For most of the past decade, hedging jet fuel costs has been a standard practice at virtually every U.S. airline. Yet the American Airlines Group (NASDAQ:AAL) management team -- CEO Doug Parker, President Scott Kirby, and CFO Derek Kerr -- have gone against the grain. In the past year at American Airlines, and in the previous five years at US Airways, they have refused to hedge fuel costs.
After having a bad experience with fuel hedging in 2008 and 2009, Parker and his top lieutenants decided to go cold turkey on hedging. Since then, they have developed a strong argument for why their competitors' hedging strategies are misguided.
With oil prices having plummeted in the past few weeks, American Airlines' no-hedging strategy is set to pay off in a big way this fall. That said, with oil prices at multi-year lows, this may be a good time for airlines to lock in future fuel prices by opening new hedges. Could American Airlines' top leaders take this opportunity to reverse their long-standing opposition to hedging?
Hedging: a dangerous game
Southwest Airlines was the industry leader in fuel hedging in the years leading up to the Great Recession. Southwest's policy of locking in hedges far in advance paid off as oil prices soared from less than $30 in 2003 to more than $140 by mid-2008.
Southwest offset fuel price increases with billions of dollars of hedging gains between 2004 and 2008. As oil prices skyrocketed during this time period, other airlines saw Southwest's hedging gains and increased their own hedging activity.
Yet by mid-2008, the credit crunch had begun and the global economy was spiraling toward the Great Recession. Travel demand plummeted, hurting airline revenues. Meanwhile, oil prices gave up nearly five years of gains in the span of six months. Yet airlines were locked into higher fuel costs due to the recent flurry of hedging activity.
It was around this time that the US Airways leadership team concluded that hedging didn't make as much sense as everyone in the airline industry had previously assumed. Perversely, the oil price drop in late 2008 caused even bigger problems for US Airways than the previous run-up in oil prices.
The case against hedging
From the perspective of the new American Airlines (and former US Airways) management team, there are three main problems with fuel hedging. The first is that ticket prices are a "natural hedge" for airlines.
If the global economy strengthens, oil prices may rise, but airlines should also be able to raise ticket prices. Likewise, falling oil prices can offset demand weakness in a bad economy. Hedging fuel costs disrupts this "natural" hedge. Most importantly, it means that fuel costs won't decline as quickly during a recession.
Second, a "disciplined" hedging strategy -- buying new hedges every month to gradually lock in fuel prices for the next few quarters -- doesn't offer any long-term protection. Buying hedges every month provides no advantage over buying jet fuel every month. Either way, over the long term you're going to be paying low prices some of the time and high prices at other times.
Third, fuel hedging can be very pricey. Most airlines hedge with call options, which allow them to cap their fuel costs without locking them in if oil prices happen to fall. The downside of this strategy is that the airline has to pay a premium for each call option. Unless oil prices rise by a significant amount before the option expires, the airline will lose money on the hedge.
The decision to stop hedging worked well for US Airways. Between 2010 and mid-2013, US Airways had the lowest or second-lowest "all-in" fuel cost among U.S. airlines in 10 out of 14 quarters -- despite a significant rise in fuel prices during that period. Hedging premiums had more than offset the occasional hedging gains achieved by other airlines.
Easing up on hedges
In the past year or two, other airlines have started to catch on to the strategy pioneered at US Airways. Most other airlines still hedge, but they hedge a much smaller proportion of their fuel needs. Airlines have also put more emphasis on limiting call option premium costs. This will serve them well in the near future, as oil prices have dropped significantly since June.
Still, American Airlines has the most to gain from lower fuel prices, due to its no-hedging policy. For example, top rival Delta Air Lines reported $347 million in "mark-to-market" losses last quarter due to the declining value of its fuel hedges. Oil prices have continued to fall since the end of Q3, setting Delta up for additional hedging losses in Q4.
Time for another shift?
Doug Parker and his team have shown that they aren't afraid to buck the industry consensus. Today, other airlines are moving to less aggressive hedging policies. Yet American Airlines may want to consider a move in the opposite direction.
Oil prices are currently at a four-year low. The U.S. shale boom has played a big role in boosting world oil supply. Yet many of the shale oil projects that have raised U.S. oil production to levels not seen in 3-4 decades will become unprofitable if oil prices fall any further.
This potentially creates a low-cost hedging opportunity. Rather than buying call options from banks (which will only sell these options if they expect to make a profit), American Airlines could work directly with shale oil producers that are looking to lock in future prices above their cost of production.
Oil producers have just as great an interest in hedging against falling oil prices as airlines do in hedging against rising oil prices. This would give American Airlines (or another airline) an opportunity to lock in a portion of its future fuel costs at the market price, rather than paying a premium. This removes one of the biggest downsides of hedging.
This strategy also wouldn't suffer from the same flaw as "disciplined" hedging. It would be a one-time decision to lock in oil prices at a fair level where American Airlines could probably make money even if oil prices ended up somewhat lower.
Lastly, while locking in oil prices breaks the natural hedge of oil prices vs. demand, the high cost of production in many North American oil fields makes it unlikely that prices would fall much further even during a recession. Meanwhile, it guards against the risk of a severe supply shock -- e.g. a regional war in the Middle East that could rapidly cut oil exports from the Persian Gulf.
Will American Airlines pull the trigger?
Given the long-standing opposition to hedging among the American Airlines management team, a return to hedging is clearly a long shot. That said, some of the objections that Parker, Kirby, and Kerr have historically raised regarding fuel hedging may no longer apply.
There is a strong case to be made that airlines should be hedging more aggressively today than they have in recent years. Oil prices are at a four-year low, yet there are significant geopolitical threats to the global oil supply (such as the rise of ISIS in the Middle East).
Doug Parker and his team are all smart airline managers. If the facts about fuel hedging have changed, they just might change their position and reinstate hedging at American Airlines.