southwest airlines- fuel hedging case analysis

Southwest Airlines: Fuel Hedging Analysis

October 13, 2013 BA 618: Advanced Corporate Finance

Vishal Prabhakar | Ajay Gnanasekaran Embry-Riddle Aeronautical University

2

Table of Contents

Sl.No Contents

1. Southwest Airlines -Introduction 2. Fuel Hedging- A Win-Win 3. To Hedge or not to Hedge 4. Case Background 5. Hedging Strategies and Analysis 6. @Risk Analysis 7. Conclusion 8. Current Outlook-Hedging 9. References

3

SOUTHWEST AIRLINES – INTRODUCTION

In order to stay airborne, a commercial airline has to consistently keep generating

profits. Profits in an airline industry come from passenger revenue, hence all stratagems

must be customer centric. In this current scenario with all the mergers and acquisitions,

airlines competing with each other, one way of attracting passengers is to keep the cost

of flying low. Southwest’s business model is the best low cost model yielding

considerable profit, while providing value for money. The main expenses for an airline

are the operating and fuel cost, expenses must be tightly controlled to reach and stay at

the lowest possible level. Certain expenses are unavoidable; however, one variable that

can be kept low through decisive planning and foresight is the cost of fuel. Fuel prices

are extremely volatile. A good way to achieve this is by hedging fuel, which is a

complex, but rewarding process as Southwest Airlines proves beyond doubt.

Southwest Airlines, is the third largest airline in the world as well as in America in terms

of passenger aircraft among all of the world's commercial airlines. It operates more than

540 Boeing 737 aircraft today between 67 cities in the U.S.A. Today, Southwest

operates approximately 3,300 flights daily and boasts of being the only major airline to

post profits every year for the last thirty-six years. It justifiably claims to be United

States’ most successful low-fare, high frequency, point-to-point carrier.

It would be worthwhile examining Southwest’s modus operandi and strategies employed

to stay profitable every year, though it did suffer a minor hiccup when it’s profit dived

under the waterline in two quarters in 2008. Southwest keeps its aircraft in flight for

more than twelve hours a day. It carefully selects optimized destinations that could be

called secondary airfields, which facilitate fast turnaround averaging less than fifteen

minutes and charge low administrative fees. Using the same logic, they use only one

aircraft type. This helps them to reduce the fleet maintenance cost. The Boeing 737 has a

reasonable passenger capacity of around one hundred and twenty five to one hundred

and fifty. These are fitted with the most fuel-efficient engines and aerodynamically have

the lowest drag wet-wings available.

4

FUEL HEDGING – A WIN-WIN

Jet fuel represents a critical expense category for any airline that bears its own fuel costs

and most airlines bear at least 80% of its fuel costs. Fuel has consistently been one of the

largest expense categories for domestic airlines. During 2003, fuel costs represented, on

average, over 16% of the total operating expenses for all U.S. domestic airlines.

Moreover, airlines are generally unable to increase fares to offset any significant

increase in fuel costs. From 2001 to2003, these same airlines experienced a 25.9%

compound annual increase in jet fuel costs while average airline pricing decreased by

0.1%, as measured by revenue per available seat mile. Jet fuel costs have gone up over

the past several years laying a constant pressure on airlines to maintain a profitable

operation. Savings in the lines of operation and fuel cost turn out to be the profit earned.

In a fuel driven industry like Commercial Aviation, sudden hikes and fluctuations in

fuel prices can have an immense effect on the business plan, not to mention adding to

the difficult task of budgeting of Future fuel expenditures. If fuel costs are not actively

managed, they can lead a company into losses. Airlines can mitigate their exposure to

volatility and sudden hike in fuel costs, as well as natural gas and electricity costs,

through hedging. Hedging allows the fuel market participants to fix prices in advance,

while reducing the potential impact of volatile fuel prices.

‘Hedging’ items is a standard practice in almost every field that involves finance,

including Market players in precious metals like Gold, Silver and Platinum. While fuel

costs may be hedged, there is no perfect hedge available in either over-the-counter or

exchange traded derivatives markets. Over-the-counter derivatives on jet fuel are very

illiquid which makes them rather expensive and not available in quantities sufficient to

hedge all of an airlines’ jet fuel consumption. Exchange-traded derivatives are not

available in the United States for jet fuel, so airlines must use futures contracts on

commodities that are highly correlated with jet fuel, such as crude and heating oil. As

such, airlines employ a variety of strategies ranging from not hedging to fully hedging

using a combination of products. Domestic airlines have a variety of hedging strategies

available to them. These include using both over-the-counter and exchange-traded

derivatives or remaining unhedged. Options, including collars and swaps are the

5

primary derivatives used by airlines. Many airlines, including southwest, stated that they

prefer over-the-counter derivatives (OTC) to exchange traded futures because they were

more customizable. OTC derivatives are traded directly between the airlines and

investment Banks, and as such have counterparty risk that must be considered.

Therefore, airlines like Southwest prefer to trade with three or four different banks to

diversify this risk and also to get the best pricing possible (ibid). Southwest Airlines

evidently kept their ears close to the ground by going in for very high levels of futures

before Iraq and Desert Storm drove oil prices upwards. The Airline went in for even

more hedging in 2004, 2005 and early 2006 in anticipation of oil Prices surging to

unprecedented levels.

TO HEDGE OR NOT TO HEDGE

Being unhedged is the ultimate short position; this infers we are constantly expecting the

fuel prices to go down which is an ultimate utopian scenario. Although airlines

sometimes lose money hedging, overall those that hedge have a 5% to 10% better

financial performance than those that don’t. Hedged airlines can make investments in

their operations and equipment; make other important decisions that positively affect

their firm's overall value. Hedging is about having an insurance policy against prices

rising. A position that is not hedged i.e., the holder of a naked position has taken no step

to reduce the risk inherent to the position.

The risk offsetting investments in a hedging strategy will not experience price changes

in entirely equal proportions. This imperfect correlation between the two investments

creates the potential for excess gains or losses in a hedging strategy, thus adding risk to

the position. This is known as basis risk. Basis in a hedging situation is defined as the

difference between the spot price of the asset being hedged and the futures price of the

contract used. The basis risk arises from the hedger’s uncertainty associated to the basis

at the expiration of the hedge.

Price risk is the biggest risk faced by all investors. Although price risk specific to a stock

can be minimized through diversification, market risk cannot be diversified away. Price

risk, while unavoidable, can be mitigated through the use of hedging techniques. Price

6

risk also depends on the volatility of the securities held within a portfolio. For example,

an investor who only holds a handful of junior mining companies in his or her portfolio

may be exposed to a greater degree of price risk than an investor with a well-diversified

portfolio of blue-chip stocks. Investors can use a number of tools and techniques to

hedge price risk, ranging from relatively conservative decisions such as buying put

options, to more aggressive strategies including short-selling and inverse ETFs.

SFAS 133, the standard for financial reporting of derivatives and hedging transactions,

was adopted in 1998 by the Financial Accounting Standards Board to resolve

inconsistent previous reporting standards and practices. It went into effect at most U.S.

companies at the beginning of 2001. It was issued to make a company’s exposure to its

derivative positions more apparent. It requires changes in derivatives’ fair value to be

recorded in the income statement or in a component of equity known as other

comprehensive income. The FAS 133 requirement in order to make the hedge more

effective has to consider both historical performance and anticipated future performance.

It has given broad guidelines regarding the “80-125” rule or the dollar-offset method and

the correlation method.

In the “80-125” rule, a hedge is deemed effective if the ratio of the change in the value

of the derivative to the change in the value of the hedged item falls between 80% and

125%. In the correlation method, a hedge is deemed effective if correlation between the

value of the hedged item and the derivative is high; the R-squared of the regression of

this relation is around 80% and the slope of the regression line should be close to 1.

Contango and Normal Backwardation

Patterns over time have established that a futures market is normal if futures prices are

higher at longer maturities and inverted if futures prices are lower at distant maturities.

• As we approach contract maturity (we might be long or short on the futures

contract), the futures price must converge toward the spot price. The difference is

called the basis. That's because, on the maturity date, the futures price must equal

the spot price. If they don't converge on maturity, anybody could make free

money with an easy arbitrage.

7

• The most rational futures price is the expected future spot price. For example, if

you and your counterparty both foresee that the spot price in crude oil would be

$80 in one year, you would rationally settle on an $80 futures price. Anything

above or below would represent a loss for one of you!

Now we can define contango and normal backwardation. Suppose we entered into a

December 2013 futures contract, today, for $100. One month later the same December

2013 future contract could still be $100, but it might also increase to $110 (this implies

normal backwardation) or it might decrease to $90 (implies contango).

• Contango is when the futures price is above the expected future spot price.

Because the futures price must converge on the expected future spot price,

contango implies that futures prices are falling over time as new information

brings them into line with the expected future spot price.

• Normal backwardation is when the futures price is below the expected future

spot price. This is desirable for speculators who are "net long" in their positions:

they want the futures price to increase. So, normal backwardation is when the

futures prices are increasing.

Let’s consider a near month futures contract for light sweet crude oil as the August

2013 contract, which settled on July 18 at $108.22 per barrel. But looking out 11 months

into the future to the July 2014 contract, we find that it closed at just $95.56. That is a

huge difference, and it says that oil futures traders are not willing to bet on the current

month's high price continuing into the future. In other words, it is a temporary anomaly.

Such anomalies can contain important information. This week's chart looks at the raw

price spread between the near month contract and the contract that is 11 months out.

When the near month contract is priced lower than the out months, that condition is

known as "contango". In commodities like gold and silver, contango is the norm since

the available supply consists of not just the mining production but also all of the bullion

sitting in warehouses and safes around the world.

But because oil is so much more expensive to store than gold is, there is not the same

sort of standing inventory available to remediate temporary supply-demand disruptions.

8

So oil prices can move to very large conditions of contango, or to the opposite condition

known as "backwardation" like we are seeing right now.

CASE BACKGROUND

Scott Topping, the Director of Corporate Finance for Southwest Airlines 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.

After labor, jet fuel was the second largest operating expense for airlines. If airlines

could 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 knew 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.

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. 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.)

9

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 un-hedged.

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. Do nothing.

2. Hedge using a plain vanilla jet fuel or heating oil swap.

3. Hedging using options.

4. Hedge using a zero-cost collar strategy.

5. Hedge using a crude oil or heating oil futures contract.

SOUTH WEST AIRLINES FUEL HEDGING ANALYSIS Table 1 gives the Fuel Cost per Gallon for the past 7 years. The fuel price rise in year

1999 & 2000 wreaked havoc and had increased the total fuel costs to the airline by a

considerable amount. The airline has no control over the volatility of fuel prices and

hence makes it difficult to control fuel costs and total costs.

Year Fuel Cost per Gallon in $

2000 0.7869

1999 0.53

1998 0.4567

1997 0.6246

1996 0.6547

1995 0.5522

1994 0.5392

Table 1

10

In order to offset fuel price rise and control fuel costs, keeping it constant to a level

acceptable, Southwest Airlines have to choose the best option among the following

alternatives based on two possible scenarios: 1) Fuel price decline and 2) Fuel price rise.

Table 2 below gives the list of variables and prices considered or assumed in each

scenario and for the hedging strategies.

NOTE: All Fuel and Total costs are indicated in $ millions.

Table 2

1) Hedging Using a Plain Vanilla Jet Fuel Swap- This alternative is simple and a

basic form of swap. A certain amount of floating price is exchanged for a fixed

price over a certain period of time. 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 arranged in the OTC market. Jet Fuel is not a liquid enough market to

warrant exchange-traded contracts unlike the Crude Oil and Heating oil, which have

active liquid markets (NYMEX and IPE). The contract size in this case is 1 million

gallons.

Scenario 1 Scenario 2Jet fuel spot price= 0.393 $/gallon 1.1960 $/gallonHeating oil spot price= 0.388 $/gallon 1.1860 $/gallonCrude oil spot price= 14.10 $/barrel 40.00 $/barrelHedging %= 50%6/11/01 spot price(Jet Fuel)= 0.7945 $/gallonFixed Rate(Jet Fuel Swap) 0.7600 $/gallonCall Option Premium 1.8000 $/contractJet Fuel Swap Contract Size 1.00 MM gal6/11/01 spot price(Heating Oil)= 0.7002 $/gallonFixed Rate(Heating Oil Swap) 0.73 $/gallonHeating oil Contract Size 0.042 MM gal6/11/01 Futures Price (Crude Oil) 26.39 $/barrel # ContractsContract Size 0.001 MM barrelFuel usage(Jet Fuel)= 1,100 MM gal 1,100

100% Hedging(Jet Fuel)= 1,100 MM gal 1,100 50% Hedging(Jet Fuel)= 550 MM gal 550

Fuel usage(Crude)= 26.1905 MM Barrel 26,190.48

100% Hedging(Crude)= 26.1905 MM Barrel 26,190.48 50% Hedging(Crude)= 13.0952 MM Barrel 13,095.24 Fuel usage(HO)= 1,100 MM gal 26,190.48 100% Hedging(HO)= 1,100 MM gal 26,190.48 50% Hedging(HO)= 550 MM gal 13,095.24

11

During the life of the contract, the airline buys jet fuel from the market as usual but

the swap contract makes up for the difference when fuel prices rise and removes

differences when fuel prices decline. This would result for the airline to maintain a

fixed fuel expense for the period covered. The fixed rate payment is set based on

the market conditions when the swap contract was initiated. In this case, the fixed

rate is $0.76 per gallon of Jet Fuel. The floating price is commonly based on Platt’s

New York Harbor jet fuel price and is calculated monthly using daily prices for the

month. However in this case, we will calculate the monthly floating rate based on

the beginning Spot Price of Jet fuel and the estimated spot price at end of year.

Based on the amount of fuel hedged, and the possible scenario, the airline can either

make a profit from the swap or a loss from its swap. The two fuel hedging ratios

analyzed in this case are the full hedge and 50% fuel hedge. The airline fuel usage

is estimated to be 1100 million gallons. Refer to Table 3A and 3B–Scenario 1 and

Scenario 2.

Table 3A-Fuel price decline: Jet Fuel Swap

Hedge using a plain vanilla jet fuel swap-FullScenario 1-JET FUEL

100% Hedge 50% HedgeSl. No Date Fixed Pmt Floating Pmt Gain(Loss) Gain(Loss)

1 Jul-01 0.76 0.7610 0.0955 0.0477 2 Aug-01 0.76 0.7276 (2.9715) (1.4858)3 Sep-01 0.76 0.6941 (6.0385) (3.0193)4 Oct-01 0.76 0.6607 (9.1056) (4.5528)5 Nov-01 0.76 0.6272 (12.1726) (6.0863)6 Dec-01 0.76 0.5938 (15.2396) (7.6198)7 Jan-02 0.76 0.5603 (18.3066) (9.1533)8 Feb-02 0.76 0.5268 (21.3736) (10.6868)9 Mar-02 0.76 0.4934 (24.4406) (12.2203)

10 Apr-02 0.76 0.4599 (27.5076) (13.7538)11 May-02 0.76 0.4265 (30.5747) (15.2873)

12 Jun-02 0.76 0.3930 (33.6417) (16.8208)

(201.2771)

(100.6385)

Total Gain(Loss)-100% Hedge

Monthly Settlements


12

Table 3B-Fuel price rise: Jet Fuel Swap

The jet fuel spot price on June 11th, 2001 was $0.7945 per gallon and the estimated

spot price (June 2002), for scenario 1 is $ 0.393 per gallon. The estimated spot price

(June 2002), for scenario 2 is $ 1.196 per gallon.

2) Hedging Using a Plain Vanilla Heating Oil Swap- This is similar to the jet fuel

swap in its operation, but this option is used with the NYMEX New York Heating

Oil Calendar Swap. The swap contract is 42000 gallons, the same size as the

NYMEX heating oil futures contract. The swap is in Heating Oil futures prices and

the rise or decline of these prices would act as an offset to the Fuel price volatility

since the correlation between Jet fuel prices and heating oil prices are high, as both

are byproducts of crude oil and assuming the basis has not changed. The loss or gain

in the futures contract will be offset by the lower cash price of jet fuel or by higher

cash price of jet fuel respectively. As a result, the airline effectively pays a fixed

price for jet fuel.

The fixed rate payment is set based on the market conditions when the swap contract

was initiated. In this case, the fixed rate is $0.73 per gallon of Heating Oil. The

Hedge using a plain vanilla jet fuel swap-FullScenario 2-JET FUEL 100%

Hedge 50% HedgeSl. No Date Fixed Pmt Floating Pmt Gain(Loss) Gain(Loss)

1 Jul-01 0.7600 0.8280 6.2295 3.11482 Aug-01 0.7600 0.8614 9.2965 4.64833 Sep-01 0.7600 0.8949 12.3635 6.18184 Oct-01 0.7600 0.9283 15.4306 7.71535 Nov-01 0.7600 0.9618 18.4976 9.24886 Dec-01 0.7600 0.9953 21.5646 10.78237 Jan-02 0.7600 1.0287 24.6316 12.31588 Feb-02 0.7600 1.0622 27.6986 13.84939 Mar-02 0.7600 1.0956 30.7656 15.3828

10 Apr-02 0.7600 1.1291 33.8326 16.916311 May-02 0.7600 1.1625 36.8997 18.4498

12 Jun-02 0.7600 1.1960 39.9667 19.9833

277.1771

138.5885

Monthly Settlements



13

floating price is commonly based on monthly heating oil Futures prices. However in

this case, we will calculate the monthly floating rate based on the beginning Spot

Price of Heating Oil and the estimated spot price at end of year. The heating oil

future price on June 11th, 2001 was $0.7002 per gallon and the estimated spot price

(June 2002), for scenario 1 is $ 0.388 per gallon. The estimated spot price (June

2002), for scenario 2 is $ 1.186 per gallon.

Based on the amount of fuel hedged, and the possible scenario, the airline can either

make a profit from the swap or a loss from the swap. The two fuel hedging ratios

analyzed in this case are the full hedge and 50% fuel hedge. The airline fuel usage is

estimated to be 1100 million gallons. Refer to Table 3C and 3D–Scenario 1 and

Scenario 2.

Table 3C-Heating Oil Price decline: Heating Oil Swap

Hedge using a plain vanilla heating oil swap-Full

Scenario 1-Heating Oil

100% Hedge 50% Hedge

Sl. No Date Fixed Pmt Floating Pmt Gain(Loss) Gain(Loss)1 Jul-01 0.73 0.6742 (5.1165) (2.5583)2 Aug-01 0.73 0.6482 (7.5014) (3.7507)3 Sep-01 0.73 0.6222 (9.8863) (4.9431)4 Oct-01 0.73 0.5961 (12.2711) (6.1356)5 Nov-01 0.73 0.5701 (14.6560) (7.3280)6 Dec-01 0.73 0.5441 (17.0408) (8.5204)7 Jan-02 0.73 0.5181 (19.4257) (9.7128)8 Feb-02 0.73 0.4921 (21.8106) (10.9053)9 Mar-02 0.73 0.4661 (24.1954) (12.0977)

10 Apr-02 0.73 0.4400 (26.5803) (13.2901)11 May-02 0.73 0.4140 (28.9651) (14.4826)12 Jun-02 0.73 0.3880 (31.3500) (15.6750)

(218.7992)(109.3996)

Monthly Settlements

Total Gain(Loss)-50% HedgeTotal Gain(Loss)-100% Hedge

14

Table 3D-Heating Oil Price rise: Heating Oil Swap

3) Hedging using a Crude Oil Call option- The call option gives the right to buy a

particular asset at a predetermined fixed price (strike price) at a time up until the

maturity date. In case of price rise, the call option can be exercised and the option

would make a profit, and would offset the loss from the actual price rise of the

commodity. In the case of a price decline, the call option may not be exercised,

giving it an advantage over other hedging strategies and hence would benefit

considerably from the price decline. However, the call option requires a premium to

be paid up front. This would sometimes act as a disadvantage to the airlines that

need to pay the cash upfront unlike other strategies.

In this alternative, the call option on crude oil futures is chosen. The profits or losses

made by this strategy would depend on the price volatility of crude oil in the market.

The call option with a premium of $1.80 per contract, and a strike price of $28 is

bought. The future price for crude oil (June 2001) is $26.39. The expected spot price

as per scenario 1 and scenario 2 is assumed to be $14.10 and $40. The contract size

for Crude Oil futures is 1000 barrels and the fuel usage in terms of barrel is 26.19

million barrels, where 1 barrel is 42 gallons of oil. Based on the amount of fuel

hedged, and the possible scenario, the airline can either make a profit or a loss from


Scenario 2-Heating Oil100%

Hedge 50% Hedge

Sl. No Date Fixed Pmt Floating Pmt Gain(Loss) Gain(Loss)1 Jul-01 0.7300 0.7407 0.9793 0.48972 Aug-01 0.7300 0.7812 4.6903 2.34513 Sep-01 0.7300 0.8217 8.4013 4.20064 Oct-01 0.7300 0.8621 12.1122 6.05615 Nov-01 0.7300 0.9026 15.8232 7.91166 Dec-01 0.7300 0.9431 19.5342 9.76717 Jan-02 0.7300 0.9836 23.2451 11.62268 Feb-02 0.7300 1.0241 26.9561 13.47819 Mar-02 0.7300 1.0646 30.6671 15.3335

10 Apr-02 0.7300 1.1050 34.3781 17.189011 May-02 0.7300 1.1455 38.0890 19.044512 Jun-02 0.7300 1.1860 41.8000 20.9000

256.6758128.3379

Monthly Settlements

Total Gain(Loss)-100% HedgeTotal Gain(Loss)-50% Hedge

15

its options. The two fuel hedging ratios analyzed in this case are the full hedge and

50% fuel hedge.

The profits or losses made by this strategy will offset the profit or loss made by the

jet fuel price. An important issue to consider here is the Basis Risk associated with

Crude Oil. Crude Oil has a higher basis risk than Heating Oil. After refining crude

oil, the products obtained are Heating Oil, Diesel Fuel, Jet Kerosene or Fuel. Refer

to Table 4A and 4B–Scenario 1 and Scenario 2.

Table 4A-Crude Oil Price decline: Crude Call Option

Table 4B-Crude Oil Price rise: Crude Call Option

4) Hedging using Zero Cost Crude Oil Collar- This is a combination of a call option

and a put option. The airline will buy the call option and sell the put option. It is a

zero cost collar because the premiums of both the options are the same. The

Scenario 1- OPTION 3--Crude OilCall Strike Price(Jun 02) 28.00$ Premium 1.80$ Spot Price 14.10$

Payoff -$ Profit(Loss)-100% Hedge -47.14 $

Payoff -$ Profit(Loss)-50% Hedge -23.57 $

Call Option Not exercised

Strike Price(Jun 02) 28.00$ Premium 1.80$ Spot Price 40.00$

Payoff 314.29$ Profit(Loss)-100% Hedge 267.14$

Payoff 157.14$ Profit(Loss)-50% Hedge 133.57$

Scenario 2-OPTION 3--Crude Oil

16

premium received from the put option will be used to pay the premium of the call

option. This is beneficial to those that cannot pay high upfront costs. In this case, the

options on crude oil futures are chosen.

In this alternative, the call option with a premium of $1.80 per contract, and a strike

price of $28 is bought. A put option with the same premium of $1.80 per contract

and a strike price of $22.50 is sold. The future price for crude oil (June 2001) is

$26.39. The expected spot price as per scenario 1 and scenario 2 is assumed to be

$14.10 and $40. The contract size for Crude Oil futures is 1000 barrels and the fuel

usage in terms of barrel is 26.19 million barrels, where 1 barrel is 42 gallons of oil.

The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel

hedge. In scenario 1, when the crude oil price declines, the call option will not be

exercised by the airline but the buyer of the put option will exercise the put option

and the airline would pay the buyer of the put option the difference of the strike price

and the spot price at year end. In scenario 2, when the crude oil price rises, the

airline would exercise the call option and would benefit from the difference of the

spot price at year-end and the strike price. The buyer will not exercise the put option.

The profits or losses made by this strategy will offset the profit or loss made by the

jet fuel price. Like in the previous strategy, the basis risk is pretty high with Crude

Oil Futures.

Table 5A-Crude Oil Price decline: Crude Zero Cost Collar Option

Call Strike Price 28.00$ Put Strike Price 22.50$ Premium(Call&Put) 1.80$ Crude Spot Price 14.10$ Payoff (220.0000) Profit (Loss)-Full Hedge (220.0000)

Payoff (110.0000) Profit (Loss)-50% Hedge (110.0000)

Scenario 1- OPTION 4-Crude Oil Collar

Buyer of Put option exercises the Put option and SWA (buyerof call) will not exercise the

call option

17

Table 5B-Crude Oil Price rise: Crude Zero Cost Collar Option

5) Hedging using a Heating Oil Futures contract- 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 airline, which is the buyer, has a long position to

offset against the fuel price rise. There is a daily settlement to minimize the chance

of default. In this case, in order to hedge, the airline buys heating oil futures contract

from the NYMEX. The heating oil Future Price on June 11th, 2001 was $0.7002 per

gallon and the estimated spot price (June 2002), for scenario 1 is $ 0.388 per gallon.

The estimated spot price (June 2002), for scenario 2 is $ 1.186 per gallon. In

scenario 1, due to the price decline in Heating Oil, the loss from the hedge is the

difference between the future price and the spot price of $ 0.388 per gallon. In

scenario 2, due to the price rise in Heating Oil, the profit from the hedge is the

difference between the future price and the spot price of $ 1.186 per gallon. The

contract size is 42000 gallons and the amount of fuel used is 1100 million gallons.

The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel

hedge. The profits or losses made by this strategy will offset the profit or loss made

by the jet fuel price. In scenario 1, the basis loss is 8.93 cents/gallon and in scenario

2, there is a basis loss of 8 cents per gallon.

Call Strike Price 28.00$ Put Strike Price 22.50$ Premium(Call&Put) 1.80$ Crude Spot Price 40.00$ Payoff 314.2857 Profit (Loss)-Full Hedge 314.2857

Payoff 157.1429 Profit (Loss)-50% Hedge 157.1429

Scenario 2- OPTION 4-Crude Oil Collar

Buyer of Put option does not exercise the Put option and SWA (buyer of call)

will exercise the call option

18

Table 6A-Heating Oil Price decline: Heating Oil Futures Contract

Table 6B-Heating Oil Price rise: Heating Oil Futures Contract

6) Hedging using a Crude Oil Futures contract- This is similar to the Heating Oil

Futures Contract. The Crude Oil futures contract traded from NYMEX is a long

position for the airline. The Crude oil Future Price on June 11th, 2001 was $26.39 per

gallon and the estimated spot price (June 2002), for scenario 1 is $ 14.10 per gallon.

The estimated spot price (June 2002), for scenario 2 is $ 40 per gallon. In scenario 1,

due to the price decline in Crude Oil, the loss from the hedge is the difference

between the future price and the spot price of $ 14.10 per gallon. In scenario 2, due

to the price rise in Crude Oil, the profit from the hedge is the difference between the

future price and the spot price of $ 40 per gallon. The contract size is 1000 barrels

and the amount of fuel used is 26.19 million barrels. The two fuel hedging ratios

analyzed in this case are the full hedge and 50% fuel hedge. The profits or losses

made by this strategy will offset the profit or loss made by the jet fuel price. In

Scenario 1-Hedge using a heating oil futures contract

Future Price(6/11/01) 0.7002$ Jun-01 0.0943Spot Price 0.388$ Jun-02 0.0050

0.0893 Gain(Loss)-100% Hedge (343.42)$ Gain(Loss)-50% Hedge (171.71)$

Basis Risk

Scenario 2-Hedge using a heating oil futures contract

Future Price(6/11/01) 0.7002$ 0.0943Spot Price 1.186$ 0.0100

0.08 Gain(Loss)-100% Hedge 534.38$ Gain(Loss)-50% Hedge 267.19$

Basis Risk

Jun-02Jun-01

19

scenario 1, the basis gain is $11.89 per gallon and in scenario 2, there is a basis loss

of $13.21 per gallon.

Table 7A-Crude Oil Price decline: Crude Oil Futures Contract

Table 7B-Crude Oil Price rise: Crude Oil Futures Contract

Overall Analysis:

Coming to the overall analysis of the Hedging strategies, Table 8 gives a comprehensive

list of all the Fuel Costs, Hedging Costs and Net Fuel Costs or Total Fuel Costs incurred

by the airline when all the discussed strategies are employed. The costs are shown in $

millions. The two main objectives of Southwest Airlines in fuel hedging are to

maintain fuel expenses at a constant level or minimum variance and to minimize the

fuel costs.

In order to achieve its objectives, the airline considers the probability of each scenario to

occur exactly the same i.e., 50%. Hence the minimum fuel costs are computed based on

Scenario 1-Hedge using a crude oil futures contract

Spot Price 14.100$ Gain(Loss)-100% Hedge (321.8810)$ June-01 -25.60Gain(Loss)-50% Hedge (160.940)$ Jun-02 -13.71

-11.89

Future Price(6/11/01) 26.39$ Basis Risk

Scenario 2-Hedge using a crude oil futures contract

Spot Price 40.000$ Gain(Loss)-100% Hedge 356.45$ June-01 (25.596)$ Gain(Loss)-50% Hedge 178.2$ June-02 (38.804)$

13.21$

26.39 Basis RiskFuture Price(6/11/01)

20

the average of the fuel costs in Scenario 1 and Scenario 2. The minimum fuel costs are

shown in the column highlighted by green.

It is important to note that when no hedging takes place, there is no offset of risk or

protection against fuel rise. In this case, the fuel costs is the total fuel cost incurred by

the airline. In scenario 1, the total fuel cost is $432.3 million and $1315.6 million in

scenario 2. The average of these two costs ($873.95 million) is used as benchmark to

compute the variance of the fuel costs in each strategy. The column titled Var1

computes the difference of Total Fuel Costs in scenario 1 and the benchmark cost of

$873.95 million. The column titled Var2 computes the difference of Total Fuel Costs in

scenario 2 and the benchmark cost of $873.95 million. The Variance of Fuel costs as

shown in the column highlighted by red, are the average of Var1 and Var2 as there is an

equal probability of either scenario to occur.

Table 8

Description 1 2 3 4

OptionFuel Costs

Hedge Costs (Profit)

Total Fuel Costs

Fuel Costs


Total Fuel Costs

Average Fuel Costs Var1 Var2 Variance

1 Do nothing 432.3 0.0 432.3 1315.6 0.0 1315.6 873.95 441.65 441.65 441.652a-100% Hedge using a plain vanilla jet fuel swap-Full 432.3 201.3 633.6 1315.6 (277.2) 1038.4 836.00 240.37 164.47 202.422a-50% Hedge using a plain vanilla jet fuel swap-50% 432.3 100.6 532.9 1315.6 (138.6) 1177.0 854.98 341.01 303.06 322.04

2b-100% Hedge using a plain vanilla heating oil swap-Full 432.3 218.8 651.1 1315.6 (256.7) 1058.9 855.01 222.85 184.97 203.912b-50% Hedge using a plain vanilla heating oil swap-50% 432.3 109.4 541.7 1315.6 (128.3) 1187.3 864.48 332.25 313.31 322.783-100% Hedging using options-Full 432.3 47.1 479.4 1315.6 (267.1) 1048.5 763.95 394.51 174.51 284.513-50% Hedging using options-50% 432.3 23.6 455.9 1315.6 (133.6) 1182.0 818.95 418.08 308.08 363.08

4-100% Hedge using a zero-cost collar strategy-Full 432.3 220.0 652.3 1315.6 (314.3) 1001.3 826.81 221.65 127.36 174.514-50% Hedge using a zero-cost collar strategy-50% 432.3 110.0 542.3 1315.6 (157.1) 1158.5 850.38 331.65 284.51 308.08

5a-100% Hedge using a crude oil futures contract-Full 432.3 321.9 754.2 1315.6 (356.5) 959.1 856.66 119.77 85.20 102.485a-50% Hedge using a crude oil futures contract-50% 432.3 160.9 593.2 1315.6 (178.2) 1137.4 865.31 280.71 263.42 272.07

5b-100% Hedge using a heating oil futures contract-Full 432.3 343.4 775.7 1315.6 (534.4) 781.2 778.47 98.23 92.73 95.485b-50% Heade using a heating oil futures contract-50% 432.3 171.7 604.0 1315.6 (267.2) 1048.4 826.21 269.94 174.46 222.20

Scenario 1 Scenario 2

21

Southwest Airlines has to choose the best hedging strategy that would have minimum

fuel variance and minimum fuel costs. As per basic analysis from Table 8, it appears

that the minimum fuel cost of $763.95 million is achieved from the Full Hedge –Call

Option strategy based on the annual fuel consumption of $1100 million gallons and the

minimum variance of $95.48 million is achieved from the Full Hedge- Heating Oil

Futures contract.

The below Figure 1 shows the Total costs incurred by the airline in scenario 1. It shows

the costs incurred by the Hedge strategies and the actual fuel costs. In this scenario, all

the hedge strategies have made a loss since, the price declines. Hence in this scenario,

the un-hedged strategy has the minimum fuel cost of $432.3 million.

Figure 2 shows the Total costs incurred by the airline in scenario 2. It shows the costs

incurred by the Hedge strategies and the actual fuel costs. In this scenario, all the hedge

strategies have made a profit since, the price rises. In this scenario, the 100% hedging

strategy of heating oil futures has the minimum fuel cost of $781.2 million.

Figure 1

0

100

200

300

400

500

600

700

800

900

($M

M)

Total Costs Scenario 1


Fuel Costs

22

Figure 2

Figures 3 shows the Total Fuel costs of each strategy in Scenario 1. The purple bars

show the total costs when hedged fully and the maroon bars show the total costs when

50% hedging takes place. As discussed earlier, the un-hedged strategy (1st purple bar)

has the minimum fuel cost.

Figure 3

-1000

-500

0

500

1000

1500 ($

MM

)

Total Costs Scenario 2

Fuel Costs


0

200

400

600

800

1000

1200

1400

1 2 3 4 5 6 7

Cos

ts ($

MM

)

Total Costs - Scenario 1

Full Hedge

50% Hedge

23

Figures 4 shows the Total Fuel costs of each strategy in Scenario 2. The purple bars

show the total costs when hedged fully and the maroon bars show the total costs when

50% hedging takes place. As discussed earlier, the 100% hedged strategy with Heating

Oil Futures contract has the minimum fuel cost.

Figure 4

Figure 5 combines Scenario 1 and 2 in one chart and shows the Net Cost or Total Fuel

costs incurred by the airline.

Figure 5

0

200

400

600

800

1000

1200

1400

1 2 3 4 5 6 7

Cos

ts ($

MM

)

Total Costs - Scenario 2

Full Hedge

50% Hedge

0 200 400 600 800

1000 1200 1400

Do Nothing

Hedge using a plain

vanilla jet fuel swap-Full

Hedge using a plain

vanilla heating

oil swap-Full

Hedging using

options-Full

Hedge using a zero-cost collar

strategy-Full

Hedge using a crude oil futures

contract-Full

Hedge using a heating

oil futures

contract-Full

Cos

ts ($

MM

)

Net Cost of Jet Fuel

Scenario 1 Full Hedge Scenario 2 Full Hedge Scenario 1 50% Hedge Scenario 2 50% Hedge

24

Figure 6

Figure 6 shows the Scenario variance of Fuel costs (Scenario 1 – Scenario 2) for all the

hedging strategies. The yellow bars are for the 100% hedged strategies. The purple bars

are for the 50% hedged strategies. This chart shows the variance between the fuel costs

in each scenario.

In order to consider a more comprehensive and effective analysis, the minimum fuel

costs and minimum variance considering equal probability of each scenario are

computed. Figure 7 shows the Average Fuel costs considering equal occurrence of

scenario 1 and 2. As stated earlier, the 100% hedging using call options have the

minimum fuel cost followed by the 100% hedge of heating oil futures.

-800 -700 -600 -500 -400 -300 -200 -100

0 Hedge using a plain vanilla jet fuel swap-Full


Hedging using options-Full

Hedge using a zero-cost collar

strategy-Full

Hedge using a crude oil futures

contract-Full

Hedge using a heating oil

futures contract-Full

Cos

ts ($

MM

) Scenario Costs Variance

Scenario 1 - Scen 2 Scenario 1 - Scen 2

25

Figure 7

Figure 8 shows the variance of fuel costs, considering equal occurrence of each

scenario. It can be seen that the minimum variance of $95.48 million is achieved by

using the 100% hedge –Heating oil futures contract. The maximum variance is by the

un-hedged or Do nothing option, as the fuel costs are not offset by any risk of price rise

or fall.

700.00 720.00 740.00 760.00 780.00 800.00 820.00 840.00 860.00 880.00 900.00

Average Fuel Costs

Average Fuel Costs

26

Figure 8

As per basic analysis, the minimum fuel cost of $763.95 million is achieved from the

Full Hedge –Call Option strategy based on the annual fuel consumption of $1100

million gallons and the minimum variance of $95.48 million is achieved from the

Full Hedge- Heating Oil Futures contract. Introduction of sensitivity analysis will

further strengthen and make the analysis and decision for Southwest Airlines more

effective and complete.

@Risk Sensitivity Analysis

Each of the hedging strategies and the un-hedged strategy was evaluated using the

@Risk software to find the various output scenarios and probabilities for a range of key

input drivers. For the purpose of this project, the following key drivers were considered

for the analysis (Refer Table 9):

0.00 50.00 100.00 150.00 200.00 250.00 300.00 350.00 400.00 450.00 500.00

Variance

Variance

27

• Fuel Usage (Jet Fuel): This is an important input for the analysis, as the fuel

consumption plays an important role in determining the total fuel costs incurred by

the Airline. The fuel consumption of an airline increases yearly as the airline keeps

growing and adds more aircraft to its fleet. Based on the past fuel consumption data

available for Southwest Airlines, the fuel consumption range for the year 2001-2002

was decided. The values for the Max. , Median (most likely) and Min. are 1100,1150

and 1200 million gallons respectively.

• Jet Fuel Spot Price (2001): Since the expected future spot price of Jet fuel is

factored in the analysis in each scenario (price rise and decline). The variance of the

current spot price will vary the expected future spot price of Jet Fuel. The spot price

of Jet fuel has been varied by 15%. The values for the Max., Median (most likely)

and Min. are 0.68, 0.7962 and 0.9140 dollars per gallon respectively.

• Heating Oil Spot Price (2001): Similarly, since the expected future spot price of

heating oil is factored in the analysis in each scenario (price rise and decline). The

variance of the current spot price will vary the expected future spot price of Heating

Oil. The spot price of Heating Oil has been varied by 15%. The values for the Max. ,

Median (most likely) and Min. are 0.5952, 0.7018 and 0.81 dollars per gallon

respectively.

• Crude Oil Spot Price (2001): Similarly, since the expected future spot price of

crude oil is factored in the analysis in each scenario (price rise and decline). The

variance of the current spot price will vary the expected future spot price of Crude

Oil. The spot price of Crude Oil has been varied by 15%. The values for the Max. ,

Median (most likely) and Min. are 22.4315, 26.39 and 30.3485 dollars per gallon

respectively.

• Call option premium: This input would have an impact on the hedging strategy

using Crude Call options. If spot price is less than the strike price, then the airline

will not exercise the call option but will pay the premium. If the spot price is greater

than the strike price then the airline will exercise the call option but will pay the

premium as a cost. The value of the premium cost can be a factor in the analysis

where hedging options are considered. The values for the Max. , Median (most

likely) and Min. are 1.0, 1.83 and 2.7 dollars per contract respectively.

28

Table 9-@ Risk Model Inputs

Model Output -@Risk Analysis

In this analysis, there are 26 outputs considered. 13 outputs corresponding to the

Average Fuel costs of each hedging strategy and 13 outputs corresponding to the

Variance of each hedging strategy. Each output will consider an equal occurrence of

Scenario 1 and Scenario 2.

Average Fuel Outputs:

• Do-Nothing or Un-hedged-Average Fuel Cost

• Full Hedge using a Plain Vanilla Jet-fuel Swap-Average Fuel Cost

• 50% Hedge using a Plain Vanilla Jet-fuel Swap-Average Fuel Cost

• Full Hedge using a Plain Vanilla Heating Oil Swap-Average Fuel Cost

• 50% Hedge using a Plain Vanilla Heating Oil Swap-Average Fuel Cost

• Full Hedge using a Call option on Crude Futures -Average Fuel Cost

29

• 50% Hedge using a Call option on Crude Futures -Average Fuel Cost

• Full Hedge using a Zero cost collar option on Crude Futures -Average Fuel Cost.

• 50% Hedge using a Zero cost collar option on Crude Futures -Average Fuel

Cost.

• Full Hedge using a Crude Oil Futures Contract-Average Fuel Cost.

• 50% Hedge using a Crude Oil Futures Contract-Average Fuel Cost.

• Full Hedge using a Heating Oil Futures Contract-Average Fuel Cost.

• 50% Hedge using a Heating Oil Futures Contract-Average Fuel Cost.

Variance Outputs

• Do-Nothing or Un-hedged-Variance.

• Full Hedge using a Plain Vanilla Jet-fuel Swap- Variance.

• 50% Hedge using a Plain Vanilla Jet-fuel Swap- Variance.

• Full Hedge using a Plain Vanilla Heating Oil Swap- Variance.

• 50% Hedge using a Plain Vanilla Heating Oil Swap- Variance.

• Full Hedge using a Call option on Crude Futures –Variance.

• 50% Hedge using a Call option on Crude Futures – Variance.

• Full Hedge using a Zero cost collar option on Crude Futures – Variance.

• 50% Hedge using a Zero cost collar option on Crude Futures – Variance.

• Full Hedge using a Crude Oil Futures Contract- Variance.

• 50% Hedge using a Crude Oil Futures Contract- Variance.

• Full Hedge using a Heating Oil Futures Contract- Variance.

• 50% Hedge using a Heating Oil Futures Contract- Variance.

30

Target Level 1 Target Level 2

Target-Fuel Cost Variance (SWA)-2002 118.7024149 129.4935436

Estimated-Fuel Cost per Gallon (SWA)-2002 $ 0.76

Target-Total Fuel Cost (SWA)-2002 $836.00

Table 10-Target Values for Fuel hedging

The target levels (Table 10) for the fuel cost and variance to be achieved by each of the

strategies is decided based on the past fuel cost data mentioned in Table 1. Based on the

annual fuel consumption data of 1100 million gallons and estimated jet fuel price of

$0.76 per gallon, the target average fuel cost is set at $836 million. Therefore any

strategy having the highest amount of probability below the target value of $836 million

is a good strategy for the airline.

The 1st target level for variance is set at a price of $118.70 million based on the standard

deviation of previous annual fuel prices (Table 1) and fuel consumption of 1100 million

gallons. The 2nd target level for variance is set at a price of $129.49 million based on the

standard deviation of previous annual fuel prices (Table 1) and fuel consumption of

1200 million gallons. Therefore any strategy having the highest amount of variance

probability below Target level 2 is considered very good. If probability of strategy is

below Target level 1, then the strategy is considered extremely good in terms of keeping

the fuel constant.

Southwest Airlines would require a hedging strategy that has a very high amount of

probability indicating minimum variance and minimum fuel.

The following outputs- Average fuel costs show the density probability distribution

diagram and the key inputs with the regression coefficients that impact the output the

most.

31

1. Do-Nothing or Un-hedged-Average Fuel Cost

Figure 9

Figure 9 shows that there is a probability of only 9% that the average fuel cost would

reach below the target level of $836 million.

2. Full Hedge using a Plain Vanilla Jet-fuel Swap-Average Fuel Cost

Figure 10

32

Figure 10 shows that there is 0% probability that the average fuel cost would reach

below the target level of $836 million. Figure 11 shows that the only input, which

impacts in the Average Fuel price, is the fuel usage or fuel consumption. It has a very

high positive correlation of 1.00.

Figure 11

Regression and Rank Information for Hedge using a plain vanilla jet fuel swap-‐Full / Average Fuel Costs Rank Name Regr Corr 1 Fuel usage (Jet Fuel)= / Scenario 1 1.000 1.000 2 6/11/01 spot price (Jet Fuel)= /

Scenario 1 0.000 -‐0.004017771

Figure 12

33

3. 50% Hedge using a Plain Vanilla Jet-fuel Swap-Average Fuel Cost

Figure 13

Figure 13 shows that there is only about 2% probability that the average fuel cost would

reach below the target level of $836 million. Figure 14 displays that the Spot price of Jet

fuel and the fuel usage input impacts the output considerably. The jet fuel spot price and

fuel usage input has a very high positive correlation of 0.86 and 0.48 respectively.

Figure 14

34

Regression and Rank Information for Hedge using a plain vanilla jet fuel swap-‐50% / Average Fuel Costs

Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.867 0.862 2 Fuel usage (Jet Fuel)= / Scenario 1 0.501 0.477

Figure 15

4. Full Hedge using a Plain Vanilla Heating Oil Swap-Average Fuel Cost

Figure 16

35

Figure 16 shows that there is about 23% probability that the average fuel cost would

reach below the target level of $836 million. Figure 17 displays that the Spot price of

Jet fuel, spot price of Heating oil and the fuel usage input impacts the output. The jet

fuel spot price and fuel usage input has a positive correlation of 0.71 and 0.2

respectively, where as the spot price of Heating oil has a negative correlation of 0.64.

The jet fuel increases the actual fuel costs whereas the heating oil makes a profit from

the hedge costs, thereby having a negative correlation with the output.

Figure 17

Regression and Rank Information for Hedge using a plain vanilla heating oil swap-‐Full / Average Fuel Costs Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.723 0.707 2 6/11/01 spot price (Heating Oil)= / Scenario 1 -‐0.664 -‐0.644 3 Fuel usage (Jet Fuel)= / Scenario 1 0.209 0.196

Figure 18

36

5. 50% Hedge using a Plain Vanilla Heating Oil Swap-Average Fuel Cost

Figure 19



Jet fuel, spot price of Heating oil and the fuel usage input impacts the output.

The jet fuel spot price and fuel usage input has a positive correlation of 0.88 and 0.24

respectively, where as the spot price of Heating oil has a negative correlation of 0.37.

The jet fuel increases the actual fuel costs whereas the heating oil makes a profit from

the hedge costs, thereby having a negative correlation with the output.

37

Figure 20

Regression and Rank Information for Hedge using a plain vanilla heating oil swap-‐50% / Average Fuel Costs

Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.881 0.876 2 6/11/01 spot price (Heating Oil)= / Scenario 1 -‐0.404 -‐0.378 3 Fuel usage (Jet Fuel)= / Scenario 1 0.257 0.240

Figure 21

38

6. Full Hedge using a Call option on Crude Futures -Average Fuel Cost

Figure 22


reach below the target level of $836 million. This is a very good indication that the

strategy would ensure minimum fuel costs. Figure 23 displays that the Spot price of Jet

fuel, future spot price of crude oil, fuel usage and the call option premium impact the

output.

The jet fuel spot price, fuel usage input and call option premium has a positive

correlation of 0.88, 0.22 and 0.14 respectively, where as the futures spot price of Crude

oil has a negative correlation of 0.34. The jet fuel increases the actual fuel costs whereas

the crude oil makes a profit from the hedge costs, thereby having a negative correlation

with the output. The fuel usage and call option add to the total costs of the output.

39

Figure 23

Regression and Rank Information for Hedging using options-‐Full / Average Fuel Costs

Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.894 0.888

2 6/11/01 Futures Price (Crude Oil) / Scenario 1 -‐0.360 -‐0.335 3 Fuel usage (Jet Fuel)= / Scenario 1 0.232 0.217

4 Call Option Premium / Scenario 1 0.155 0.138

Figure 24

40

7. 50% Hedge using a Call option on Crude Futures -Average Fuel Cost

Figure 25



Jet fuel, future spot price of crude oil, fuel usage and the call option premium impact the

output.

Figure 26

41

The jet fuel spot price, fuel usage input and call option premium has a positive

correlation of 0.94, 0.24 and 0.067 respectively, where as the futures spot price of Crude

oil has a negative correlation of 0.172. The jet fuel increases the actual fuel costs

whereas the crude oil makes a profit from the hedge costs, thereby having a negative

correlation with the output. The call option has a very negligible impact to the total

costs.

Regression and Rank Information for Hedging using options-‐50% / Average Fuel Costs Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.945 0.942 2 Fuel usage (Jet Fuel)= / Scenario 1 0.262 0.244 3 6/11/01 Futures Price (Crude Oil) / Scenario 1 -‐0.190 -‐0.172 4 Call Option Premium / Scenario 1 0.082 0.067

Figure 27

8. Full Hedge using Zero-cost collar on Crude Futures -Average Fuel Cost.

Figure 28

42



Jet fuel, future spot price of crude oil, and fuel usage impact the output.

Figure 29


respectively, where as the futures spot price of Crude oil has a negative correlation of

0.592. The jet fuel increases the actual fuel costs whereas the crude oil makes a profit

from the hedge costs, thereby having a negative correlation with the output. The fuel

usage adds to the total costs of the output.

Regression and Rank Information for Hedge using a zero-‐cost collar strategy-‐Full / Average Fuel Costs Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.763 0.751 2 6/11/01 Futures Price (Crude Oil) / Scenario 1 -‐0.615 -‐0.592 3 Fuel usage (Jet Fuel)= / Scenario 1 0.214 0.202

Figure 30

43

9. 50% Hedge using a Zero cost collar option on Crude Futures -Average Fuel

Cost.

Figure 31



Jet fuel, future spot price of crude oil, and fuel usage impact the output.

Figure 32


respectively, where as the futures spot price of Crude oil has a negative correlation of

0.336. The jet fuel increases the actual fuel costs whereas the crude oil makes a profit

44

from the hedge costs, thereby having a negative correlation with the output. The fuel

usage adds to the total costs of the output.

Regression and Rank Information for Hedge using a zero-‐cost collar strategy-‐50% / Average Fuel Costs Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.899 0.894 2 6/11/01 Futures Price (Crude Oil) / Scenario 1 -‐0.362 -‐0.336 3 Fuel usage (Jet Fuel)= / Scenario 1 0.259 0.243

Figure 33

10. Full Hedge using a Crude Oil Futures Contract-Average Fuel Cost.

Figure 34

45



Jet fuel, and fuel usage impact the output.

Figure 35

Regression and Rank Information for Hedge using a crude oil futures contract-‐Full / Average Fuel Costs Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.961 0.960 2 Fuel usage (Jet Fuel)= / Scenario 1 0.279 0.259 3 6/11/01 Futures Price (Crude Oil) / Scenario 1 0.000 0.007182983

Figure 36


respectively, where as the futures spot price of Crude oil has a very negligible impact.

The jet fuel spot price increases the actual fuel costs whereas the fuel usage adds to the

total costs of the output.

46

11. 50% Hedge using a Crude Oil Futures Contract-Average Fuel Cost.

Figure 37



Jet fuel, and fuel usage impact the output.

Figure 38


respectively, where as the futures spot price of Crude oil has a very negligible impact.

47

The jet fuel spot price increases the actual fuel costs whereas the fuel usage adds to the

total costs of the output.

Regression and Rank Information for Hedge using a crude oil futures contract-‐50% / Average Fuel Costs Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.961 0.959 2 Fuel usage (Jet Fuel)= / Scenario 1 0.281 0.261 3 6/11/01 Futures Price (Crude Oil) / Scenario 1 0.000 0.007167339

Figure 39

12. Full Hedge using a Heating Oil Futures Contract-Average Fuel Cost.

Figure 40

48


reach below the target level of $836 million. This is a very good indication of hedging

strategy to be used for minimum fuel costs. Figure 41 displays that the Spot price of Jet

fuel, Spot price of Heating Oil and fuel usage impact the output.

Figure 41

The jet fuel spot price, heating oil spot price and fuel usage input have a positive

correlation of 0.88,0.391 and 0.217 respectively. The jet fuel spot price and the heating

oil spot price increases the actual fuel costs whereas the fuel usage adds to the total costs

of the output.

Regression and Rank Information for Hedge using a heating oil futures contract-‐Full / Average Fuel Costs Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.882 0.883 2 6/11/01 spot price (Heating Oil)= / Scenario 1 0.405 0.391 3 Fuel usage (Jet Fuel)= / Scenario 1 0.233 0.217

Figure 42

49

13. 50% Hedge using a Heating Oil Futures Contract-Average Fuel Cost.

Figure 43



Jet fuel, Spot price of Heating oil and fuel usage impact the output.

Figure 44

50

The jet fuel spot price, heating oil spot price and fuel usage input has a positive

correlation of 0.94,0.208 and 0.244 respectively. The jet fuel spot price and the heating

oil spot price increases the actual fuel costs whereas the fuel usage adds to the total costs

of the output.

Regression and Rank Information for Hedge using a heating oil futures contract-‐50% / Average Fuel Costs

Rank Name Regr Corr 1 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.940 0.940 2 Fuel usage (Jet Fuel)= / Scenario 1 0.263 0.244 3 6/11/01 spot price (Heating Oil)= / Scenario 1 0.216 0.208

Figure 45

Variance –Outputs: With the variance, most of the outputs have a probability of zero in

reaching Target Level 1 or Target Level 2. Hence only those outputs having a

probability of reaching the Target levels will be discussed below:

1. Full Hedge using a Crude Oil Futures Contract- Variance.

Figure 46

51

Figure 46 shows that there is 100% probability that this hedging strategy would reach

the target level 1 and level 2 of variance. Hence this strategy is very effective in

maintaining fuel costs constant or with minimum variance. Figure 47 shows that the

fuel usage has the biggest impact on the variance of the output as indicated by the

correlation of 1, whereas the other inputs such as spot price of Jet fuel and spot price of

Crude oil futures have a negligible effect.

Figure 47 Regression and Rank Information for Full Hedge-‐Crude Oil Futures-‐Variance

Rank Name Regr Corr 1 Fuel usage (Jet Fuel)= / Scenario 1 1.000 1.000

2 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.000 -‐0.004017771

3 6/11/01 Futures Price (Crude Oil) / Scenario 1 0.000 -‐0.001101022

Figure 48

52

2. Full Hedge using a Heating Oil Futures Contract- Variance.

Figure 49

Figure 49 shows that there is 87% and 76% probability that this hedging strategy would

reach the target level 2 and level 1 of variance. Hence this strategy is very effective in

maintaining fuel costs constant or with minimum variance. Figure 50 shows that the

spot price of Heating Oil futures has the biggest impact on the variance of the output as

indicated by the negative correlation of 0.997, whereas the other input i.e., Usage of jet

fuel has a negligible effect with a correlation of 0.068. The negative correlation of the

Heating oil spot price show that this input helps in limiting variance.

Figure 50

53

Regression and Rank Information for Full Hedge-‐Heating Oil Futures-‐Variance Rank Name Regr Corr 1 6/11/01 spot price (Heating Oil)= / Scenario 1 -‐0.996 -‐0.997 2 Fuel usage (Jet Fuel)= / Scenario 1 0.070 0.068 3 6/11/01 spot price (Jet Fuel)= / Scenario 1 0.000 -‐0.00762999

Figure 51

Summary of @Risk analysis.

• As per the analysis of the Outputs -Average Fuel Costs and Outputs- Variance, it

is clear that in order to achieve the objectives of Southwest Airlines, it is

necessary to have a strategy, which has a combination of both the minimum fuel

cost and minimum variance.

• The minimum fuel cost objective is achieved by having a strategy that has the

highest probability to reach below the target level of $836 million. There are two

strategies that have achieved this target with the highest amount of probability

than the others. They are the Full Hedge using a Call option on Crude Futures

and the Full Hedge using a Heating Oil Futures Contract.

• The minimum variance objective is achieved by having a strategy that has the

highest probability to reach below the target level 1 of $118.7 million and target

level 2 of 129.4 million. There are two strategies that have achieved this target

with the highest amount of probability than the others. They are the Full Hedge

using a Crude Oil Futures and the Full Hedge using a Heating Oil Futures

Contract.

• Since, the Full Hedge using a Heating Oil Futures contract strategy has a very

high amount of probability in achieving the Target levels of the objectives, it is

the preferred hedging strategy to achieve Southwest’s objectives.

54

Conclusion After carefully considering all the hedging strategies, in the primary and the sensitivity

analysis, it can be recommended that the best strategy, which can be used to maintain

constant and minimum fuel costs, is the Full Hedge Heating Oil Futures Contract. This

strategy also has a very low basis risk compared to the other strategies using Crude Oil.

It is therefore advised that Scott Topping utilizes this strategy for Southwest Airlines.

Current Outlook

Most of the major airlines are hedging fuel using jet fuel, gas oil and crude derivatives.

Few cover more than 12 months’ expected consumption, and it is rare to find more than

80% of future needs hedged beyond three months ahead. Crude oil provides more

liquidity and flexibility for hedging, but the spread between crude and jet aviation fuel

had tended to widen at times of market instability. Not many airlines report gains and

losses from fuel hedging activity, but many are now required to report the market value

of unexpired contracts on their balance sheets. There seems to be no reason to contradict

the economic fundamentals of hedging. A policy of permanent hedging of fuel costs

should leave expected long-run profits unchanged. If it damps out profit volatility, it

should do so in a way that the market would not value. Data suggests it may not damp

out volatility, after all. Oil prices and air travel demand cycles are correlated when oil

supply reductions drive GDP declines. But oil and travel are negatively correlated when

GDP demand surges drive oil price increases. So oil prices can be observed to either

increase or decrease airline profit cycles, depending on the time period sampled.

A fuel price hedge would create exceptional value is when an airline is on the edge of

bankruptcy. However, when on the verge of bankruptcy, an airline does not have the

liquidity to buy oil futures. On the other hand, foreign exchange hedges probably did

make sense, when airlines were state-supported. And variable levels of hedging can be

useful in transferring profits from one quarter to another. Finally, hedging may be a

zero-cost signal to investors that management is technically alert. Perhaps this is the

most compelling argument for airline hedging. However, it lies more in the realm of the

psychology of markets than the mathematics of economics.

55

Table 11-‐Southwest Fuel Derivative Data

Airline Jet fuel as a % of Operating

Expenses

Years Jet Fuel

Hedged

Average % of Next Year

Hedged

Std. Dev of Next year Hedged

Fuel Pass- through

Agreement

Charter Operations

AirTran 18.84% 2000-2008 29% 8 0 0 Alaska Air 13.92% 2001-2008 36% 16 0 0 American 11.97% 2000-2008 23% 12 0 0

Continental 15.14% 2000-2008 13% 13 0 0 Delta Air 12.20% 2000-2008 37% 23 0 0 Frontier Airlines

15.58% 2002-2008 17% 15 0 0

JetBlue Airlines

16.07% 2002-2008 22% 17 0 0

Southwest Airlines

14.51% 2000-2008 69% 28 0 0

United Airlines

12.30% 2000-2008 10% 12 0 0

US Airways 9.69% 2000-2008 23% 17 0 0 Average 14.02% 28%

Table 12-‐U.S. Airline Industry Hedging Data by FASB

Southwest Airlines Co. Fuel Derivative Contracts

As of April 22, 2013 Estimated economic jet fuel price per gallon,

including taxes Average Brent Crude Oil price per barrel

2Q 2013 (2) Second Half of 2013 (2)

$80 $2.95 - $3.00 $2.90 - $2.95 $90 $2.95 - $3.00 $2.95 - $3.00 Current Market (1) $3.00 - $3.05 $3.00 - $3.05 $110 $3.10 - $3.15 $3.20 - $3.25 $120 $3.15 - $3.20 $3.30 - $3.35 Period Average percent of estimated fuel consumption covered

by fuel derivative contracts at varying WTI/Brent crude oil-equivalent price levels

2014 Approx. 60% 2015 Approx. 35% 2016 Approx. 30% 2017 Approx. 50% (1) Brent crude oil average market prices as of April 22, 2013 were approximately $101 and $99 per barrel for second quarter and second half 2013, respectively. (2) The Company has approximately 95 percent of its second quarter and second half 2013 estimated fuel consumption covered by fuel derivative contracts with approximately 75 percent at varying Gulf Coast jet fuel-equivalent prices and the remainder at varying Brent crude oil-equivalent prices. The economic fuel price per gallon sensitivities provided above assume the relationship between Brent crude oil and refined products based on market prices as of April 22, 2013.

56

REFERENCES Raghavan, S. (2010). Advanced case studies in corporate finance with application to

aviation & aerospace industries. (5th ed.). New York: Linus Publications,Inc. Retrieved October 12, 2013 from http://www.financialsense.com Retrieved October 12, 2013 from http://www.finance.yahoo.com Retrieved October 12, 2013 from http://www.cnbc.com Retrieved October 12, 2013 from http://www.longviewfunds.com Retrieved October 12, 2013 from http://www.investopedia.com/articles/07/contango

southwest airlines- fuel hedging case analysis

Economy & Finance

maroon bars

purple bars

plain vanilla

annual fuel

fuel usage

actual fuel

jet fuel increases

61101 spot