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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.

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