Betting the Business

On its quarterly earnings call earlier this week, the new American Airlines confirmed speculation that it would end the company’s legacy policy of hedging jet fuel prices. The hedges that are in place will be allowed to runoff, but they will not be replaced.

American’s merger with US Airways was completed in December, and the combined company is being led by US Airways’ management team. For a number of years now, since 2008, US Airways has shunned hedging. Now that policy is being extended to the merged firm.

Why?

Experience is one factor. Going into 2008, US Airways hedged jet fuel prices just like other companies. But 2008 was a wild ride for all businesses in which fuel costs are a major line item, airlines especially. Oil prices spiked dramatically during the first half of the year, and then collapsed even more dramatically during the second half. While the company may have profited off of its hedges in the first two quarters, it reported whopping losses on its hedges in the last two–$488 million in the 3^rd quarter and another $234 in the 4^th quarter, each time approximately half the company’s total loss in the quarter. Of course, at the same time the airline was paying a smaller price to buy jet fuel, so the company’s net cash flow on fuel plus the hedge showed less volatility. That’s how a hedge is supposed to work. But hedge decisions are always second guessed whenever the financial leg of the package earns a loss.

The second guessing at US Airways goes a little deeper than usual, and the management team’s rationale deserves a fair hearing.

Management seems to think that hedging somehow invites companies to be less ruthless about cost discipline. At it’s Q2 earnings call last year, US Airways President Scott Kirby said

And our cost discipline has been equally impressive. First, since US Airways stopped hedging fuel we’ve had the lowest or second lowest cost of fuel in 10 of the last 14 quarters, a strong validation of our no hedging strategy.

Management also thinks it isn’t really as exposed to fuel costs as many imagine. Casual observers focus too narrowly on jet fuel costs alone, the company points out. Looking at operating margin – revenue less variable cost – the company has a much smaller exposure to jet fuel prices than first meets the eye. Here’s Scott Kirby again, from a 2012 conference:

I think a non-fuel hedging program is the most effective and the most rational program because we have a natural hedge. This is a natural hedge — fuel prices versus demand. When fuel prices are going up, in most cases revenue is going to follow and vice-versa. Fuel prices are driven in many regards by the economy. That’s not the only driver of fuel prices, but it’s probably — over a longer time horizon, it is the principal driver of fuel prices as what’s happening with the economy, and so we have a strong natural hedge. And if we hedge jet fuel prices or hedge oil prices, you’re breaking this natural hedge, not to mention the expense of hedging but just the natural hedge that you have between jet fuel and revenues.

So a sizable financial hedge is not necessary, and might even increase the airline’s risk.

I have a hard time believing that the right hedge is zero. Ticket prices don’t move one-for-one with jet fuel prices, at least not immediately. Many tickets are sold in advance, whether individually or as a part of corporate and other packaged sales. And the quantity of sales will be affected by the price, too, so that the company is exposed on an aggregate basis even when its operating margin is not.

Of course, that argument does not take into account the cost of hedging. In order to cover those costs, Kirby said, fuel prices would have to rise 30% year-over-year, something he obviously doesn’t think is likely.

Since US Airways inaugurated its new policy of not hedging, oil prices have stayed in a relatively narrow band, so the policy has not yet been stress tested. Now that policy is being extended to the larger, combined American Airlines. It will be interesting to see whether it runs into any stormy price swings, and how it fares under stress.