Betting the Business

A key challenge in executing a sensible hedging strategy is the inevitable second guessing that happens with the benefit of 20-20 hindsight. Whenever a hedge loses money, outsiders question how much more profitable the company could have been without the hedge. Comparisons are made against competitors that did not hedge, and so performed better. No matter that the hedge accomplishes its objective—reducing volatility. When that reduced volatility is windfall profits foregone, the carping begins.

Last week, American Airlines was the last of the major U.S. airlines to report its 2014 financial results, and every airline was announcing improved operating cash flow due to the huge drop in jet fuel prices. Since American does not hedge, analysts were quick to announce that “they have won big time.”

Airlines that do hedge, have had to report losses on their hedge positions. Delta’s 4^th quarter announcement revealed more than $1 billion in charges due to mark-to-market adjustments on its fuel hedges. The losses on hedges offset some of the benefits the airlines are capturing from the drop in fuel prices. If they hadn’t hedged, shareholders would have seen a larger gain from the drop in fuel prices. That puts pressure on management to get rid of the hedging program.

Southwest Airlines announced that it had eliminated its hedge on 2015 prices, so if the oil price drops any further, all of that will drop to its bottom line. It also reduced the scale of its hedging in 2016, 2017 and 2018.

Does it make sense to eliminate the hedge? Is this a case of trend following—having missed the initial decline, the company hopes to catch the next decline? Is this a case of not standing by a well thought through strategy when short-term events fail to go your way? These are real problems in executing a hedging strategy.

A case can be made for adjusting the hedge ratios in response to the fall in price. After all, as Southwest’s executives explained, the purpose of hedging is to provide “catastrophic protection”, meaning against sky high jet fuel prices. With prices as far down as they are, we’re far away from catastrophe. If prices start back up, and if the company is nimble, there will be time to insure against catastrophe.