Airlines still not hedging oil

Four years ago I started wondering why airlines weren’t hedging oil.

I noted that “[w]ithout hedging, the airlines are actually speculating on the price of oil, since they know they're going to be buyers. Since they probably don't have inside information on where oil prices are headed, this would seem to be questionable.”

A year later I was still wondering, noting that Southwest had saved $155 million by capping 86% of its fuel expenses at the equivalent of just $26 a barrel of crude oil. At that time, oil was around $50/barrel. I guessed it might have to do with the fact that “much of the industry is operating in bankruptcy?”

But the industry is out of bankruptcy, oil prices are still soaring, and Southwest is still the only hedger. Today the WSJ’s George Anders wonders,

With oil near $130 a barrel, why does Southwest Airlines stand alone in the airline industry in its aggressive use of hedging to keep fuel costs under control? Southwest has locked in more than 70% of its jet-fuel requirements this year at a price equivalent to $51 a barrel for crude oil. By contrast, other big carriers have hedged 30% or less of their fuel needs this year. Those carriers generally expect to pay the equivalent of $85 to $100 per barrel of oil under their hedging programs.

Anders cites some explanations by David Carter, who has studied hedging by Southwest (case study) and the US airline industry. The industry study, from back in 2002, concludes that hedging jet fuel can be valuable, but that non-hedgers may not be acting act suboptimally. That would seem to be harder to stomach six years later. 

For today's column, Carter suggests that it's "psychologically hard to switch strategies when prices are moving against you" and that airlines are stymied by frequent management changes.  Southwest's treasurer Scott Topping claims they're able to move decisively because they have a small group making decisions.

I have some other explanations:

• Fear of fiduciary liability for hedging mistakes. And it cuts both ways -- the "psychological" problem Carter refers to may be a fear of making their previous decision not to hedge look bad.
• Managers are paid and judged by what the rest of the industry is doing, so they stay in lock-step.
• Creditors may be wary about financing hedging only to see executives misspending hedging profits while they hold the bag for losses. See Tufano, Agency Costs of Corporate Risk Management.
• Derivatives can be scary because they reduce transparency (e.g., Enron).
• SOX could be rearing its ugly head. Hedging might entail extensive disclosures, and potentially huge individual liability for certifying financials that omit something. As I’ve argued often, SOX penalizes risk-taking. Of course it's also risky not to hedge in this environment, but at least managers won't go to jail or face personal liability for failing to hedge, particularly if they can point to competing executives doing the same thing.

Fear and group-think don’t make for lovely business strategy, but these seem to be the elements of our current business environment.

There may be a solution.  In my Rise of the Uncorporation (new version out shortly) I suggest that the tighter discipline of what I call “uncorporations” – firms that operate under partnership-type incentives and discipline – may help solve agency problems, including problems associated with using derivatives. These controls may make it easier for creditors and others to trust managers' decisions regarding derivatives.

Anders concludes his WSJ article by noting that "[hedging] has been a big enough boon [for Southwest] that other airlines should ask why they missed out." And we should ask what kind of institutional perversity might be causing this failure.

Comments

[Michael F. Martin]

There's another answer: transactions costs.

A lot of institutional investors don't want to buy an airline + oil company because they figure they can buy the oil at lower transactions costs than the airline would be able to.

They're right about that, but they're ignoring something even more important -- namely, that the airline knows far better than the institutional investor what its needs for oil are going to look like over time.

[John Dewey]

Fuel is a huge cost for large transportation companies. It probably makes sense for them to directly hedge their price risks. For other goods and services, though, most corporations can lock in costs by writing long term contracts with suppliers.

Years ago I was a meat buyer for a large restaurant division of a Fortune 200 corporation. I tried to persuade our executives to hedge our beef purchases, but they declined, citing the risk of doing something which headquarters would deem very stupid. So I simply asked our beef supplier to hedge for us, and provide us a relatively stable beef price for the next three years. Our executives had no problem signing such a contract, even though they were aware of what was going on.

I don't know if airlines could ask their jet fuel suppliers for a long term contract. But if they did, I'm sure the smart folks at Exxon or BP would hedge their exposure to crude oil costs.

[Michael F. Martin]

@John Dewey

If that same thing is what's going on in the airline industry, then it would have to be near the top of the list of the most expensive principal-agent problems in history.

[MDF]

I think your swipe against SOX is misplaced, since so many other public issuers in other industries hedge as a matter of course. I haven't heard that these industries curtailed this practice once SOX was passed.

[Pender]

How about a first mover problem? If you make no hedge and no one else does either, then the airline industry rises and falls together. It's much better to fail together than to fail alone, for two reasons: (1) failing together means federal bailouts are more likely, and (2) failing together means your competitors can't take advantage of your weakness, so your only real constraint is passengers' ability to substitute away from flight altogether -- that is, the entire industry can raise prices as one up to the monopolistic threshold.

If you hedge, you're going out on a limb. You'll succeed alone (as Southwest has done) or fail alone. Success is good, and it's even better when all of your competitors are failing since there's more surplus to capture, but for risk-averse directors interested in keeping their jobs, success isn't as good as failure is bad. And, as I suggested above, failing together is much preferred to failing alone. So not hedging is, in this perverse sense, the less "leveraged" approach in terms of expected returns to an individual player.

I have no idea what the solution to this market failure is. It seems like a classic instance of self-interested director risk aversion.

Of course, except for the process costs of bankruptcy and the unfortunate tendency of the government to start throwing bailouts around, it's not entirely clear why it's such a bad outcome. Investors can hedge individually, and for that matter, so can passengers. If you know you're going to need to fly a certain amount, you can buy oil futures that will essentially lock in the current price of air travel if you are so inclined (and can stomach the transaction costs).

I'm curious what people think.