2006 - southwest airlines - hedging and shareholder value

Legal Studies Research Paper Series

Working Paper Number 06‐__ September 2006

SOUTHWEST AIRLINES:

HEDGING AND SHAREHOLDER VALUE (TEACHING CASE)

Prepared November 2005 Revised August 2006∗

Michael Ingrassia, Georgetown University Law Center Victor Fleischer, University of Colorado Law School

∗ This case was prepared by Michael Ingrassia, J.D. 2006, Georgetown University Law

Center, and Professor Victor Fleischer, University of Colorado Law School. Certain events have been dramatized for teaching purposes. The case is intended as a teaching exercise and is not intended to evaluate the conduct of any of the subjects of the case study.

DEALS F2006 SOUTHWEST AIRLINES

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INTRODUCTION

Deborah Ackerman paced her office, running the options through her head. As General Counsel of Southwest Airlines, Ackerman was preparing to meet with Southwest’s CFO, Laura Wright, to discuss the implications of Southwest’s long‐term fuel hedging plan. Hedging had long been considered an essential part of Southwest’s operations, making any change in strategy a potential lightning rod for shareholder complaints. Southwest’s CEO, Gary Kelly, had asked Wright and Ac‐kerman to set aside everything else they were working on to concentrate on it. Wright was familiar with the financial benefits and pitfalls of hedging. But she felt that, given the sensitivity of shareholders to this is‐sue, it would be prudent to have the advice of counsel. Hedge funds and other institutional investors had accumulated significant stakes in Southwest, and Wright and Kelly wanted to make sure that their decision would not be criticized as a waste of shareholder value. Hedging had long been a source of pride for Southwest Airlines. Southwest has had the most extensive fuel hedging program in the air‐line industry for years, helping it to weather the rapidly increasing fuel prices of 2003‐2005 that drove several of its competitors into bankruptcy. But by November of 2005, the prospect of those hedging contracts pro‐tecting Southwest appeared slim. Beginning in January of 2006, the per‐cent of Southwest’s fuel needs that would be hedged was due to drop steadily until 2009, when the last of its hedging contracts would expire.1 This posed a dilemma for Southwest.

• Should it enter into additional (now more costly) fuel hedging contracts?

1 Micheline Maynard, So Southwest is Mortal After All, N.Y. TIMES, Oct. 16, 2005 at C1.

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o If so, what instruments should be used?

o If not, should the company seek other methods of reduc‐

ing its exposure to rising fuel costs?

• What would shareholders think of each of these alternatives?

BACKGROUND Southwest Airlines is a low‐cost carrier (“LCC”) airline with do‐mestic point‐to‐point service (as compared to the hub‐and‐spoke system utilized by legacy carriers). The company employs a low‐cost model that has become the envy of the U.S. airline industry. 2 Southwest began operations in 1971 as a local carrier, based out of Love Field in Dallas, with routes only in Texas. During the 1980s, Southwest expanded its presence throughout the southwestern and cen‐tral United States, including service to Los Angeles, Phoenix, St. Louis, and Chicago. During the 1990s, the airline continued to expand its routes, including in its coverage service to New England, the Pacific Northwest, the Atlantic Coast, and the Southeast. 3 Each time Southwest decided to enter a new market, it did so with an opportunistic strategy that would later become the model for other LCCs. The company would identify those markets that were either underserved (often due to retrenchments by other airlines) or that had high prices due to a lack of competition. Southwest would then enter that market, offering lower fares in order to rapidly build market share. They would then slowly raise prices to make the route as profitable as possible while still undercutting competing airlines. 4

2 See Analyst Report on Southwest Airlines Co., BB&T Capital Markets, May 13, 2004 at 2

[hereinafter BB&T, May 2004]. 3 See Southwest Airlines website, available at www.southwest.com. 4 See BB&T, May 2004, at 2.

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www.southwest.com


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The keys to Southwest’s successful expansion policy were both its intelligent identification of attractive new markets and its ability to con‐sistently keep its costs below those of its competitors. The metric of cost competitiveness in the airline industry is CASM (“Cost per Available Seat Mile”). CASM is derived by dividing total operating costs by ASMs (the available number of seats for passengers multiplied by the number of scheduled miles flown).5 Within the highly‐competitive airline industry, the highest‐ and the lowest‐cost carriers in any given year may be sepa‐rated by as little as $0.02 per ASM.6 Southwest’s lower labor costs and greater operating efficiency have allowed it to achieve lower CASM lev‐els than its peers, including both legacy carriers and LCCs (see Exhibit 1).7 This CASM advantage has increased in recent years due to South‐west’s industry‐leading hedging program.8

SOUTHWEST’S HEDGING PROGRAM Hedging refers to a contract or set of contracts that a company en‐ters into in order to limit its exposure to a business risk that could nega‐tively impact the results of its operations. A cereal maker might hedge against a rise in corn prices caused by drought; a hotel might hedge against a drop in visitors caused by bad weather. So, for example, a ce‐real maker might hedge against a rise in corn prices by buying a three‐year call option that gives it the right (but not the obligation) to buy a given amount of corn three years from now at today’s price. If corn prices rise, then the cereal maker will exercise the option and buy the corn at today’s price. If corn prices decline, the cereal maker will allow the option to lapse and buy the corn at the then‐cheaper market price.

5 See id. at 23. 6 See id. at 11. 7 See id. at 9. 8 See id. at 14.

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For several years Southwest Airlines has hedged its fuel needs to protect itself from fluctuations in jet fuel prices—one of the largest and most volatile components of an airline’s CASM. As early as 2001, South‐west was hedged on 80% of its fuel needs.9 Beginning in September of 2002—in anticipation of a possible war in the Persian Gulf—Southwest began to hedge its fuel needs even more aggressively, paving the way for it to remain the most profitable airline over the next three years.10 Southwest Airlines’ hedging program consists principally of pur‐chased call options, collar structures, and fixed‐price swap agreements.11 Each of these instruments is described in Exhibit 2. As jet fuel is not traded on a futures exchange, it is common within the airline industry to use options contracts (or swaps or collars) based on heating oil or crude oil, as these commodities most closely track jet fuel prices.12 In order to convert crude oil into jet fuel, the crude oil must be refined, resulting in a refining margin known as the “crack spread.”13 Jet fuel trades at a pre‐mium to crude oil (commonly referred to as “West Texas Intermediate” or “WTI”) “because of the cost of refining (‘cracking’) raw (‘WTI’) oil into jet fuel.”14 Therefore, airlines seeking to hedge against fluctuations in jet fuel prices must hedge against both changes in WTI prices and against changes in the crack spread, thus explaining Southwest’s use of heating‐oil based financial derivatives (as heating oil is also a refined product, it offsets the jet fuel margin risk).15 However, as most of its longer‐term

9 See Analyst Report on Southwest Airlines Co., Morgan Stanley Dean Witter, May 1,

2001, at 5. 10 Daniel Altman, Trying to Make Fuel Prices Less of a Wartime Gamble, N.Y. TIMES, May 23,

2003, at C4. 11 Southwest Airlines 10‐K Report (2005) at 45. 12 See id.; see also Daniel Altman, Trying to Make Fuel Prices Less of a Wartime Gamble, N.Y.

TIMES, May 23, 2003, at C4 (indicating that the majority of Southwest’s short‐term hedging contracts are based on heating oil prices as they more closely track jet fuel prices than do crude oil prices). 13 Analyst report on the European Transport Industry, Morgan Stanley, Sept. 15, 2005, at

3. 14 Id. at 4. 15 Analyst report on Southwest Airlines, Citigroup, Oct. 12, 2005, at 2.

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hedging contracts are based on crude oil prices,16 Southwest remains largely exposed to the crack spread. Going forward, Southwest is hedged for approximately 65% of its 2006 fuel needs, 45% of its 2007 fuel needs, 30% of its 2008 fuel needs, and 25% of its 2009 fuel needs.17 This makes Southwest the most hedged of its U.S. peers with respect to its fuel needs, although it is not as hedged as many European airlines (see Exhibit 3). Southwest’s aggressive hedging program has allowed it to achieve a level of success over the past few years that has exceeded the results of its peer group (see Exhibit 4). Jet fuel prices rose 52% from Sep‐tember of 2004 to September of 2005, on top of a rise of 60% from 2002 to 200418 (see Exhibit 5). Because jet fuel and labor costs are the two biggest operating costs for airlines, large fluctuations can lead to bankruptcy for participants in an industry that has also experienced declining traffic in the wake of 9/11 and falling prices due to increased LCC competition. Although earnings per share (EPS) for Southwest’s competitors have fallen precipitously since 2000, forcing many of the legacy carriers (and some of the LCCs) into bankruptcy, Southwest has managed to sus‐tain its record of consistent profitability (see Exhibit 4). While Southwest has always managed to achieve a lower CASM than its competitors due to lower labor costs and higher efficiency ratios, in recent years much of this CASM advantage has been due to the company’s hedging program. Southwest’s fuel hedging has allowed it to achieve a 35% CASM advan‐tage vs. its competitors (see Exhibit 1).19 However, with its hedges wind‐ing down, analysts have predicted that Southwest’s CASM advantage will fall to 23% by 2006 and decline thereafter (see Exhibit 6).20 Southwest must now decide how it will deal with its fuel costs going forward.

16 Southwest Airlines 10‐K Report (2005) at 45. 17 Id. 18 See BB&T, May, 2004, at 15; see also Analyst report on the U.S. Airline Industry, Bear

Stearns, Oct. 11, 2005, at 4. 19 See Analyst report on Southwest Airlines, Citigroup, Oct. 12, 2005, at 6. 20 See Analyst report on Southwest Airlines, Bear Stearns, Oct. 17, 2005, at 3.

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STRATEGIC OPTIONS Wright has focused on seven alternatives available to Southwest:

1. Do nothing; 2. Pass on to passengers any increased fuel costs through surcharges

or increased fares; 3. Increase the use of cost reduction techniques, such as adding

blended winglets (a wing design that reduces fuel consumption); 4. Hedge using a swap (heating oil or jet fuel); 5. Hedge using options; 6. Hedge using a collar; or 7. Hedge using a futures contract (heating oil or crude oil).

Given the impact of fuel costs on an airline’s cost structure (both Northwest and Delta blamed their bankruptcy petitions, in large part, on rising fuel prices21), Gary Kelly (Southwest’s CEO ) would prefer to be proactive in deciding how to handle fuel costs. While the board of direc‐tors might be receptive to a “do nothing” approach should the costs of the other alternatives (including hedging) prove excessive, it would cer‐tainly expect a careful analysis to back up any decision. Should Southwest decide to do something proactively, it could focus on increasing its revenues per available seat mile (“RASM”) rather than on decreasing its CASM. This could be achieved through fuel sur‐charges or fare hikes. However, this might be difficult for Southwest, which has always marketed itself as the “low fare airline,” as it could an‐tagonize passengers with any significant fare increases. Wright herself once stated: “Our low‐fare brand is who and what we are.”22 On the other hand, given Southwest’s strong “brand equity” among customers

21 Micheline Maynard, So Southwest is Mortal After All, N.Y. TIMES, Oct. 16, 2005 at C1. 22 Id.

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as a low‐cost carrier and its industry‐low CASM, it might be able to raise fares for short periods without losing market share. Southwest could, alternatively, seek other means of reducing its operating costs. For example, the company recently added blended winglets to its 737‐700 fleet, which it estimates will reduce jet fuel costs by 3‐4% among those aircraft.23 But how many other ways could there be to reduce costs for an airline that already has the industry’s lowest CASM? Finally, Southwest could enter into hedging arrangements using swaps, calls, collars, or futures contracts (discussed in greater detail in Exhibit 2). For example, Southwest could protect itself against a rise in jet fuel prices by purchasing a series of call options on crude oil at $65 per barrel (a price above the current market rate) extending out beyond 2009. Should crude oil prices remain below $65 per barrel in any given year, Southwest would simply forgo exercising its options in that year. Should market prices rise above $65, Southwest could exercise for the spread and thereby at least partially offset the rise in jet fuel prices. But, as men‐tioned in the discussion in Exhibit 2, there are costs associated with many hedging arrangements. Southwest, as the holder of an option, would have to pay a premium for that privilege regardless of whether or not it decided to exercise that option.24 Other hedging arrangements, such as swaps and futures contracts, expose the hedging party to downside risk by locking them in to what could be a high price. Following the first Gulf War in 1991, for example, the drop in prices that accompanied the early victories of coalition forces took many companies by surprise, causing several to suffer great losses due to hedging positions they took in antici‐pation of rising fuel costs.25 All of these concerns were racing through Ackerman’s mind as she pondered Southwest’s dilemma. Should she fail to counsel Wright

23 See BB&T, May, 2004, at 15. 24 See Dave Carter, Dan Rogers, & Betty Simkins, Fuel Hedging in the Airline Industry: The Case of Southwest Airlines (unpublished 2004), Fig. 5 at 25. 25 Daniel Altman, Trying to Make Fuel Prices Less of a Wartime Gamble, N.Y. TIMES, May 23,

2003, at C4.

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appropriately, Southwest’s managers and directors might face increasing pressure from Southwest’s institutional shareholders.

HEDGING AND SHAREHOLDER VALUE Designing an effective hedge was not Ackerman’s job. As gen‐eral counsel, however, she had to anticipate potential objections from the board and from shareholders. Management, she knew, wished to avoid bankruptcy at all costs. Costs, however, were exactly what some share‐holders were concerned about. Would Southwest fritter away its com‐petitive advantage by entering into expensive new hedging contracts? The problem with hedging is that it can be expensive. Share‐holders understand that investing in equities is risky, but they diversify their portfolios to mitigate that risk. Hedging thus may be an unneces‐sary diversification of firm‐specific risk. It may just reflect the risk aver‐sion of managers, imposing unnecessary costs on the firm and thereby diminishing returns. Defenders of hedging, however, note that the same can be said of insurance. 26 And yet few would argue that corporations should be categorically banned from purchasing insurance. Deciding whether hedging makes sense, then, requires a more nuanced and con‐text‐specific inquiry.27 A. Arguments in Favor of Hedging

26 See Kimberly D. Krawiec, Derivatives, Corporate Hedging, and Shareholder Wealth: Modi‐gliani‐Miller Forty Years Later, 1998 U. ILL. L. REV. 1039, 1046 (1998). 27 Cf. Victor P. Goldberg, Aversion to Risk Aversion in the New Institutional Economics, 146 J.

INST. & THEOR. ECON. 216 (1990).

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Proponents of hedging argue that by failing to hedge against firm‐specific risk, a firm may reduce its expected cash flows and thereby diminish shareholder wealth.28 1. Reduction of Transaction Costs One explanation for the positive impact of hedging on share‐holder wealth lies in transaction costs. Two obvious transaction costs that can be reduced through hedging are the costs associated with bankruptcy and the costs of contracting with the firm’s risk‐averse stakeholders (em‐ployees, customers, and suppliers).29 If a firm is forced into bankruptcy, there are a host of disruptive costs, both direct and indirect, that the firm must bear.30 Unsecured creditors shoulder the weight of reorganization costs; thus, the threat of insolvency casts a heavy shadow that can reduce shareholder wealth through higher interest rates or triggering default on loans because of a failure to meet debt covenants. By hedging against key risks, such as jet fuel prices, a firm can smooth out its cash flows, diminishing the shadow of bankruptcy and its accompanying costs. And there are other transaction costs, outside of the insolvency context, that a firm must bear in contracting with its stakeholders; many of these costs can be reduced through hedging. For example, a potential employee will demand a risk premium before joining a firm if she be‐lieves the company might have cash flow problems.31 Similarly, custom‐ers and suppliers might demand more favorable contractual terms if they to view the firm’s operational results (and therefore ability to perform its contractual obligations) as volatile.32

28 See Krawiec at 1059. 29 See id. at 1061. 30 See id. 31 See id. at 1063. 32 See id. at 1065‐68.


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How should the ability to reduce transaction costs through hedg‐ing impact Southwest’s decision, particularly given the transaction costs inherent in many hedging arrangements? How might the spate of recent bankruptcy filings by other airlines factor into Southwest’s decision? Are transaction costs still likely to influence Southwest’s hedging decision given the relative bargaining leverage that Southwest has with its em‐ployees due to its success relative to its peers? 2. Enhancement of Flexibility in the Firm’s Investment Policies Firms often choose to finance capital‐intensive projects with funds generated by internal cash flow. Southwest, for example, plans on purchasing somewhere between 57 and 139 Boeing 737‐700’s from 2006‐2008.33 Greater volatility in a firm’s cash flows limits its ability to fund such a project using internal funds alone.34 For example, an airline seek‐ing to purchase four additional aircraft may have to invest $800 million per year over four years in order to complete such a purchasing program. Assume that the airline suffers from greatly fluctuating cash flows due to high operational volatility, such that in year 3 it only has $500 million in available funds for aircraft purchases that year. It can either (a) hold off on purchasing additional aircraft that year; (b) seek financing from exter‐nal capital markets, which may be more expensive than its internal cost of capital; or (c) shift funds for the aircraft from other areas, either through unplanned cost reductions or asset divestitures. In any of the above situations, a firm with high operational vola‐tility may experience a significant adverse impact on shareholder wealth by exposing itself to the information costs of the external capital markets rather than hedging itself. What impact should this understanding of the effect of hedging on a firm’s investment policies have on Southwest’s de‐cision? 3. Reduction in the Firm’s Agency Costs

33 Southwest Airlines 10‐K Report (2005) at 8. 34 See Krawiec at 1069.


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The agency costs faced by corporations can also be reduced through hedging.35 Particularly, those agency costs associated with “noise” can be reduced.36

Hedging may reduce the “noise” in a firm’s performance by re‐ducing the impact of events outside of the firm’s control, thereby allow‐ing shareholders to more clearly observe the competence of the firm’s management.37 For example, if Northwest and Delta had been well‐hedged against fuel costs, they would have been unable to blame their spiral into bankruptcy on rising fuel costs. Instead, shareholders would have been able to more clearly observe whether the firm’s poor perform‐ance was due to managerial incompetence or extraneous events. What implications exist for Southwest in its decision‐making process given the potential impact of hedging on agency costs? Would a rational shareholder consider reduced agency costs to be a legitimate rea‐son for Southwest to enter into potentially costly hedging arrangements? 4. Replication of Vertical Integration For some firms, hedging may serve to assure a stable and afford‐able supply or output source.38 Therefore, for these firms, hedging would substitute for vertical integration.39 Vertical integration itself, while it may be accretive to shareholder wealth, may well be either finan‐cially impossible because the firm cannot afford to acquire a supplier or legally prohibited due to antitrust concerns. In some ways, hedging is similar to a vertical merger in that the hedging firm guarantees itself access to a given input, protected from fluctuations in that input’s market price. Thus, by hedging against fluc‐

35 See id. at 1072. 36 See id. at 1073‐75. 37 See id. at 1075. 38 Id. 39 See id.


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tuations in the price of a given supply, a firm could realize many of the same shareholder wealth benefits of vertical integration without having to actually acquire a downstream partner through a vertical business combination.40 Is Southwest’s hedging program effectively a way to replicate a vertical merger? 5. Diversification for Shareholders Another argument put forward to defend hedging as a means of enhancing shareholder wealth is that, despite the common assumption and expectation that shareholders are diversified, in fact not all share‐holders are, including employees who own stock.41 Therefore, by hedg‐ing against certain key risks, a firm can reduce its exposure to significant unsystematic risks, thereby replicating the benefits of diversification for its investors. This argument has, however, been largely discounted even by proponents of hedging. What are the key weaknesses of this argument? Should South‐west utilize hedging arrangements in order to provide greater diversifica‐tion to its shareholders, assuming that they have not already diversified their investment portfolios? Is this effectively a reformulation of the much‐maligned conglomerate‐theory of corporate management that en‐joyed popularity in the 1960s and 1970s? B. Arguments Against Hedging Other commentators have questioned the role of hedging in management’s fiduciary duties. The questions frequently turn on: (i) whether the true beneficiary of management’s fiduciary duties should be

40 See id. 41 See id. at 1078.


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shareholders or the corporate entity (in effect, stakeholders) and (ii) whether hedging is consistent with management’s duties in either case. The argument that hedging is inconsistent with management’s fiduciary duties begins with the premise that the proper beneficiaries of those duties are the firm’s shareholders.42 Therefore, any management actions that are chiefly for the benefit of others—rather than for the bene‐fit of the firm’s shareholders—violate management’s duty of loyalty. Thus, hedging can be seen as furthering corporate wealth rather than shareholder wealth and thereby violates management’s fiduciary duty of loyalty. Further, even if managers are looking to enhance shareholder wealth through hedging (and are therefore not violating their duty of loyalty), some claim that they are not actually enhancing shareholder wealth and are thus violating their duty of care by wasting the corpora‐tion’s assets. These two contentions are contained in the two chief arguments by those opposed to hedging. The first argument is that hedging ar‐rangements are usually entered into to manage accounting earnings (i.e., to enhance corporate welfare) rather than to improve the firm’s net pre‐sent value (i.e., to enhance shareholder welfare).43 The second argument is that hedging merely reduces unsystematic risk, which shareholders can (and do) reduce on their own through diversification.44 1. Hedging as a Mechanism to Manage Accounting Earnings The first argument often proffered by those opposed to the use of hedging arrangements has its roots in the duty of loyalty. According to this argument, many companies utilize hedging arrangements to limit their exposure to accounting earnings, rather than to reduce the com‐pany’s exposure to economic fluctuations.45

42 Henry T.C. Hu, New Financial Products, the Modern Process of Financial Innovation, and the Puzzle of Shareholder Welfare, 69 TEX. L. REV. 1273, 1278 (1991). 43 See id. at 1306‐07. 44 See id. at 1307‐09. 45 See id. at 1306.


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Hedging against accounting fluctuations does not enhance shareholder wealth, but instead merely benefits corporate managers in the short‐run. 46 Particularly, the firm’s managers and employees benefit from carefully‐managed numbers (by enhancing their professional mar‐ket value and by increasing their compensation if it is tied to perform‐ance) at the expense of shareholders, who ultimately bear any transaction costs involved. This argument emphasizes the principal‐agent dilemma inherent in the greater risk aversion of managers as compared to share‐holders. What are the implications of this argument for Southwest as it considers whether to hedge against rising fuel costs? If one considers any efforts to “manage accounting numbers” to be wasteful from a share‐holder wealth standpoint, then must hedging be deemed a violation of management’s fiduciary duties? Or is there a legitimate argument that hedging serves a desired purpose from a shareholder wealth standpoint and is not merely a mechanism for management to manipulate account‐ing results? 2. Hedging as a Mechanism to Reduce Unsystematic Risk The second argument frequently put forward in opposition to the use of hedging has its roots in the duty of care (and to some degree the duty of loyalty). This argument sees hedging as primarily a means of re‐ducing unsystematic risk.47 Given that most shareholders have already reduced their exposure to unsystematic risk through diversification, the use of costly hedging arrangements would under this view be wasteful from a shareholder wealth standpoint.48 Under this argument, hedging might violate management’s duty of care by wasting corporate assets. Further, hedging might also violate

46 See id. 47 See id. at 1307‐08. 48 See id.


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management’s duty of loyalty by transferring wealth from shareholders to other stakeholders (assuming that most shareholders are diversified): after all, a diversified shareholder has already reduced her exposure to many of the (unsystematic) risks that hedging is designed to address, while managers and employees lack that luxury and suffer from in‐creased volatility in the firm’s performance. Hedging, therefore, acts as a mechanism for managers, employees, and undiversified shareholders to reduce their exposure to risk. Diversified shareholders, meanwhile, re‐ceive no corresponding benefit while bearing most of the cost of this risk reduction. What are the implications of this argument for Southwest as it considers what to do regarding its hedging program? Would a court consider extensive hedging by Southwest to be wasteful from a share‐holder wealth standpoint and therefore a violation of management’s duty of care? Could Southwest’s managers or directors be deemed to have violated their duty of loyalty to the firm’s shareholders by using hedging arrangements to protect their own interests rather than those of the firm’s shareholders? Concluding Questions As a practical matter, it seems highly unlikely that a shareholder lawsuit would succeed. Under current law, management’s decisions would almost certainly be protected by the business judgment rule. How should this fact affect the role of in‐house counsel? Is her duty simply to advise the board about the legal consequences of its decisions? Or should she also voice the potential concerns of shareholders, even though the litigation risk is slight? Given the situation, what should Ackerman recommend to Wright regarding Southwest’s fuel hedging program going forward? What are the key concerns that she should communicate to Wright re‐garding each of the available options? From a legal standpoint, which al‐ternatives appear most attractive?


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Appendix Exhibit 1: CASM Data by Carrier (2000 vs. 2004 vs. 2005-Q2) 8 6 4

2 0

10

12

14

16

Continental United American US Air Delta Northwest Alaska America West

JetBlue Airtran Southwest Avg.

2000-FY 2004-FY 2005-Q2

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 28-29. Exhibit 2: Description of Southwest Swaps, Options, and Collars Frequently Used Fuel Hedging Instruments by Airlines This section describes the most commonly used hedging contracts by airlines: swap con-tracts (including plain vanilla, differential, and basis swaps), call options (including caps), collars (including zero-cost and premium collars), futures contracts and forwards con-tracts. 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 obliga-


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tions 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 peri-ods (usually monthly, but sometimes quarterly, semi-annually, or annually). 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 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 dif-ferential 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 op-tions 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 illustra-tion for hedging gains or losses using swaps, call options, and premium collars when lock-ing into a 60-cent/gallon price of jet fuel. Collars, Including Zero-Cost and Premium Collars


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A collar is a combination of a put option and a call option. For a hedger planning to pur-chase 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 pre-mium received from selling the put option helps offset the cost of the call option. By estab-lishing 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 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 op-tion 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 specu-lative return. However, if jet fuel prices fall significantly, as illustrated in Figure 6, the air-line 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 posi-tion, 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 fu-tures 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 for-ward 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.


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The NYMEX exchange trades futures on crude oil, heating oil, and gasoline (among other commodities). Source: Dave Carter, Dan Rogers, & Betty Simkins, Fuel Hedging in the Airline Industry: The Case of Southwest Airlines (2004) at 5-8. Exhibit 3: Hedging by U.S. and Foreign Airlines Summary of Fuel Hedging in the U.S. Airline Industry

% Hedged Price % Hedged Price % Hedged PriceAirTran 34% $1.71 / gal. 14% $1.72 / gal. 8% $1.69 / gal.Alaska 50% $30 / bbl 42% $40 / bbl 20% $45 / bblAmerica West 53% $1.40 / gal. 4% $1.44 / gal. 0% NAAmerican 4% $48 / bbl 0% NA 0% NAContinental 0% NA 0% NA 0% NADelta 0% NA 0% NA 0% NAJetBlue 20% $30 / bbl 0% NA 0% NANorthwest 0% NA 0% NA 0% NASouthwest 85% $26 / bbl 65% $32 / bbl 45% $31 / bblU.S. Airways 0% NA 0% NA 0% NAUnited 3% $1.24 / gal. 0% NA 0% NAAverage (ex-Southwest) 16% NA 6% NA 3% NA

2H 2005 2006E 2007EAirline

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 31-32. Summary of Fuel Hedging in the European Airline Industry

% Hedged Price % Hedged Price % Hedged Price % Hedged PriceAir France-KLM 83% $42 / bbl 83% $42 / bbl 54% $52 / bbl 31% $58 / bblBritish Airways 81% $45 / bbl 81% $45 / bbl 40% $50 / bbl NA NAeasyJet 20% NA NA NA NA NA NA NAIberia 50% $43 / bbl NA NA 0% NA 0% NALufthansa 90% $35 / bbl 90% $40 / bbl NA NA NA NARyanair 90% $57 / bbl 90% $49 / bbl NA NA NA NASAS 50% NA 50% NA NA NA NA NAAverage 66% NA 79% NA NA NA NA NA

Airline 2H 2005 Late 05 - Early 06 4/06 - 3/07 4/07 - 3/08

Source: Analyst Report on European Airline Industry, Morgan Stanley, Sept. 15, 2005, at 3-5. Summary of Effective Fuel Costs per Gallon After Hedging in the U.S. Airline In-dustry


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AirTranAlaskaAmerica WestAmericanContinentalDeltaJetBlueNorthwestSouthwestU.S. AirwaysUnitedAverage (ex-Southwest)Southwest Advantage 44% 27% 19%

$1.49$1.86$1.86

$1.85$1.85

$1.88$1.88

$1.86$1.86$1.86$1.86

$1.84$1.76$1.86$1.86$1.88

$1.86$1.62$1.86

$1.88$1.88$1.88$1.88

$1.35$1.00$1.89$1.87

$1.80

$1.89$1.89$1.72$1.89

$1.83$1.46$1.63$1.88

Airline 2007E2006E2H 2005

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 31-32. Summary of Southwest Fuel Hedging

% HedgedHedge Rate / bbl (WTI)Current Fwd Rate / bbl (WTI)Crack SpreadWTI + CrackCost After Hedge (per bbl)Cost After Hedge (per gal)

$1.63$1.60

2009E

25%

$35.00

$62.00

$13.00$75.00

$68.25

2008E

30%

$33.00

$63.00

$13.00$76.00

$67.00

$1.00 $1.35 $1.49

$76.50 $79.00 $78.00

$42.08 $56.90 $62.70

$66.50 $66.00 $65.00

$10.00 $13.00 $13.00

85% 65% 45%

$26.00 $32.00 $31.00

2H 2005 2006E 2007E

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 31-32.


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Exhibit 4: Diluted Earnings Per Share Results for U.S. Airline Industry (2003-06E) Airline 2003 2004 2005E 2006EAirTran 0.74 0.13 (0.15) 0.40Alaska (1.15) 0.20 1.85 3.20American (9.69) (5.57) (3.73) (3.20)Continental (3.36) (4.32) (3.62) (1.00)Delta (8.58) (18.10) (14.11) (11.25)JetBlue 0.85 0.43 0.20 0.25Northwest (6.57) (8.41) (18.24) (3.55)Southwest 0.36 0.41 0.63 0.63U.S. Airways NA NA (8.04) (4.50)Average (ex-Southwest) (3.97) (5.09) (5.73) (2.46) Source: Analyst report on Airline Industry, Bear Stearns, Oct. 11, 2005, at 10. Exhibit 5: Jet Fuel and Crude Oil Prices (2004-2005) NYMEX Futures Price of No. 2 Heating Oil

(Jan. 2002 – Nov. 2005)

0

50

100

150

200

250

1/02 9/03 1/04 5/04 9/04 1/05 5/05 9/051/03 5/035/02 9/02 11/05

Cents per Gal.

Source: U.S. Department of Energy, Energy Information Administration (Nov. 23, 2005 update).


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Exhibit 6: Southwest CASM Advantage v. Airline Industry (2000-2006E)

-60%

-50%

-40%

-30%

-20%

-10%

0%2000 2001 2002 2003 2004 2005E 2006E

Advantage v. LCCs

Advantage v. Legacies

Advantage v. Industry

Source: Analyst report on Southwest Airlines, Bear Stearns, Oct. 17, 2005, at 4.


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Exhibit 7: Southwest Share Price vs. DJIA and vs. Airline Group (2001-2005)

Source: Wall Street Journal Online, Nov. 15, 2005.


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Exhibit 8: Southwest Income Statement (1999-2007E)

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 40. Exhibit 9: Southwest Basic Earnings per Share and Analyst Estimates (2002-2007E)

2002 2003 2004 2005E 2006E 2007E0.26 0.38 0.43 - - -

- - - 0.55 0.51 0.52- - - 0.57 0.58 NA- - - 0.55 0.50 NAJP Morgan Estimate

Citigroup EstimateMorgan Stanley Estimate

Actual

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 40; Ana-lyst Report on Southwest Airlines Co., Morgan Stanley, Apr. 15, 2005, at 5-6; Analyst Report on U.S. Airline Industry, JP Morgan, Sept. 21, 2005, at 7.

2006 - southwest airlines - hedging and shareholder value

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