Hedging Against $200 Oil

For the financial whizzes of Southwest Airlines, it just gets more expensive to buy protection as oil prices keep climbing

by Moira Herbst

Justin Sullivan/Getty Images

Oil is getting pricier by the minute. A barrel of the benchmark West Texas Intermediate crude hit a record of $123.80 in intraday trading May 7, before settling at $123.53. And look out: on May 6, investment bank Goldman Sachs (GS) said oil prices could hit $200 within the next two years as limited supply growth and rising demand causes a "super spike".

That's not welcome news for airlines. Rising jet fuel prices—one of the industry's biggest costs—have helped send seven airlines into bankruptcy this year, and more could follow. One exception to the sea of red ink so far is Southwest Airlines (LUV), which has saved billions since 2000 by successfully hedging against increases in oil prices. But with each rise in oil prices, that strategy gets more and more expensive.

Rich Payoff

"We would like to see more coverage, and we're reviewing our options," says Scott Topping, treasurer of Southwest and manager of its hedging program. "The fundamentals still point to the risk of higher prices; we feel we need to [hedge]."

A hedge is a financial instrument that allows investors to lock in certain prices to act as insurance against the possibility that the open-market, or spot, price of that commodity will rise. If the price then rises, the company gets a financial payoff that cushions the blow of higher prices. In this way, investors can actually make money using hedging as insurance, giving them an advantage over competitors in the marketplace.

Southwest is currently the only major airline with most of its fuel costs hedged at lower prices, largely because it is the only large carrier with the cash flow to do so. For 2008, 70% of its fuel needs are hedged at $51 a barrel. That means that while competitors have to contend with spot prices hovering around $120 a barrel, Southwest can buy oil at less than half that. Access to this discounted price means Southwest feels less pressure to pass on higher costs to customers, which could afford it more market share as competitors hike ticket prices.

Southwest's bets have paid off richly. For the first quarter of 2008, $302 million in hedges allowed Southwest to report a profit of $34 million as competitors like United (UAUA) and US Airways (LCC) posted losses. Overall in 2007, hedging saved the company $727 million, when Southwest was 90% protected at oil prices around $51 a barrel. To see the link between oil and airline share prices, just look at what happened to airline share prices on May 6, as oil prices soared. American Airlines' parent AMR (AMR), was down 17¢, or 2%, to 8.85; Delta Air Lines (DAL) was down 24¢, or 3%, to 7.87; and United was down 85¢, or 5.7%, to 14.15. Southwest's shares, meanwhile, fell 3¢, or 0.2%, to 13.37.

Hefty Cash Outlay

Even with prices hovering at $122 per barrel and higher, Southwest should be well positioned for the next few years. For 2009, the company is covered about 55% at $51 a barrel; for 2010, 30% at $53 per barrel; and for 2011 and 2012, at more than 15% at $64 and $63 per barrel, respectively. Because the oil market is so volatile and hedging requires so much cash up front, the percentage of coverage gets smaller in later years.