995.1 Continental Airlines 4.26% 887.0 Airborne Express 3.80% 277.7 US Airways 1.19% 129.6 TransWorld Airlines 0.56% 69.1 Southwest Airlines 0.30% 57.4 Alaska Air 0.25% 53.7 Hawaiian Airlines 0.23% 23,345.60 Total 100.00% Note: FedEx, United Parcel Service, Atlas Air, and Airborne Express are cargo-only carriers. The other firms listed are primarily passenger airlines. Airfreight Carrier

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Table 5 Example of a Jet Fuel Cross-hedge Using the NYMEX Heating Oil Futures Contract On January 6, 2000, a fuel purchasing director wants to hedge his September jet fuel consumption at current prices. He buys a September New York Harbor heating oil futures contract on the NYMEX at 66.28 cents per gallon (contract size is for 42,000 gallons). On the same day, the New York jet fuel spot price is 80.28 cents per gallon. The director closes out this futures contract on August 29, 2000 at 98.59 cents per gallon. As shown below, the director has made a profit of 32.31 cents per gallon (98.59 minus 66.28) on the futures contract. In essence, the hedger bought a futures contract (a long hedge) in January and then sold back the futures contract in August. The spot price of NY jet fuel on August 29th is 103.6 cents per gallon. Without the futures hedge, the director would have paid 23.32 cents/gallon more for the fuel. However, by using the futures contract and purchasing jet fuel in the spot market, the gain of 32.31 on the futures offsets the 23.32 increase in the jet fuel spot price. As a result, the director’s net cost of jet fuel is 71.29 cents per gallon (i.e. 103.6 spot price in August minus the futures hedging gain of 32.31 cents/gallon).
Cash Price (i.e. Spot Price) January 6 cash price 80.28 cents/gallon August 29 cash price 103.6 cents/gallon Futures Price 66.28 cents/gallon 98.59 32.31 cents/gallon gain Basis (Cash price minus futures price) 14.00 cents/gallon 5.01 8.99 cents/gallon basis loss

Result: Cash purchase price of jet fuel 103.6 cents/gallon Minus heating oil futures gain - 32.31 cents/gallon Net purchase price of jet fuel 71.29 cents/gallon

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Table 6 Statement of Financial Accounting Standards 133 (SFAS 133) Balance Sheet and Income Statement Impacts of Cash Flow and Fair Value Hedges This table summarizes the balance sheet and income statement impacts of hedging according to SFAS 133. Type of Derivative
Cash Flow Hedge

Balance Sheet Impact
Derivative (asset or liability) is reported at fair value. Changes in fair value of derivative are reported as components of Other Comprehensive Income (balance sheet)

Income Statement Impact
No immediate income statement impact. Changes in fair value of derivatives are reclassified into the income statement (from Other Comprehensive Income in the balance sheet) when the expected (hedged) transaction affects the net income. Derivative must qualify for hedge accounting treatment. Changes in fair value are reported as income/loss in the income statement. Offsetting changes in fair value of the hedged item are also reported as an income/loss in the income statement Changes in the fair value are reported as income/loss in the income statement.

Fair Value Hedge

Derivative (asset or liability) is reported at fair value. Hedged item is also reported at fair value.

Speculative Transaction

Derivative (asset or liability) is reported at fair value

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Table 7 Disclosures on Hedging From Southwest Airlines’ 2000 Annual Report FINANCIAL DERIVATIVE INSTRUMENTS The Company utilizes a variety of derivative instruments, including both crude oil and heating oil based derivatives, to hedge a portion of its exposure to jet fuel price increases. These instruments consist primarily of purchased call options, collar structures, and fixed price swap agreements. The net cost paid for option premiums and gains and losses on fixed price swap agreements, including those terminated or settled early, are deferred and charged or credited to fuel expense in the same month that the underlying jet fuel being hedged is used. Hedging gains and losses are recorded as a reduction of fuel and oil expense. Beginning January 1, 2001, the Company will adopt Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities which will change the way it accounts for financial derivative instruments. See Recent Accounting Developments. RECENT ACCOUNTING DEVELOPMENTS In 1998, the Financial Accounting Standards Board (FASB) issued SFAS 133. SFAS 133, as amended, is required to be adopted in fiscal years beginning after June 15, 2000. The Company will adopt SFAS 133 effective January 1, 2001. SFAS 133 will require the Company to record all derivatives on its balance sheet at fair value. Derivatives that are not designated as hedges must be adjusted to fair value through income. If the derivative is designated as a hedge, depending on the nature of the hedge, changes in the fair value of derivatives that are considered to be effective, as defined, will either offset the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or will be recorded in other comprehensive income until the hedged item is recorded in earnings. Any portion of a change in a derivative's fair value that is considered to be ineffective, as defined, may have to be immediately recorded in earnings. Any portion of a change in a derivative's fair value that the Company has elected to exclude from its measurement of effectiveness, such as the change in time value of option contracts, will be recorded in earnings. The Company will account for its fuel hedge derivative instruments as cash flow hedges, as defined. Although the fair value of the Company's derivative instruments fluctuates daily, as of January 1, 2001, the fair value of the Company's fuel hedge derivative instruments was approximately $98.3 million, of which approximately $75.8 million was not recorded in the Consolidated Balance Sheet. The $75.8 million will be recorded as an asset on the Company's balance sheet as part of the transition adjustment related to the Company's adoption of SFAS 133. The offset to this balance sheet adjustment will be an increase to "Accumulated other comprehensive income", a component of stockholders' equity. The portion of the transition adjustment in "Accumulated other comprehensive income" that relates to 2001 hedge positions, based on fair value as of January 1, 2001, is approximately $73.9 million and will be reclassified into earnings during 2001. The remainder of the transition amount will be reclassified to earnings in periods subsequent to 2001. The Company believes the adoption of SFAS 133 will result in more volatility in its financial statements than in the past.

20

U.S. Cents/Gallon

105

125

25 1/3/1994 4/3/1994 7/3/1994 10/3/1994 1/3/1995 4/3/1995 7/3/1995 10/3/1995 1/3/1996 4/3/1996 7/3/1996 10/3/1996 1/3/1997 4/3/1997 7/3/1997
Date

45 OPIS Chicago Jet 54 OPIS Gulf Coast Jet 54 OPIS Los Angeles Jet 54 OPIS N.Y. Harbor Jet 54 OPIS San Francisco Jet 54

65

85

Figure 1

OPIS Regional Jet Fuel Prices

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21
10/3/1997 1/3/1998 4/3/1998 7/3/1998 10/3/1998 1/3/1999 4/3/1999 7/3/1999 10/3/1999 1/3/2000 4/3/2000 7/3/2000 10/3/2000 1/3/2001 4/3/2001

Review copy for use of the Case Research Journal. Not for reproduction or distribution. Figure 2 Historical Gulf Coast Spot Jet Fuel Price Volatility

COM PUTING VOLATILITY (Standard Deviation)

Results:
Variance Standard Deviation (i.e. VOLATILITY) Mean

Periodic Annualized 0.001378 0.344570998 3.71% 58.70% -0.06% N/A

Obs. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Date 1/2/2001 1/3/2001 1/4/2001 1/5/2001 1/8/2001 1/9/2001 1/10/2001 1/11/2001 1/12/2001 1/16/2001 1/17/2001 1/18/2001 1/19/2001 1/22/2001 1/23/2001 1/24/2001 1/25/2001 1/26/2001 1/29/2001 1/30/2001 1/31/2001 2/1/2001 2/2/2001 2/5/2001 2/6/2001 2/7/2001 Totals

Jet Fuel Price 86.8 81.65 82.8 85.83 82.13 79.98 86 84.43 85.4 87.75 87.25 90.15 91.47 92.4 91.82 85.88 89 93.25 90.13 85.83 86.78 82.84 87.83 87.3 87.95 87.63

Sim ple Continuously Rate of Com pounded Return Rate of Return NA NA -5.93% -6.12% 1.41% 1.40% 3.66% 3.59% -4.31% -4.41% -2.62% -2.65% 7.53% 7.26% -1.83% -1.84% 1.15% 1.14% 2.75% 2.71% -0.57% -0.57% 3.32% 3.27% 1.46% 1.45% 1.02% 1.01% -0.63% -0.63% -6.47% -6.69% 3.63% 3.57% 4.78% 4.66% -3.35% -3.40% -4.77% -4.89% 1.11% 1.10% -4.54% -4.65% 6.02% 5.85% -0.60% -0.61% 0.74% 0.74% -0.36% -0.36% Count= 25

Squared Deviation NA 0.003741 0.000196 0.001292 0.001942 0.000704 0.005267 0.000339 0.000130 0.000737 0.000033 0.001069 0.000211 0.000102 0.000040 0.004473 0.001273 0.002176 0.001158 0.002390 0.000121 0.002159 0.003421 0.000037 0.000055 0.000013 0.033079

22

Spread (Jet Fuel - Heating Oil) in Cents/Gallon 10 15 20 25 30

0

5

Figure 3

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Price Spread Between Jet Fuel and Heating Oil for Gulf Coast Prompt

23
Date Source: Bloomberg

M ar -9 Ju 0 lN 90 ov M 90 ar -9 Ju 1 lN 91 ov M 91 ar -9 Ju 2 lN 92 ov M 92 ar -9 Ju 3 lN 93 ov M 93 ar -9 Ju 4 lN 94 ov M 94 ar -9 Ju 5 lN 95 ov M 95 ar -9 Ju 6 lN 96 ov M 96 ar -9 Ju 7 lN 97 ov M 97 ar -9 Ju 8 lN 98 ov M 98 ar -9 Ju 9 lN 99 ov M 99 ar -0 Ju 0 lN 00 ov -0 0

Review copy for use of the Case Research Journal. Not for reproduction or distribution. Figure 4 Fuel Hedging Using Swap Contracts

Pay fixed rate of $X per gallon per the swap contract

Airline is Fixed-rate payer
Airline receives floating rate based on monthly average jet fuel price

Counterparty is Floating-rate payer

Example 1 using a Plain Vanilla Jet Fuel Swap Arranged in the OTC Market Typically, the airline pays a fixed price and receives a floating price, both indexed to expected jet fuel use during each monthly settlement period. The volume of fuel hedged is negotiated because this is a customized contract. During the life of the swap contract, the airline buys jet fuel in the cash market, as usual, but the swap contract makes up the difference when prices rise and removes the difference when prices decline. The result for the airline is a fixed price for the period covered. The fixed rate payment is set based on market conditions when the swap contract is initiated. The floating price of jet fuel is commonly based on Platt’s New York Harbor jet fuel price and is calculated monthly using daily prices for the month. The net monthly payment (or cost) to the fixed-rate payer is the floating rate minus the fixed rate. For example, if the floating rate for a month averages 80 cents per gallon and the fixed rate is 70 cents per gallon, then the floating rate payer makes a 10 cents per gallon payment that month to the airline. If the size of the contract is 100,000 gallons, a payment of $10,000 is made to the airline (i.e. $0.10 x 100,000). Example 2 using the NYMEX New York Harbor Heating Oil Calendar Swap The NYMEX New York Heating Oil Calendar Swap lets hedgers arrange positions in the heating oil market as far forward as 36 months. The price settlement of the contract is based on the arithmetic average of the NYMEX New York Harbor heating oil futures nearby month settlement price for each business day during the contract month. The swap contract is for 42,000-gallons – the same size as the NYMEX heating oil futures contract. Consider an 18month swap currently trading with a fixed-price of 0.6841 cents/gallon. Suppose the futures average daily price for the month was 0.5900. The hedger who is long the futures contract (such as the airline) will make a payment to the counterparty of $3952.20 [i.e. (0.6841 – 0.5900) x 42,000]. The airline would purchase jet fuel in the spot market. Assuming the basis has not changed between jet fuel and heating oil (i.e. the high correlation between heating oil and jet fuel remains unchanged), the loss on the futures contract will be offset by the lower cash price of jet fuel. As a result, the airline effectively pays a fixed price for jet fuel.

24

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Figure 5 Swap, Call Option, and Premium Collar Illustration

25

Review copy for use of the Case Research Journal. Not for reproduction or distribution. Figure 6 Net Cost of Jet Fuel Using a Collar Strategy (Buy 80 Cent/Gallon Call and Sell 60 Cent/Gallon Put)

90

80

70 Net Cost of Jet Fuel Using a Collar Strategy

60

50

40

30

20

10

0 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 102 105 108 111 114 117 120 123 126 129 132 135 Price of Jet Fuel in Cents per Gallon 138

26

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Appendix 1 Glossary of Airline Terms Aircraft (average during period): The average number of aircraft operated during the period. Aircraft utilization: The average number of block hours operated in scheduled service per day per aircraft for the total fleet of aircraft. Available seat miles (ASMs): The number of seats available for scheduled passengers multiplied by the number of miles those seats were flown. Average fare: The average fare paid by a revenue passenger. Average seats per departure: The average number of available seats per departing aircraft. Average stage length: The average number of miles flown per flight. Block hour: The total time an aircraft is in motion from brake release at the origination to brake application at the destination. Break-even load factor: The load factor at which scheduled passenger revenues would have been equal to operating plus non-operating expenses/(income) (holding yield constant). Cost per available seat mile (CASM): Operating expenses plus non-operating expenses/(income) divided by ASMs. Departure: A scheduled aircraft flight. Fuel price per gallon: The average price per gallon of jet fuel for the fleet (excluding into plane fees) Load factor: RPMs divided by ASMs. Onboard passengers: The number of revenue passengers carried. Revenue passenger miles (RPMs): The number of miles flown by revenue passengers. Passenger revenue per available seat mile (PRASM): Passenger revenues divided by ASMs. Yield: The average scheduled passenger fare paid for each mile a scheduled revenue passenger is carried.

27

Review copy for use of the Case Research Journal. Not for reproduction or distribution. Appendix 2 Futures Options Data as per Barrons on 6-11-01 (NYMEX)
Month Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Sep-01 Sep-01 Sep-01 Sep-01 Sep-01 Sep-01 Oct-01 Oct-01 Oct-01 Nov-01 Dec-01 Dec-01 Dec-01 Dec-01 Dec-01 Apr-02 Jun-02 Jun-02 Dec-03 CRUDE OIL CALLS Strike Volume $27.50 706 $28.00 3,610 $28.50 3,085 $29.00 5,122 $29.50 2,659 $30.00 8,575 $30.50 708 $31.00 2,463 $32.00 4,086 $36.00 506 $28.00 1,966 $28.50 4,054 $29.00 2,930 $29.50 4,892 $30.00 6,127 $31.00 1,726 $31.50 1,012 $32.00 7,880 $33.00 1,880 $35.00 2,309 $40.00 1,161 $45.00 1,000 $28.00 750 $28.50 921 $29.00 900 $30.50 700 $33.00 1,371 $34.00 4,305 $28.00 $33.00 $34.00 $32.00 $27.50 $28.00 $29.00 $30.00 $34.00 $26.50 $26.00 $28.00 $23.00 675 945 2,430 2,700 568 602 500 579 600 525 1,287 600 700 Premium $1.05 $0.71 $0.47 $0.29 $0.18 $0.10 $0.06 $0.04 $0.02 $0.01 $1.43 $1.16 $0.91 $0.73 $0.58 $0.34 $0.26 $0.19 $0.13 $0.09 $0.02 $0.01 $1.75 $1.48 $1.22 $0.71 $0.26 $0.18 $1.92 $0.39 $0.29 $0.63 $2.24 $1.89 $1.46 $1.14 $0.42 $2.50 $2.61 $1.80 $2.91 Jun-02 Jun-02 Dec-03 $22.50 $20.50 $23.00 900 950 700 $1.80 $0.56 $2.65 Month Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Jul-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 Aug-01 CRUDE OIL PUTS Strike Volume $24.00 1,792 $25.00 1,274 $25.50 881 $26.00 2,145 $26.50 750 $27.00 4,005 $27.50 1,583 $28.00 5,128 $23.00 $24.00 $25.00 $26.00 $26.50 $27.00 $27.50 $28.00 535 761 1,022 2,957 1,003 2,026 1,017 5,064 Premium $0.01 $0.02 $0.03 $0.04 $0.07 $0.12 $0.22 $0.38 $0.05 $0.07 $0.12 $0.24 $0.33 $0.46 $0.62 $0.80

Sep-01 Sep-01 Sep-01 Sep-01 Sep-01 Sep-01 Oct-01 Oct-01 Oct-01 Oct-01 Nov-01 Nov-01 Dec-01 Dec-01 Dec-01 Dec-01 Dec-01

$24.00 $25.00 $26.50 $27.50 $28.00 $31.00 $20.00 $24.00 $27.00 $28.00 $20.00 $24.00 $22.00 $23.00 $25.00 $26.00 $27.50

733 921 810 1,200 1,708 500 815 520 655 525 1,250 3,325 1,055 5,850 2,750 3,151 650

$0.16 $0.28 $0.59 $0.92 $1.12 $2.93 $0.06 $0.27 $1.02 $1.42 $0.10 $0.40 $0.22 $0.34 $0.77 $1.08 $1.67

28

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Month Jul 01 Aug 01 Sep 01 Oct 01 Nov 01 Dec 01 Jan 02 Feb 02 Mar 02 Apr 02 May 02 Jun 02 Jul 02 Aug 02 Sep 02 Oct 02 Nov 02 Dec 02

Futures Data as per Barrons on 6-11-01 Heating Oil (NYMEX HO) 42,000 gallons per contract (cents/gallon) Week’s High Week’s Low Week’s Settle 78.40 75.00 76.65 78.35 75.70 77.12 78.90 76.30 77.77 79.55 77.50 78.52 80.35 78.10 79.27 80.90 78.80 79.82 80.90 79.00 80.02 80.40 78.00 78.87 77.80 75.60 76.17 74.90 73.18 73.62 71.90 70.95 71.27 70.75 69.75 70.02 70.02 69.62 69.62 … … 69.77 … … 70.12 … … 70.52 71.9 70.38 70.92 71.73 71.65 71.42 Light Sweet Crude (NYMEX CL) 1,000 barrels per contract (dollars/barrel) 28.74 27.25 28.33 28.90 27.71 28.63 28.85 27.90 28.63 28.61 27.90 28.50 28.33 27.81 28.32 28.20 27.55 28.07 27.65 27.20 27.51 27.21 26.87 27.23 … … 26.67 26.42 26.10 26.39 … … 26.13 25.74 25.60 25.87 … … 25.62 … … 25.38 … … 25.16 24.99 24.71 24.96 … … 24.77 … … 24.59 … … 24.43 29

Open Interest 29,709 19,087 12,679 7,415 9,606 21,185 8,576 7,055 9,774 1,981 1,584 1,795 474 289 289 207 382 103

Jul 01 Aug 01 Sep 01 Oct 01 Nov 01 Dec 01 Feb 02 Mar 02 May 02 Jun 02 Jul 02 Aug 02 Sep 02 Oct 02 Nov 02 Dec 02 Jan 03 Feb 03 Mar 03

93,423 95,499 46,117 23,347 21,390 35,792 9,215 5,214 4,616 19,331 4,822 2,687 8,269 4,494 3,246 18,953 3,976 819 904

Review copy for use of the Case Research Journal. Not for reproduction or distribution. Apr 03 May 03 Jun 03 Jul 03 Aug 03 Sep 03 Oct 03 Nov 03 Dec 03 Jun 04 Dec 04 Dec 05 Dec 06 Dec 07 … … 24.10 … … … … … … 22.88 22.69 … … … … … 23.79 … … … … … … 22.67 22.65 … … … 24.28 24.14 24.01 23.88 23.75 23.62 23.49 23.37 23.26 22.88 22.57 22.17 21.82 21.77 267 217 6,504 169 230 415 … … 9,995 200 5,999 5,302 1,996 375

30

Review copy for use of the Case Research Journal. Not for reproduction or distribution. Appendix 3

Monthly Stock Returns of 11 Major Airlines Versus the Montly Percentage Change in Jet Fuel Costs Over the Period 1994-1999
30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% -25.00%

Return

4

5

6

7

8

9 Ma y-9

4

4

5

5

6

6

7

7

8

Ma y-9

Ma y-9

Ma y-9

Ma y-9

Ma y-9

8

9

Se p-9

Se p-9

Se p-9

Date Airline Portfolio Return Change in Jet Fuel Costs

31

Se p-9

Se p-9

Se p-9

Ja n-9

Ja n-9

Ja n-9

Ja n-9

Ja n-9

Ja n-9

9

Review copy for use of the Case Research Journal. Not for reproduction or distribution. Appendix 4

Monthly Load Factors for U.S. Airline Domestic Flights
80

75

Load Factor (RPM/ASM) %

70

65

60

55

50
0 0 00 00 00 00 r-0 r-0 ynnbp a a u a e A J J M F M 0 1 1 01 00 00 00 01 01 00 00 l-0 r-0 r-0 yvcpgnbctp a a o e e u a e Ju A O J M F N S A D M Date Source: Bloomberg

32