Hedging Against $200 Oil

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Even an expert like Topping, who spends his days consulting with oil experts and poring over analyst reports, says he doesn't know for certain where oil prices are headed. But for now, indications point upward, which justifies more hedging. "There doesn't seem to be hope for a big price drop unless an unexpected dramatic event took a big chunk out of demand," says Topping. While high prices are beginning to slow demand for oil in Western countries, developing nations like China and India have an ever-growing thirst for oil. Consider that the U.S. currently has 800 vehicles per 1,000 people, vs. fewer than 30 in China and India. As those countries' economies ramp up—and as hundreds of millions of people seek their first cars—energy demand will also rise.

But protecting against fuel increases is itself cash-intensive. To purchase options, investors need to pay a commodities clearing house a margin of about 10%. For example, a contract for 1,000 barrels of crude oil at $123 per barrel would be worth $123,000. To hedge at that price, the investor would need to pay about $12,300 and ultimately be prepared to pay the balance. Generally speaking, an option written one year ago, in a $65-per-barrel environment, was roughly half the cost of an equivalent option placed today.

Besides the margin costs, investors must also pay a transaction cost for each hedge, called a "bid-ask spread." And companies like Southwest choose to pay premiums for options that offer downside protection in case oil prices fall. In other words, if the price drops below the strike price, Southwest can allow the option to expire (as opposed to being locked in to buying oil at a given price, as in "swap" contracts). In this scenario, the company loses the premium in exchange for the insurance the option offers.

An Inability and Reluctance to Hedge

The large initial cash outlay is one of the main reasons other airlines haven't followed in Southwest's footsteps. "It's a question of credit risk," says Peter Fusaro, founder of the Energy Hedge Fund Center, an energy-trading information firm. "Facing higher energy prices and billions of dollars in debt, most airlines can't afford to hedge." Instead, says Fusaro, airlines either have to pass increased costs on to customers or absorb them.

Alaska Airlines maintains what Treasurer Jay Schaefer calls a moderate program that keeps the company hedged up to 50% in three-year intervals. "We think of it as an insurance policy," says Schaefer. "We pay a premium for call options, but it has been absolutely worth it. The runup in oil prices has been traumatic to our industry, and our hedging program has helped ensure our survival." But fuel-price hedging can only go so far. Alaska Airlines' parent company, Alaska Air Group (ALK), which also owns Portland (Ore.)-based Horizon Air, reported a $35.9 million loss in the first quarter of 2008, and rising fuel prices were a big factor.

The price runup has led some other airlines to shrink from hedging. Allegiant Travel's (ALGT) Allegiant Airlines, a low-cost, all-jet airline based in Las Vegas, got out of the options game last autumn as energy prices soared. Allegiant now buys its fuel on the spot market. The advantages offered by the short-term contracts the company was signing were elusive given the market's volatility, says Allegiant Chairman and CEO Maurice Gallagher Jr.: "It got to be very expensive. If you were on the other side of a [fuel] trade and have to give us money…you're going to charge a pretty good premium for that."

Indeed, many airline executives shy away from the risks involved. "I think airlines have been reluctant to hedge because corporate culture views futures as a gambling tool," says Stephen Schork, an energy consultant in Villanova, Pa., and editor of The Schork Report, a daily energy newsletter. "But they've been reluctant to their own detriment. If you're an airline without a significant hedge, you're in a difficult spot."

Herbst is a reporter for BusinessWeek in New York.