Southwest Airlines- Fuel Hedging Case Analysis
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Southwest Airlines- Fuel Hedging Case Analysis

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Southwest Airlines- Fuel Hedging Case Analysis

Southwest Airlines- Fuel Hedging Case Analysis

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Southwest Airlines- Fuel Hedging Case Analysis Southwest Airlines- Fuel Hedging Case Analysis Document Transcript

  •   Southwest  Airlines:     Fuel  Hedging  Analysis       October  13,  2013   BA  618:  Advanced  Corporate  Finance       Vishal Prabhakar | Ajay Gnanasekaran Embry-Riddle Aeronautical University
  • Table of Contents   Sl.No 1. 2. 3. 4. 5. 6. 7. 8. 9. Contents Southwest Airlines -Introduction Fuel Hedging- A Win-Win To Hedge or not to Hedge Case Background Hedging Strategies and Analysis @Risk Analysis Conclusion Current Outlook-Hedging References                                                   2  
  • SOUTHWEST AIRLINES – INTRODUCTION In order to stay airborne, a commercial airline has to consistently keep generating profits. Profits in an airline industry come from passenger revenue, hence all stratagems must be customer centric. In this current scenario with all the mergers and acquisitions, airlines competing with each other, one way of attracting passengers is to keep the cost of flying low. Southwest’s business model is the best low cost model yielding considerable profit, while providing value for money. The main expenses for an airline are the operating and fuel cost, expenses must be tightly controlled to reach and stay at the lowest possible level. Certain expenses are unavoidable; however, one variable that can be kept low through decisive planning and foresight is the cost of fuel. Fuel prices are extremely volatile. A good way to achieve this is by hedging fuel, which is a complex, but rewarding process as Southwest Airlines proves beyond doubt. Southwest Airlines, is the third largest airline in the world as well as in America in terms of passenger aircraft among all of the world's commercial airlines. It operates more than 540 Boeing 737 aircraft today between 67 cities in the U.S.A. Today, Southwest operates approximately 3,300 flights daily and boasts of being the only major airline to post profits every year for the last thirty-six years. It justifiably claims to be United States’ most successful low-fare, high frequency, point-to-point carrier. It would be worthwhile examining Southwest’s modus operandi and strategies employed to stay profitable every year, though it did suffer a minor hiccup when it’s profit dived under the waterline in two quarters in 2008. Southwest keeps its aircraft in flight for more than twelve hours a day. It carefully selects optimized destinations that could be called secondary airfields, which facilitate fast turnaround averaging less than fifteen minutes and charge low administrative fees. Using the same logic, they use only one aircraft type. This helps them to reduce the fleet maintenance cost. The Boeing 737 has a reasonable passenger capacity of around one hundred and twenty five to one hundred and fifty. These are fitted with the most fuel-efficient engines and aerodynamically have the lowest drag wet-wings available.   3  
  • FUEL HEDGING – A WIN-WIN Jet fuel represents a critical expense category for any airline that bears its own fuel costs and most airlines bear at least 80% of its fuel costs. Fuel has consistently been one of the largest expense categories for domestic airlines. During 2003, fuel costs represented, on average, over 16% of the total operating expenses for all U.S. domestic airlines. Moreover, airlines are generally unable to increase fares to offset any significant increase in fuel costs. From 2001 to2003, these same airlines experienced a 25.9% compound annual increase in jet fuel costs while average airline pricing decreased by 0.1%, as measured by revenue per available seat mile. Jet fuel costs have gone up over the past several years laying a constant pressure on airlines to maintain a profitable operation. Savings in the lines of operation and fuel cost turn out to be the profit earned. In a fuel driven industry like Commercial Aviation, sudden hikes and fluctuations in fuel prices can have an immense effect on the business plan, not to mention adding to the difficult task of budgeting of Future fuel expenditures. If fuel costs are not actively managed, they can lead a company into losses. Airlines can mitigate their exposure to volatility and sudden hike in fuel costs, as well as natural gas and electricity costs, through hedging. Hedging allows the fuel market participants to fix prices in advance, while reducing the potential impact of volatile fuel prices. ‘Hedging’ items is a standard practice in almost every field that involves finance, including Market players in precious metals like Gold, Silver and Platinum. While fuel costs may be hedged, there is no perfect hedge available in either over-the-counter or exchange traded derivatives markets. Over-the-counter derivatives on jet fuel are very illiquid which makes them rather expensive and not available in quantities sufficient to hedge all of an airlines’ jet fuel consumption. Exchange-traded derivatives are not available in the United States for jet fuel, so airlines must use futures contracts on commodities that are highly correlated with jet fuel, such as crude and heating oil. As such, airlines employ a variety of strategies ranging from not hedging to fully hedging using a combination of products. Domestic airlines have a variety of hedging strategies available to them. These include using both over-the-counter and exchange-traded derivatives or remaining unhedged. Options, including collars and swaps are the   4  
  • primary derivatives used by airlines. Many airlines, including southwest, stated that they prefer over-the-counter derivatives (OTC) to exchange traded futures because they were more customizable. OTC derivatives are traded directly between the airlines and investment Banks, and as such have counterparty risk that must be considered. Therefore, airlines like Southwest prefer to trade with three or four different banks to diversify this risk and also to get the best pricing possible (ibid). Southwest Airlines evidently kept their ears close to the ground by going in for very high levels of futures before Iraq and Desert Storm drove oil prices upwards. The Airline went in for even more hedging in 2004, 2005 and early 2006 in anticipation of oil Prices surging to unprecedented levels. TO HEDGE OR NOT TO HEDGE Being unhedged is the ultimate short position; this infers we are constantly expecting the fuel prices to go down which is an ultimate utopian scenario. Although airlines sometimes lose money hedging, overall those that hedge have a 5% to 10% better financial performance than those that don’t. Hedged airlines can make investments in their operations and equipment; make other important decisions that positively affect their firm's overall value. Hedging is about having an insurance policy against prices rising. A position that is not hedged i.e., the holder of a naked position has taken no step to reduce the risk inherent to the position. The risk offsetting investments in a hedging strategy will not experience price changes in entirely equal proportions. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position. This is known as basis risk. Basis in a hedging situation is defined as the difference between the spot price of the asset being hedged and the futures price of the contract used. The basis risk arises from the hedger’s uncertainty associated to the basis at the expiration of the hedge. Price risk is the biggest risk faced by all investors. Although price risk specific to a stock can be minimized through diversification, market risk cannot be diversified away. Price risk, while unavoidable, can be mitigated through the use of hedging techniques. Price   5  
  • risk also depends on the volatility of the securities held within a portfolio. For example, an investor who only holds a handful of junior mining companies in his or her portfolio may be exposed to a greater degree of price risk than an investor with a well-diversified portfolio of blue-chip stocks. Investors can use a number of tools and techniques to hedge price risk, ranging from relatively conservative decisions such as buying put options, to more aggressive strategies including short-selling and inverse ETFs. SFAS 133, the standard for financial reporting of derivatives and hedging transactions, was adopted in 1998 by the Financial Accounting Standards Board to resolve inconsistent previous reporting standards and practices. It went into effect at most U.S. companies at the beginning of 2001. It was issued to make a company’s exposure to its derivative positions more apparent. It requires changes in derivatives’ fair value to be recorded in the income statement or in a component of equity known as other comprehensive income. The FAS 133 requirement in order to make the hedge more effective has to consider both historical performance and anticipated future performance. It has given broad guidelines regarding the “80-125” rule or the dollar-offset method and the correlation method. In the “80-125” rule, a hedge is deemed effective if the ratio of the change in the value of the derivative to the change in the value of the hedged item falls between 80% and 125%. In the correlation method, a hedge is deemed effective if correlation between the value of the hedged item and the derivative is high; the R-squared of the regression of this relation is around 80% and the slope of the regression line should be close to 1. Contango and Normal Backwardation Patterns over time have established that a futures market is normal if futures prices are higher at longer maturities and inverted if futures prices are lower at distant maturities. • As we approach contract maturity (we might be long or short on the futures contract), the futures price must converge toward the spot price. The difference is called the basis. That's because, on the maturity date, the futures price must equal the spot price. If they don't converge on maturity, anybody could make free money with an easy arbitrage.   6  
  • • The most rational futures price is the expected future spot price. For example, if you and your counterparty both foresee that the spot price in crude oil would be $80 in one year, you would rationally settle on an $80 futures price. Anything above or below would represent a loss for one of you! Now we can define contango and normal backwardation. Suppose we entered into a December 2013 futures contract, today, for $100. One month later the same December 2013 future contract could still be $100, but it might also increase to $110 (this implies normal • backwardation) or it might decrease to $90 (implies contango). Contango is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies that futures prices are falling over time as new information brings them into line with the expected future spot price. • Normal backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who are "net long" in their positions: they want the futures price to increase. So, normal backwardation is when the futures prices are increasing. Let’s consider a near month futures contract for light sweet crude oil as the August 2013 contract, which settled on July 18 at $108.22 per barrel. But looking out 11 months into the future to the July 2014 contract, we find that it closed at just $95.56. That is a huge difference, and it says that oil futures traders are not willing to bet on the current month's high price continuing into the future. In other words, it is a temporary anomaly. Such anomalies can contain important information. This week's chart looks at the raw price spread between the near month contract and the contract that is 11 months out. When the near month contract is priced lower than the out months, that condition is known as "contango". In commodities like gold and silver, contango is the norm since the available supply consists of not just the mining production but also all of the bullion sitting in warehouses and safes around the world. But because oil is so much more expensive to store than gold is, there is not the same sort of standing inventory available to remediate temporary supply-demand disruptions.   7  
  • So oil prices can move to very large conditions of contango, or to the opposite condition known as "backwardation" like we are seeing right now. CASE BACKGROUND Scott Topping, the Director of Corporate Finance for Southwest Airlines was concerned about the cost of fuel for Southwest. High jet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew that since the industry was deregulated in 1978, airline profitability and survival depended on controlling costs. After labor, jet fuel was the second largest operating expense for airlines. If airlines could control the cost of fuel, they can more accurately estimate budgets and forecast earnings. It was Scott’s job to hedge fuel costs, however, he knew that jet fuel prices are largely unpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overall upward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. On September 11, 2000, the Gulf Coast jet fuel spot price was 101.25 cents/gallon – a whopping increase of 255 % in the spot price since the low in 1998. The prior day’s (June 11, 2001) spot price for Gulf Coast jet fuel closed at a price of 79.45 cents/gallon. While this price was lower than the highest level, Scott knew that future jet fuel prices would be uncertain. Senior management asked Scott to propose Southwest’s hedging strategy for the next one to three years. Because of the current high price of jet fuel, Scott was unsure of the best hedging strategy to employ. Because Southwest adopted SFAS 133 in 2001, Scott needed to consider this in his hedging strategy. Southwest’s average fuel cost per gallon in 2000 was $0.7869, which was the highest annual average fuel cost per gallon experienced by the company since 1984. As discussed previously, fuel and oil expense per ASM increased 44.1 percent in 2000, primarily due to the 49.3 percent increase in the average jet fuel cost per gallon. (Refer to Table 1: The average price per gallon of jet fuel in 2000 was $0.7869 compared to $0.5271 in 1999.)   8  
  • Although Scott thought the price of jet fuel would decrease over the next year, he cannot be sure energy prices are notoriously hard to predict. Scott knew that: “Predicting is very difficult, especially as it concerns the future” (Chinese Proverb). Any political instability in the Middle East could cause energy prices to rise dramatically without much warning. If the cost of jet fuel continued to rise, the cost of fuel for Southwest would rise accordingly without hedging. On the other hand, if the cost of jet fuel declines, the cost of fuel would drop if Southwest were un-hedged. To deal with these risks, Scott identified the following 5 alternatives. Scott estimated Southwest’s jet fuel usage to be approximately 1,100 million gallons for next year. 1. Do nothing. 2. Hedge using a plain vanilla jet fuel or heating oil swap. 3. Hedging using options. 4. Hedge using a zero-cost collar strategy. 5. Hedge using a crude oil or heating oil futures contract. SOUTH WEST AIRLINES FUEL HEDGING ANALYSIS Table 1 gives the Fuel Cost per Gallon for the past 7 years. The fuel price rise in year 1999 & 2000 wreaked havoc and had increased the total fuel costs to the airline by a considerable amount. The airline has no control over the volatility of fuel prices and hence makes it difficult to control fuel costs and total costs. Year Fuel Cost per Gallon in $ 2000 0.7869 1999 0.53 1998 0.4567 1997 0.6246 1996 0.6547 1995 0.5522 1994 0.5392 Table 1   9  
  • In order to offset fuel price rise and control fuel costs, keeping it constant to a level acceptable, Southwest Airlines have to choose the best option among the following alternatives based on two possible scenarios: 1) Fuel price decline and 2) Fuel price rise. Table 2 below gives the list of variables and prices considered or assumed in each scenario and for the hedging strategies. NOTE: All Fuel and Total costs are indicated in $ millions. Scenario 1 Scenario 2 Jet fuel spot price= Heating oil spot price= Crude oil spot price= Hedging %= 6/11/01 spot price(Jet Fuel)= Fixed Rate(Jet Fuel Swap) Call Option Premium Jet Fuel Swap Contract Size 6/11/01 spot price(Heating Oil)= Fixed Rate(Heating Oil Swap) Heating oil Contract Size 0.393 0.388 14.10 50% 0.7945 0.7600 1.8000 1.00 0.7002 0.73 0.042 6/11/01 Futures Price (Crude Oil) $/gallon $/gallon $/barrel 1.1960 $/gallon 1.1860 $/gallon 40.00 $/barrel $/gallon $/gallon $/contract MM gal $/gallon $/gallon MM gal 26.39 $/barrel # Contracts Contract Size Fuel usage(Jet Fuel)= 0.001 MM barrel 1,100 MM gal 1,100 100% Hedging(Jet Fuel)= 50% Hedging(Jet Fuel)= 1,100 MM gal 550 MM gal 1,100 550 Fuel usage(Crude)= 26.1905 MM Barrel 26,190.48 100% Hedging(Crude)= 50% Hedging(Crude)= Fuel usage(HO)= 100% Hedging(HO)= 50% Hedging(HO)= 26.1905 13.0952 1,100 1,100 550 26,190.48 13,095.24 26,190.48 26,190.48 13,095.24 MM MM MM MM MM Barrel Barrel gal gal gal Table 2 1) Hedging Using a Plain Vanilla Jet Fuel Swap- This alternative is simple and a basic form of swap. A certain amount of floating price is exchanged for a fixed price over a certain period of time. The airline pays a fixed price and receives a floating price both indexed to expected jet fuel use during each monthly settlement period. The volume of fuel hedged is negotiated because this is a customized contract arranged in the OTC market. Jet Fuel is not a liquid enough market to warrant exchange-traded contracts unlike the Crude Oil and Heating oil, which have active liquid markets (NYMEX and IPE). The contract size in this case is 1 million gallons.   10  
  • During the life of the contract, the airline buys jet fuel from the market as usual but the swap contract makes up for the difference when fuel prices rise and removes differences when fuel prices decline. This would result for the airline to maintain a fixed fuel expense for the period covered. The fixed rate payment is set based on the market conditions when the swap contract was initiated. In this case, the fixed rate is $0.76 per gallon of Jet Fuel. The floating price is commonly based on Platt’s New York Harbor jet fuel price and is calculated monthly using daily prices for the month. However in this case, we will calculate the monthly floating rate based on the beginning Spot Price of Jet fuel and the estimated spot price at end of year. Based on the amount of fuel hedged, and the possible scenario, the airline can either make a profit from the swap or a loss from its swap. The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel hedge. The airline fuel usage is estimated to be 1100 million gallons. Refer to Table 3A and 3B–Scenario 1 and Scenario 2. Hedge using a plain vanilla jet fuel swap-Full Scenario 1-JET FUEL Monthly Settlements 100% Hedge 50% Hedge Gain(Loss) Gain(Loss) 0.0955 0.0477 (2.9715) (1.4858) (6.0385) (3.0193) (9.1056) (4.5528) (12.1726) (6.0863) (15.2396) (7.6198) (18.3066) (9.1533) (21.3736) (10.6868) Sl. No 1 2 3 4 5 6 7 8 Date Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Fixed Pmt 0.76 0.76 0.76 0.76 0.76 0.76 0.76 0.76 Floating Pmt 0.7610 0.7276 0.6941 0.6607 0.6272 0.5938 0.5603 0.5268 9 Mar-02 0.76 0.4934 (24.4406) (12.2203) 10 11 Apr-02 May-02 0.76 0.76 0.4599 0.4265 (27.5076) (30.5747) (13.7538) (15.2873) 12 Jun-02 0.76 0.3930 (33.6417) (16.8208) Total Gain(Loss)-100% Hedge (201.2771) Total Gain(Loss)-50% Hedge (100.6385) Table 3A-Fuel price decline: Jet Fuel Swap   11  
  • Hedge using a plain vanilla jet fuel swap-Full Scenario 2-JET FUEL Sl. No 1 2 3 4 5 6 7 8 Date Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Fixed Pmt 0.7600 0.7600 0.7600 0.7600 0.7600 0.7600 0.7600 0.7600 Floating Pmt 0.8280 0.8614 0.8949 0.9283 0.9618 0.9953 1.0287 1.0622 Monthly Settlements 100% Hedge 50% Hedge Gain(Loss) Gain(Loss) 6.2295 3.1148 9.2965 4.6483 12.3635 6.1818 15.4306 7.7153 18.4976 9.2488 21.5646 10.7823 24.6316 12.3158 27.6986 13.8493 9 Mar-02 0.7600 1.0956 30.7656 15.3828 10 11 Apr-02 May-02 0.7600 0.7600 1.1291 1.1625 33.8326 36.8997 16.9163 18.4498 12 Jun-02 0.7600 1.1960 39.9667 19.9833 Total Gain(Loss)-100% Hedge 277.1771 Total Gain(Loss)-50% Hedge 138.5885 Table 3B-Fuel price rise: Jet Fuel Swap The jet fuel spot price on June 11th, 2001 was $0.7945 per gallon and the estimated spot price (June 2002), for scenario 1 is $ 0.393 per gallon. The estimated spot price (June 2002), for scenario 2 is $ 1.196 per gallon. 2) Hedging Using a Plain Vanilla Heating Oil Swap- This is similar to the jet fuel swap in its operation, but this option is used with the NYMEX New York Heating Oil Calendar Swap. The swap contract is 42000 gallons, the same size as the NYMEX heating oil futures contract. The swap is in Heating Oil futures prices and the rise or decline of these prices would act as an offset to the Fuel price volatility since the correlation between Jet fuel prices and heating oil prices are high, as both are byproducts of crude oil and assuming the basis has not changed. The loss or gain in the futures contract will be offset by the lower cash price of jet fuel or by higher cash price of jet fuel respectively. As a result, the airline effectively pays a fixed price for jet fuel. The fixed rate payment is set based on the market conditions when the swap contract was initiated. In this case, the fixed rate is $0.73 per gallon of Heating Oil. The   12  
  • floating price is commonly based on monthly heating oil Futures prices. However in this case, we will calculate the monthly floating rate based on the beginning Spot Price of Heating Oil and the estimated spot price at end of year. The heating oil future price on June 11th, 2001 was $0.7002 per gallon and the estimated spot price (June 2002), for scenario 1 is $ 0.388 per gallon. The estimated spot price (June 2002), for scenario 2 is $ 1.186 per gallon. Based on the amount of fuel hedged, and the possible scenario, the airline can either make a profit from the swap or a loss from the swap. The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel hedge. The airline fuel usage is estimated to be 1100 million gallons. Refer to Table 3C and 3D–Scenario 1 and Scenario 2. Hedge using a plain vanilla heating oil swap-Full Scenario 1-Heating Oil Monthly Settlements 100% Hedge Sl. No 1 2 3 4 5 6 7 8 9 10 11 12 Date Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Fixed Pmt 0.73 0.73 0.73 0.73 0.73 0.73 0.73 0.73 0.73 0.73 0.73 0.73 Total Gain(Loss)-100% Hedge Total Gain(Loss)-50% Hedge Floating Pmt 0.6742 0.6482 0.6222 0.5961 0.5701 0.5441 0.5181 0.4921 0.4661 0.4400 0.4140 0.3880 50% Hedge Gain(Loss) (5.1165) (7.5014) (9.8863) (12.2711) (14.6560) (17.0408) (19.4257) (21.8106) (24.1954) (26.5803) (28.9651) (31.3500) Gain(Loss) (2.5583) (3.7507) (4.9431) (6.1356) (7.3280) (8.5204) (9.7128) (10.9053) (12.0977) (13.2901) (14.4826) (15.6750) (218.7992) (109.3996) Table 3C-Heating Oil Price decline: Heating Oil Swap   13  
  • Hedge using a plain vanilla heating oil swap-Full Scenario 2-Heating Oil Sl. No 1 2 3 4 5 6 7 8 9 10 11 12 Date Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Fixed Pmt 0.7300 0.7300 0.7300 0.7300 0.7300 0.7300 0.7300 0.7300 0.7300 0.7300 0.7300 0.7300 Total Gain(Loss)-100% Hedge Total Gain(Loss)-50% Hedge Monthly Settlements 100% Hedge 50% Hedge Floating Pmt 0.7407 0.7812 0.8217 0.8621 0.9026 0.9431 0.9836 1.0241 1.0646 1.1050 1.1455 1.1860 Gain(Loss) Gain(Loss) 0.9793 0.4897 4.6903 2.3451 8.4013 4.2006 12.1122 6.0561 15.8232 7.9116 19.5342 9.7671 23.2451 11.6226 26.9561 13.4781 30.6671 15.3335 34.3781 17.1890 38.0890 19.0445 41.8000 20.9000 256.6758 128.3379 Table 3D-Heating Oil Price rise: Heating Oil Swap 3) Hedging using a Crude Oil Call option- The call option gives the right to buy a particular asset at a predetermined fixed price (strike price) at a time up until the maturity date. In case of price rise, the call option can be exercised and the option would make a profit, and would offset the loss from the actual price rise of the commodity. In the case of a price decline, the call option may not be exercised, giving it an advantage over other hedging strategies and hence would benefit considerably from the price decline. However, the call option requires a premium to be paid up front. This would sometimes act as a disadvantage to the airlines that need to pay the cash upfront unlike other strategies. In this alternative, the call option on crude oil futures is chosen. The profits or losses made by this strategy would depend on the price volatility of crude oil in the market. The call option with a premium of $1.80 per contract, and a strike price of $28 is bought. The future price for crude oil (June 2001) is $26.39. The expected spot price as per scenario 1 and scenario 2 is assumed to be $14.10 and $40. The contract size for Crude Oil futures is 1000 barrels and the fuel usage in terms of barrel is 26.19 million barrels, where 1 barrel is 42 gallons of oil. Based on the amount of fuel hedged, and the possible scenario, the airline can either make a profit or a loss from   14  
  • its options. The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel hedge. The profits or losses made by this strategy will offset the profit or loss made by the jet fuel price. An important issue to consider here is the Basis Risk associated with Crude Oil. Crude Oil has a higher basis risk than Heating Oil. After refining crude oil, the products obtained are Heating Oil, Diesel Fuel, Jet Kerosene or Fuel. Refer to Table 4A and 4B–Scenario 1 and Scenario 2. Scenario 1- OPTION 3--Crude Oil Call Strike Price(Jun 02) Premium Spot Price Call Option Not exercised Payoff Profit(Loss)-100% Hedge $ $ $ 28.00 1.80 14.10 $ $ -47.14 Payoff Profit(Loss)-50% Hedge $ $ -23.57 Table 4A-Crude Oil Price decline: Crude Call Option Scenario 2-OPTION 3--Crude Oil Strike Price(Jun 02) Premium Spot Price $ $ $ 28.00 1.80 40.00 Payoff Profit(Loss)-100% Hedge $ $ 314.29 267.14 Payoff Profit(Loss)-50% Hedge $ $ 157.14 133.57 Table 4B-Crude Oil Price rise: Crude Call Option 4) Hedging using Zero Cost Crude Oil Collar- This is a combination of a call option and a put option. The airline will buy the call option and sell the put option. It is a zero cost collar because the premiums of both the options are the same. The   15  
  • premium received from the put option will be used to pay the premium of the call option. This is beneficial to those that cannot pay high upfront costs. In this case, the options on crude oil futures are chosen. In this alternative, the call option with a premium of $1.80 per contract, and a strike price of $28 is bought. A put option with the same premium of $1.80 per contract and a strike price of $22.50 is sold. The future price for crude oil (June 2001) is $26.39. The expected spot price as per scenario 1 and scenario 2 is assumed to be $14.10 and $40. The contract size for Crude Oil futures is 1000 barrels and the fuel usage in terms of barrel is 26.19 million barrels, where 1 barrel is 42 gallons of oil. The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel hedge. In scenario 1, when the crude oil price declines, the call option will not be exercised by the airline but the buyer of the put option will exercise the put option and the airline would pay the buyer of the put option the difference of the strike price and the spot price at year end. In scenario 2, when the crude oil price rises, the airline would exercise the call option and would benefit from the difference of the spot price at year-end and the strike price. The buyer will not exercise the put option. The profits or losses made by this strategy will offset the profit or loss made by the jet fuel price. Like in the previous strategy, the basis risk is pretty high with Crude Oil Futures. Scenario 1- OPTION 4-Crude Oil Collar Call Strike Price Put Strike Price Premium(Call&Put) Crude Spot Price Payoff Profit (Loss)-Full Hedge Payoff Profit (Loss)-50% Hedge $ $ $ $ 28.00 22.50 1.80 14.10 (220.0000) (220.0000) (110.0000) (110.0000) Buyer of Put option exercises the Put option and SWA (buyerof call) will not exercise the call option Table 5A-Crude Oil Price decline: Crude Zero Cost Collar Option   16  
  • Sce na rio 2- OPTION 4-Crude Oil Colla r Ca ll Strike Price Put Strike Price Premium(Call&Put) Crude Spot Price Payoff Profit (Loss)-Full Hedge Payoff Profit (Loss)-50% Hedge $ $ $ $ 28.00 22.50 1.80 40.00 314.2857 314.2857 157.1429 157.1429 Buye r of Put option doe s not e x e rcise the Put option a nd SW A (buye r of ca ll) w ill e x e rcise the ca ll option Table 5B-Crude Oil Price rise: Crude Zero Cost Collar Option 5) Hedging using a Heating Oil Futures contract- A futures contract is an agreement to buy or sell a specified quantity and quality of a commodity for a certain price at a designated time in the future. The airline, which is the buyer, has a long position to offset against the fuel price rise. There is a daily settlement to minimize the chance of default. In this case, in order to hedge, the airline buys heating oil futures contract from the NYMEX. The heating oil Future Price on June 11th, 2001 was $0.7002 per gallon and the estimated spot price (June 2002), for scenario 1 is $ 0.388 per gallon. The estimated spot price (June 2002), for scenario 2 is $ 1.186 per gallon. In scenario 1, due to the price decline in Heating Oil, the loss from the hedge is the difference between the future price and the spot price of $ 0.388 per gallon. In scenario 2, due to the price rise in Heating Oil, the profit from the hedge is the difference between the future price and the spot price of $ 1.186 per gallon. The contract size is 42000 gallons and the amount of fuel used is 1100 million gallons. The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel hedge. The profits or losses made by this strategy will offset the profit or loss made by the jet fuel price. In scenario 1, the basis loss is 8.93 cents/gallon and in scenario 2, there is a basis loss of 8 cents per gallon.   17  
  • Scenario 1-Hedge using a heating oil futures contract Basis Risk Future Price(6/11/01) $ 0.7002 Jun-01 0.0943 Spot Price $ 0.388 Jun-02 0.0050 0.0893 Gain(Loss)-100% Hedge $ (343.42) Gain(Loss)-50% Hedge $ (171.71) Table 6A-Heating Oil Price decline: Heating Oil Futures Contract Scenario 2-Hedge using a heating oil futures contract Basis Risk Future Price(6/11/01) $ 0.7002 Jun-01 Spot Price $ 1.186 Jun-02 Gain(Loss)-100% Hedge $ Gain(Loss)-50% Hedge $ 0.0943 0.0100 0.08 534.38 267.19 Table 6B-Heating Oil Price rise: Heating Oil Futures Contract 6) Hedging using a Crude Oil Futures contract- This is similar to the Heating Oil Futures Contract. The Crude Oil futures contract traded from NYMEX is a long position for the airline. The Crude oil Future Price on June 11th, 2001 was $26.39 per gallon and the estimated spot price (June 2002), for scenario 1 is $ 14.10 per gallon. The estimated spot price (June 2002), for scenario 2 is $ 40 per gallon. In scenario 1, due to the price decline in Crude Oil, the loss from the hedge is the difference between the future price and the spot price of $ 14.10 per gallon. In scenario 2, due to the price rise in Crude Oil, the profit from the hedge is the difference between the future price and the spot price of $ 40 per gallon. The contract size is 1000 barrels and the amount of fuel used is 26.19 million barrels. The two fuel hedging ratios analyzed in this case are the full hedge and 50% fuel hedge. The profits or losses made by this strategy will offset the profit or loss made by the jet fuel price. In   18  
  • scenario 1, the basis gain is $11.89 per gallon and in scenario 2, there is a basis loss of $13.21 per gallon. Scenario 1-Hedge using a crude oil futures contract Future Price(6/11/01) $ 26.39 Basis Risk Gain(Loss)Spot Price $ 14.100 100% Hedge $ (321.8810) June-01 -25.60 Gain(Loss)50% Hedge $ (160.940) Jun-02 -13.71 -11.89 Table 7A-Crude Oil Price decline: Crude Oil Futures Contract Scenario 2-Hedge using a crude oil futures contract Future Price(6/11/01) 26.39 Basis Risk Gain(Loss)Spot Price $ 40.000 100% Hedge $ 356.45 June-01 $ (25.596) Gain(Loss)50% Hedge $ 178.2 June-02 $ (38.804) $ 13.21 Table 7B-Crude Oil Price rise: Crude Oil Futures Contract Overall Analysis: Coming to the overall analysis of the Hedging strategies, Table 8 gives a comprehensive list of all the Fuel Costs, Hedging Costs and Net Fuel Costs or Total Fuel Costs incurred by the airline when all the discussed strategies are employed. The costs are shown in $ millions. The two main objectives of Southwest Airlines in fuel hedging are to maintain fuel expenses at a constant level or minimum variance and to minimize the fuel costs. In order to achieve its objectives, the airline considers the probability of each scenario to occur exactly the same i.e., 50%. Hence the minimum fuel costs are computed based on   19  
  • the average of the fuel costs in Scenario 1 and Scenario 2. The minimum fuel costs are shown in the column highlighted by green. It is important to note that when no hedging takes place, there is no offset of risk or protection against fuel rise. In this case, the fuel costs is the total fuel cost incurred by the airline. In scenario 1, the total fuel cost is $432.3 million and $1315.6 million in scenario 2. The average of these two costs ($873.95 million) is used as benchmark to compute the variance of the fuel costs in each strategy. The column titled Var1 computes the difference of Total Fuel Costs in scenario 1 and the benchmark cost of $873.95 million. The column titled Var2 computes the difference of Total Fuel Costs in scenario 2 and the benchmark cost of $873.95 million. The Variance of Fuel costs as shown in the column highlighted by red, are the average of Var1 and Var2 as there is an equal probability of either scenario to occur. Description Option 1 Do nothing 2a-100% Hedge using a plain vanil a jet fuel swap-Full 2a-50% Hedge using a plain vanil a jet fuel swap-50% 2b-100% Hedge using a plain vanil a heating oil swap-Full 2b-50% Hedge using a plain vanil a heating oil swap-50% 3-100% Hedging using options-Full 3-50% Hedging using options-50% 4-100% Hedge using a zero-cost collar strategy-Full 4-50% Hedge using a zero-cost collar strategy-50% 5a-100% Hedge using a crude oil futures contract-Full 5a-50% Hedge using a crude oil futures contract-50% 5b-100% Hedge using a heating oil futures contract-Full 5b-50% Heade using a heating oil futures contract-50% Scenario 1 Scenario 2 1 Fuel Hedge Costs Total Fuel Fuel Hedge Costs Total Fuel Average Fuel Costs (Profit) Costs Costs (Profit) Costs Costs 432.3 0.0 432.3 1315.6 0.0 1315.6 873.95 432.3 201.3 633.6 1315.6 (277.2) 1038.4 836.00 432.3 100.6 532.9 1315.6 (138.6) 1177.0 854.98 432.3 218.8 651.1 1315.6 (256.7) 1058.9 855.01 432.3 109.4 541.7 1315.6 (128.3) 1187.3 864.48 432.3 47.1 479.4 1315.6 (267.1) 1048.5 763.95 432.3 23.6 455.9 1315.6 (133.6) 1182.0 818.95 432.3 220.0 652.3 1315.6 (314.3) 1001.3 826.81 432.3 110.0 542.3 1315.6 (157.1) 1158.5 850.38 432.3 321.9 754.2 1315.6 (356.5) 959.1 856.66 432.3 160.9 593.2 1315.6 (178.2) 1137.4 865.31 432.3 343.4 775.7 1315.6 (534.4) 781.2 778.47 432.3 171.7 604.0 1315.6 (267.2) 1048.4 826.21 2 Var1 441.65 240.37 341.01 222.85 332.25 394.51 418.08 221.65 331.65 119.77 280.71 98.23 269.94 3 4 Var2 Variance 441.65 441.65 164.47 202.42 303.06 322.04 184.97 203.91 313.31 322.78 174.51 284.51 308.08 363.08 127.36 174.51 284.51 308.08 85.20 102.48 263.42 272.07 92.73 95.48 174.46 222.20 Table 8   20  
  • Southwest Airlines has to choose the best hedging strategy that would have minimum fuel variance and minimum fuel costs. As per basic analysis from Table 8, it appears that the minimum fuel cost of $763.95 million is achieved from the Full Hedge –Call Option strategy based on the annual fuel consumption of $1100 million gallons and the minimum variance of $95.48 million is achieved from the Full Hedge- Heating Oil Futures contract. The below Figure 1 shows the Total costs incurred by the airline in scenario 1. It shows the costs incurred by the Hedge strategies and the actual fuel costs. In this scenario, all the hedge strategies have made a loss since, the price declines. Hence in this scenario, the un-hedged strategy has the minimum fuel cost of $432.3 million. Figure 2 shows the Total costs incurred by the airline in scenario 2. It shows the costs incurred by the Hedge strategies and the actual fuel costs. In this scenario, all the hedge strategies have made a profit since, the price rises. In this scenario, the 100% hedging strategy of heating oil futures has the minimum fuel cost of $781.2 million. Total Costs Scenario 1 900 800 700 ($MM) 600 500 Hedge Costs (Profit) 400 Fuel Costs 300 200 100 0 Figure 1   21  
  • Total Costs Scenario 2 1500 1000 ($MM) 500 Fuel Costs Hedge Costs (Profit) 0 -500 -1000 Figure 2 Figures 3 shows the Total Fuel costs of each strategy in Scenario 1. The purple bars show the total costs when hedged fully and the maroon bars show the total costs when 50% hedging takes place. As discussed earlier, the un-hedged strategy (1st purple bar) has the minimum fuel cost. Total Costs - Scenario 1 1400 1200 Costs ($MM) 1000 800 Full Hedge 600 50% Hedge 400 200 0 1 2 3 4 5 6 7 Figure 3   22  
  • Figures 4 shows the Total Fuel costs of each strategy in Scenario 2. The purple bars show the total costs when hedged fully and the maroon bars show the total costs when 50% hedging takes place. As discussed earlier, the 100% hedged strategy with Heating Oil Futures contract has the minimum fuel cost. Total Costs - Scenario 2 1400 Costs ($MM) 1200 1000 800 Full Hedge 600 50% Hedge 400 200 0 1 2 3 4 5 6 7 Figure 4 Figure 5 combines Scenario 1 and 2 in one chart and shows the Net Cost or Total Fuel costs incurred by the airline. Net Cost of Jet Fuel Costs ($MM) 1400 1200 1000 800 600 400 200 0 Do Hedge Hedge Hedging Hedge Hedge Hedge Nothing using a using a using using a using a using a plain plain options- zero- crude oil heating vanilla vanilla Full cost futures oil jet fuel heating collar contract- futures swap- oil swapstrategy- Full contractFull Scenario 2 Full Hedge Full Full Full Scenario 1 Full Hedge Scenario 1 50% Hedge Scenario 2 50% Hedge Figure 5   23  
  • Scenario Costs Variance 0 Costs ($MM) -100 -200 -300 Hedge using a Hedge using a Hedging using Hedge using a Hedge using a Hedge using a plain vanilla jet plain vanilla options-Full zero-cost collar crude oil heating oil fuel swap-Full heating oil strategy-Full futures futures swap-Full contract-Full contract-Full -400 -500 -600 -700 -800 Scenario 1 - Scen 2 Scenario 1 - Scen 2 Figure 6 Figure 6 shows the Scenario variance of Fuel costs (Scenario 1 – Scenario 2) for all the hedging strategies. The yellow bars are for the 100% hedged strategies. The purple bars are for the 50% hedged strategies. This chart shows the variance between the fuel costs in each scenario. In order to consider a more comprehensive and effective analysis, the minimum fuel costs and minimum variance considering equal probability of each scenario are computed. Figure 7 shows the Average Fuel costs considering equal occurrence of scenario 1 and 2. As stated earlier, the 100% hedging using call options have the minimum fuel cost followed by the 100% hedge of heating oil futures.   24  
  • Average  Fuel  Costs   900.00   880.00   860.00   840.00   820.00   800.00   780.00   760.00   740.00   720.00   700.00   Average  Fuel   Costs   Figure 7 Figure 8 shows the variance of fuel costs, considering equal occurrence of each scenario. It can be seen that the minimum variance of $95.48 million is achieved by using the 100% hedge –Heating oil futures contract. The maximum variance is by the un-hedged or Do nothing option, as the fuel costs are not offset by any risk of price rise or fall.   25  
  • 500.00   450.00   400.00   350.00   300.00   250.00   200.00   150.00   100.00   50.00   0.00   Variance   Variance   Figure 8 As per basic analysis, the minimum fuel cost of $763.95 million is achieved from the Full Hedge –Call Option strategy based on the annual fuel consumption of $1100 million gallons and the minimum variance of $95.48 million is achieved from the Full Hedge- Heating Oil Futures contract. Introduction of sensitivity analysis will further strengthen and make the analysis and decision for Southwest Airlines more effective and complete. @Risk Sensitivity Analysis Each of the hedging strategies and the un-hedged strategy was evaluated using the @Risk software to find the various output scenarios and probabilities for a range of key input drivers. For the purpose of this project, the following key drivers were considered for the analysis (Refer Table 9):   26  
  • • Fuel Usage (Jet Fuel): This is an important input for the analysis, as the fuel consumption plays an important role in determining the total fuel costs incurred by the Airline. The fuel consumption of an airline increases yearly as the airline keeps growing and adds more aircraft to its fleet. Based on the past fuel consumption data available for Southwest Airlines, the fuel consumption range for the year 2001-2002 was decided. The values for the Max. , Median (most likely) and Min. are 1100,1150 and 1200 million gallons respectively. • Jet Fuel Spot Price (2001): Since the expected future spot price of Jet fuel is factored in the analysis in each scenario (price rise and decline). The variance of the current spot price will vary the expected future spot price of Jet Fuel. The spot price of Jet fuel has been varied by 15%. The values for the Max., Median (most likely) and Min. are 0.68, 0.7962 and 0.9140 dollars per gallon respectively. • Heating Oil Spot Price (2001): Similarly, since the expected future spot price of heating oil is factored in the analysis in each scenario (price rise and decline). The variance of the current spot price will vary the expected future spot price of Heating Oil. The spot price of Heating Oil has been varied by 15%. The values for the Max. , Median (most likely) and Min. are 0.5952, 0.7018 and 0.81 dollars per gallon respectively. • Crude Oil Spot Price (2001): Similarly, since the expected future spot price of crude oil is factored in the analysis in each scenario (price rise and decline). The variance of the current spot price will vary the expected future spot price of Crude Oil. The spot price of Crude Oil has been varied by 15%. The values for the Max. , Median (most likely) and Min. are 22.4315, 26.39 and 30.3485 dollars per gallon respectively. • Call option premium: This input would have an impact on the hedging strategy using Crude Call options. If spot price is less than the strike price, then the airline will not exercise the call option but will pay the premium. If the spot price is greater than the strike price then the airline will exercise the call option but will pay the premium as a cost. The value of the premium cost can be a factor in the analysis where hedging options are considered. The values for the Max. , Median (most likely) and Min. are 1.0, 1.83 and 2.7 dollars per contract respectively.   27  
  • Table 9-@ Risk Model Inputs Model Output -@Risk Analysis In this analysis, there are 26 outputs considered. 13 outputs corresponding to the Average Fuel costs of each hedging strategy and 13 outputs corresponding to the Variance of each hedging strategy. Each output will consider an equal occurrence of Scenario 1 and Scenario 2. Average Fuel Outputs: • Do-Nothing or Un-hedged-Average Fuel Cost • Full Hedge using a Plain Vanilla Jet-fuel Swap-Average Fuel Cost • 50% Hedge using a Plain Vanilla Jet-fuel Swap-Average Fuel Cost • Full Hedge using a Plain Vanilla Heating Oil Swap-Average Fuel Cost • 50% Hedge using a Plain Vanilla Heating Oil Swap-Average Fuel Cost • Full Hedge using a Call option on Crude Futures -Average Fuel Cost   28  
  • • 50% Hedge using a Call option on Crude Futures -Average Fuel Cost • Full Hedge using a Zero cost collar option on Crude Futures -Average Fuel Cost. • 50% Hedge using a Zero cost collar option on Crude Futures -Average Fuel Cost. • Full Hedge using a Crude Oil Futures Contract-Average Fuel Cost. • 50% Hedge using a Crude Oil Futures Contract-Average Fuel Cost. • Full Hedge using a Heating Oil Futures Contract-Average Fuel Cost. • 50% Hedge using a Heating Oil Futures Contract-Average Fuel Cost. Variance Outputs • Do-Nothing or Un-hedged-Variance. • Full Hedge using a Plain Vanilla Jet-fuel Swap- Variance. • 50% Hedge using a Plain Vanilla Jet-fuel Swap- Variance. • Full Hedge using a Plain Vanilla Heating Oil Swap- Variance. • 50% Hedge using a Plain Vanilla Heating Oil Swap- Variance. • Full Hedge using a Call option on Crude Futures –Variance. • 50% Hedge using a Call option on Crude Futures – Variance. • Full Hedge using a Zero cost collar option on Crude Futures – Variance. • 50% Hedge using a Zero cost collar option on Crude Futures – Variance. • Full Hedge using a Crude Oil Futures Contract- Variance. • 50% Hedge using a Crude Oil Futures Contract- Variance. • Full Hedge using a Heating Oil Futures Contract- Variance. • 50% Hedge using a Heating Oil Futures Contract- Variance.   29  
  • Target Level 1 118.7024149 Target-Fuel Cost Variance (SWA)-2002 Estimated-Fuel Cost per Gallon (SWA)-2002 Target-Total Fuel Cost (SWA)-2002 Target Level 2 129.4935436 $ 0.76 $836.00 Table 10-Target Values for Fuel hedging The target levels (Table 10) for the fuel cost and variance to be achieved by each of the strategies is decided based on the past fuel cost data mentioned in Table 1. Based on the annual fuel consumption data of 1100 million gallons and estimated jet fuel price of $0.76 per gallon, the target average fuel cost is set at $836 million. Therefore any strategy having the highest amount of probability below the target value of $836 million is a good strategy for the airline. The 1st target level for variance is set at a price of $118.70 million based on the standard deviation of previous annual fuel prices (Table 1) and fuel consumption of 1100 million gallons. The 2nd target level for variance is set at a price of $129.49 million based on the standard deviation of previous annual fuel prices (Table 1) and fuel consumption of 1200 million gallons. Therefore any strategy having the highest amount of variance probability below Target level 2 is considered very good. If probability of strategy is below Target level 1, then the strategy is considered extremely good in terms of keeping the fuel constant. Southwest Airlines would require a hedging strategy that has a very high amount of probability indicating minimum variance and minimum fuel. The following outputs- Average fuel costs show the density probability distribution diagram and the key inputs with the regression coefficients that impact the output the most.   30  
  • 1. Do-Nothing or Un-hedged-Average Fuel Cost Figure 9 Figure 9 shows that there is a probability of only 9% that the average fuel cost would reach below the target level of $836 million. 2. Full Hedge using a Plain Vanilla Jet-fuel Swap-Average Fuel Cost Figure 10   31  
  • Figure 10 shows that there is 0% probability that the average fuel cost would reach below the target level of $836 million. Figure 11 shows that the only input, which impacts in the Average Fuel price, is the fuel usage or fuel consumption. It has a very high positive correlation of 1.00. Figure 11 Regression  and  Rank  Information  for  Hedge  using  a  plain  vanilla  jet  fuel  swap-­‐ Full  /  Average  Fuel  Costs   Rank   Name   Regr   Corr   1   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   1.000   1.000   -­‐0.004017771   2   6/11/01  spot  price  (Jet  Fuel)=  /   0.000   Scenario  1                                                                                                                                                                                                   Figure 12   32  
  • 3. 50% Hedge using a Plain Vanilla Jet-fuel Swap-Average Fuel Cost Figure 13 Figure 13 shows that there is only about 2% probability that the average fuel cost would reach below the target level of $836 million. Figure 14 displays that the Spot price of Jet fuel and the fuel usage input impacts the output considerably. The jet fuel spot price and fuel usage input has a very high positive correlation of 0.86 and 0.48 respectively. Figure 14   33  
  • Regression  and  Rank  Information  for  Hedge  using  a  plain  vanilla  jet  fuel  swap-­‐50%  /  Average   Fuel  Costs   Rank   1   Name   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   Regr   0.867   Corr   0.862   2   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   0.501   0.477                                                                                                                                                                                                   Figure 15 4. Full Hedge using a Plain Vanilla Heating Oil Swap-Average Fuel Cost Figure 16   34  
  • Figure 16 shows that there is about 23% probability that the average fuel cost would reach below the target level of $836 million. Figure 17 displays that the Spot price of Jet fuel, spot price of Heating oil and the fuel usage input impacts the output. The jet fuel spot price and fuel usage input has a positive correlation of 0.71 and 0.2 respectively, where as the spot price of Heating oil has a negative correlation of 0.64. The jet fuel increases the actual fuel costs whereas the heating oil makes a profit from the hedge costs, thereby having a negative correlation with the output. Figure 17 Regression  and  Rank  Information  for  Hedge  using  a  plain  vanilla  heating  oil  swap-­‐Full  /   Average  Fuel  Costs   Rank   1   2   3           Name   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   6/11/01  spot  price  (Heating  Oil)=  /  Scenario  1   Fuel  usage  (Jet  Fuel)=  /  Scenario  1           Regr   0.723   -­‐0.664   0.209           Corr   0.707   -­‐0.644   0.196                                                                                                                                                           Figure 18   35  
  • 5. 50% Hedge using a Plain Vanilla Heating Oil Swap-Average Fuel Cost Figure 19 Figure 19 shows that there is about 14% probability that the average fuel cost would reach below the target level of $836 million. Figure 20 displays that the Spot price of Jet fuel, spot price of Heating oil and the fuel usage input impacts the output. The jet fuel spot price and fuel usage input has a positive correlation of 0.88 and 0.24 respectively, where as the spot price of Heating oil has a negative correlation of 0.37. The jet fuel increases the actual fuel costs whereas the heating oil makes a profit from the hedge costs, thereby having a negative correlation with the output.   36  
  • Figure 20 Regression  and  Rank  Information  for  Hedge  using  a  plain  vanilla  heating  oil  swap-­‐50%  /   Average  Fuel  Costs   Rank   1   Name   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   Regr   0.881   Corr   0.876   2   3   6/11/01  spot  price  (Heating  Oil)=  /  Scenario  1   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   -­‐0.404   0.257   -­‐0.378   0.240                                                                                                                                                                                   Figure 21   37  
  • 6. Full Hedge using a Call option on Crude Futures -Average Fuel Cost Figure 22 Figure 22 shows that there is about 70% probability that the average fuel cost would reach below the target level of $836 million. This is a very good indication that the strategy would ensure minimum fuel costs. Figure 23 displays that the Spot price of Jet fuel, future spot price of crude oil, fuel usage and the call option premium impact the output. The jet fuel spot price, fuel usage input and call option premium has a positive correlation of 0.88, 0.22 and 0.14 respectively, where as the futures spot price of Crude oil has a negative correlation of 0.34. The jet fuel increases the actual fuel costs whereas the crude oil makes a profit from the hedge costs, thereby having a negative correlation with the output. The fuel usage and call option add to the total costs of the output.   38  
  • Figure 23 Regression  and  Rank  Information  for  Hedging  using  options-­‐Full  /  Average  Fuel  Costs   Rank   1   Name   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   Regr   0.894   Corr   0.888   2   6/11/01  Futures  Price  (Crude  Oil)  /  Scenario  1   -­‐0.360   -­‐0.335   3   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   0.232   0.217   4   Call  Option  Premium  /  Scenario  1   0.155   0.138                                                                                                                                                                   Figure 24   39  
  • 7. 50% Hedge using a Call option on Crude Futures -Average Fuel Cost Figure 25 Figure 25 shows that there is about 35% probability that the average fuel cost would reach below the target level of $836 million. Figure 26 displays that the Spot price of Jet fuel, future spot price of crude oil, fuel usage and the call option premium impact the output.     Figure 26   40  
  • The jet fuel spot price, fuel usage input and call option premium has a positive correlation of 0.94, 0.24 and 0.067 respectively, where as the futures spot price of Crude oil has a negative correlation of 0.172. The jet fuel increases the actual fuel costs whereas the crude oil makes a profit from the hedge costs, thereby having a negative correlation with the output. The call option has a very negligible impact to the total costs. Regression  and  Rank  Information  for  Hedging  using  options-­‐50%  /  Average  Fuel  Costs   Rank   Name   Regr   1   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   0.945   2   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   0.262   3   6/11/01  Futures  Price  (Crude  Oil)  /  Scenario  1   -­‐0.190   4   Call  Option  Premium  /  Scenario  1   0.082   Corr   0.942   0.244   -­‐0.172   0.067                                                                                                                                                                   Figure 27 8. Full Hedge using Zero-cost collar on Crude Futures -Average Fuel Cost. Figure  28     41  
  • Figure 28 shows that there is about 34% probability that the average fuel cost would reach below the target level of $836 million. Figure 29 displays that the Spot price of Jet fuel, future spot price of crude oil, and fuel usage impact the output.       Figure 29   The jet fuel spot price and fuel usage input has a positive correlation of 0.75 and 0.20 respectively, where as the futures spot price of Crude oil has a negative correlation of 0.592. The jet fuel increases the actual fuel costs whereas the crude oil makes a profit from the hedge costs, thereby having a negative correlation with the output. The fuel usage adds to the total costs of the output. Regression  and  Rank  Information  for  Hedge  using  a  zero-­‐cost  collar  strategy-­‐Full  /  Average   Fuel  Costs   Rank   Name   Regr   Corr   1   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   0.763   0.751   2   6/11/01  Futures  Price  (Crude  Oil)  /  Scenario  1   -­‐0.615   -­‐0.592   3   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   0.214   0.202                                                                                                                                                                                   Figure 30   42  
  •   9. 50% Hedge using a Zero cost collar option on Crude Futures -Average Fuel Cost. Figure 31 Figure 31 shows that there is about 19% probability that the average fuel cost would reach below the target level of $836 million. Figure 32 displays that the Spot price of Jet fuel, future spot price of crude oil, and fuel usage impact the output. Figure 32 The jet fuel spot price and fuel usage input has a positive correlation of 0.89 and 0.24 respectively, where as the futures spot price of Crude oil has a negative correlation of 0.336. The jet fuel increases the actual fuel costs whereas the crude oil makes a profit   43  
  • from the hedge costs, thereby having a negative correlation with the output. The fuel usage adds to the total costs of the output. Regression  and  Rank  Information  for  Hedge  using  a  zero-­‐cost  collar  strategy-­‐50%  /  Average  Fuel   Costs   Rank   Name   Regr   Corr   1   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   0.899   0.894   2   6/11/01  Futures  Price  (Crude  Oil)  /  Scenario  1   -­‐0.362   -­‐0.336   3   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   0.259   0.243                                                                                                                                                                                   Figure 33 10. Full Hedge using a Crude Oil Futures Contract-Average Fuel Cost. Figure 34   44  
  • Figure 34 shows that there is about 15% probability that the average fuel cost would reach below the target level of $836 million. Figure 35 displays that the Spot price of Jet fuel, and fuel usage impact the output. Figure 35 Regression  and  Rank  Information  for  Hedge  using  a  crude  oil  futures  contract-­‐Full  /  Average   Fuel  Costs   Rank   Name   Regr   Corr   1   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   0.961   0.960   2   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   0.279   0.259   3   6/11/01  Futures  Price  (Crude  Oil)  /  Scenario  1   0.000   0.007182983                                                                                                                                                                                   Figure 36 The jet fuel spot price and fuel usage input has a positive correlation of 0.96 and 0.259 respectively, where as the futures spot price of Crude oil has a very negligible impact. The jet fuel spot price increases the actual fuel costs whereas the fuel usage adds to the total costs of the output.   45  
  • 11. 50% Hedge using a Crude Oil Futures Contract-Average Fuel Cost. Figure 37 Figure 37 shows that there is about 11% probability that the average fuel cost would reach below the target level of $836 million. Figure 38 displays that the Spot price of Jet fuel, and fuel usage impact the output. Figure 38 The jet fuel spot price and fuel usage input has a positive correlation of 0.96 and 0.261 respectively, where as the futures spot price of Crude oil has a very negligible impact.   46  
  • The jet fuel spot price increases the actual fuel costs whereas the fuel usage adds to the total costs of the output. Regression  and  Rank  Information  for  Hedge  using  a  crude  oil  futures  contract-­‐50%  /  Average   Fuel  Costs   Rank   Name   Regr   Corr   1   2   3   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   6/11/01  Futures  Price  (Crude  Oil)  /  Scenario  1   0.961   0.281   0.000   0.959   0.261   0.007167339                                                                                                                                                                                   Figure 39 12. Full Hedge using a Heating Oil Futures Contract-Average Fuel Cost. Figure 40   47  
  • Figure 40 shows that there is about 62% probability that the average fuel cost would reach below the target level of $836 million. This is a very good indication of hedging strategy to be used for minimum fuel costs. Figure 41 displays that the Spot price of Jet fuel, Spot price of Heating Oil and fuel usage impact the output. Figure 41 The jet fuel spot price, heating oil spot price and fuel usage input have a positive correlation of 0.88,0.391 and 0.217 respectively. The jet fuel spot price and the heating oil spot price increases the actual fuel costs whereas the fuel usage adds to the total costs of the output. Regression  and  Rank  Information  for  Hedge  using  a  heating  oil  futures  contract-­‐Full  /  Average   Fuel  Costs   Rank   Name   Regr   Corr   1   2   3                       6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   6/11/01  spot  price  (Heating  Oil)=  /  Scenario  1   Fuel  usage  (Jet  Fuel)=  /  Scenario  1                       0.882   0.405   0.233                       0.883   0.391   0.217                                                                                                                       Figure 42   48  
  • 13. 50% Hedge using a Heating Oil Futures Contract-Average Fuel Cost. Figure 43 Figure 43 shows that there is about 31% probability that the average fuel cost would reach below the target level of $836 million. Figure 44 displays that the Spot price of Jet fuel, Spot price of Heating oil and fuel usage impact the output. Figure 44   49  
  • The jet fuel spot price, heating oil spot price and fuel usage input has a positive correlation of 0.94,0.208 and 0.244 respectively. The jet fuel spot price and the heating oil spot price increases the actual fuel costs whereas the fuel usage adds to the total costs of the output. Regression  and  Rank  Information  for  Hedge  using  a  heating  oil  futures  contract-­‐50%  /  Average   Fuel  Costs   Rank   Name   Regr   Corr   1   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   0.940   0.940   2   3       Fuel  usage  (Jet  Fuel)=  /  Scenario  1   6/11/01  spot  price  (Heating  Oil)=  /  Scenario  1       0.263   0.216       0.244   0.208                                                                                                                                                                       Figure 45 Variance –Outputs: With the variance, most of the outputs have a probability of zero in reaching Target Level 1 or Target Level 2. Hence only those outputs having a probability of reaching the Target levels will be discussed below: 1. Full Hedge using a Crude Oil Futures Contract- Variance. Figure 46   50  
  • Figure 46 shows that there is 100% probability that this hedging strategy would reach the target level 1 and level 2 of variance. Hence this strategy is very effective in maintaining fuel costs constant or with minimum variance. Figure 47 shows that the fuel usage has the biggest impact on the variance of the output as indicated by the correlation of 1, whereas the other inputs such as spot price of Jet fuel and spot price of Crude oil futures have a negligible effect. Figure 47 Regression  and  Rank  Information  for  Full  Hedge-­‐Crude  Oil  Futures-­‐Variance   Rank   Name   Regr   Corr   1   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   1.000   1.000   2   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   0.000   -­‐0.004017771   3   6/11/01  Futures  Price  (Crude  Oil)  /  Scenario  1   0.000   -­‐0.001101022                                                                                                                                                                                   Figure 48   51  
  • 2. Full Hedge using a Heating Oil Futures Contract- Variance. Figure 49 Figure 49 shows that there is 87% and 76% probability that this hedging strategy would reach the target level 2 and level 1 of variance. Hence this strategy is very effective in maintaining fuel costs constant or with minimum variance. Figure 50 shows that the spot price of Heating Oil futures has the biggest impact on the variance of the output as indicated by the negative correlation of 0.997, whereas the other input i.e., Usage of jet fuel has a negligible effect with a correlation of 0.068. The negative correlation of the Heating oil spot price show that this input helps in limiting variance. Figure 50   52  
  • Regression  and  Rank  Information  for  Full  Hedge-­‐Heating  Oil  Futures-­‐Variance   Rank   Name   Regr   1   6/11/01  spot  price  (Heating  Oil)=  /  Scenario  1   -­‐0.996   2   Fuel  usage  (Jet  Fuel)=  /  Scenario  1   0.070   3   6/11/01  spot  price  (Jet  Fuel)=  /  Scenario  1   0.000               Corr   -­‐0.997   0.068   -­‐0.00762999                                                                                                                                                                       Figure 51 Summary of @Risk analysis. • As per the analysis of the Outputs -Average Fuel Costs and Outputs- Variance, it is clear that in order to achieve the objectives of Southwest Airlines, it is necessary to have a strategy, which has a combination of both the minimum fuel cost and minimum variance. • The minimum fuel cost objective is achieved by having a strategy that has the highest probability to reach below the target level of $836 million. There are two strategies that have achieved this target with the highest amount of probability than the others. They are the Full Hedge using a Call option on Crude Futures and the Full Hedge using a Heating Oil Futures Contract. • The minimum variance objective is achieved by having a strategy that has the highest probability to reach below the target level 1 of $118.7 million and target level 2 of 129.4 million. There are two strategies that have achieved this target with the highest amount of probability than the others. They are the Full Hedge using a Crude Oil Futures and the Full Hedge using a Heating Oil Futures Contract. • Since, the Full Hedge using a Heating Oil Futures contract strategy has a very high amount of probability in achieving the Target levels of the objectives, it is the preferred hedging strategy to achieve Southwest’s objectives.   53  
  • Conclusion After carefully considering all the hedging strategies, in the primary and the sensitivity analysis, it can be recommended that the best strategy, which can be used to maintain constant and minimum fuel costs, is the Full Hedge Heating Oil Futures Contract. This strategy also has a very low basis risk compared to the other strategies using Crude Oil. It is therefore advised that Scott Topping utilizes this strategy for Southwest Airlines. Current Outlook Most of the major airlines are hedging fuel using jet fuel, gas oil and crude derivatives. Few cover more than 12 months’ expected consumption, and it is rare to find more than 80% of future needs hedged beyond three months ahead. Crude oil provides more liquidity and flexibility for hedging, but the spread between crude and jet aviation fuel had tended to widen at times of market instability. Not many airlines report gains and losses from fuel hedging activity, but many are now required to report the market value of unexpired contracts on their balance sheets. There seems to be no reason to contradict the economic fundamentals of hedging. A policy of permanent hedging of fuel costs should leave expected long-run profits unchanged. If it damps out profit volatility, it should do so in a way that the market would not value. Data suggests it may not damp out volatility, after all. Oil prices and air travel demand cycles are correlated when oil supply reductions drive GDP declines. But oil and travel are negatively correlated when GDP demand surges drive oil price increases. So oil prices can be observed to either increase or decrease airline profit cycles, depending on the time period sampled. A fuel price hedge would create exceptional value is when an airline is on the edge of bankruptcy. However, when on the verge of bankruptcy, an airline does not have the liquidity to buy oil futures. On the other hand, foreign exchange hedges probably did make sense, when airlines were state-supported. And variable levels of hedging can be useful in transferring profits from one quarter to another. Finally, hedging may be a zero-cost signal to investors that management is technically alert. Perhaps this is the most compelling argument for airline hedging. However, it lies more in the realm of the psychology of markets than the mathematics of economics.   54  
  •   Average Brent Crude Oil price per barrel $80 $90 Current Market (1) $110 $120 Period Southwest  Airlines  Co.   Fuel  Derivative  Contracts   As  of  April  22,  2013     Estimated economic jet fuel price per gallon, including taxes 2Q 2013 (2) Second Half of 2013 (2) $2.95 - $3.00 $2.90 - $2.95 $2.95 - $3.00 $2.95 - $3.00 $3.00 - $3.05 $3.00 - $3.05 $3.10 - $3.15 $3.20 - $3.25 $3.15 - $3.20 $3.30 - $3.35 Average percent of estimated fuel consumption covered by fuel derivative contracts at varying WTI/Brent crude oil-equivalent price levels 2014 Approx. 60% 2015 Approx. 35% 2016 Approx. 30% 2017 Approx. 50% (1) Brent crude oil average market prices as of April 22, 2013 were approximately $101 and $99 per barrel for second quarter and second half 2013, respectively. (2) The Company has approximately 95 percent of its second quarter and second half 2013 estimated fuel consumption covered by fuel derivative contracts with approximately 75 percent at varying Gulf Coast jet fuel-equivalent prices and the remainder at varying Brent crude oil-equivalent prices. The economic fuel price per gallon sensitivities provided above assume the relationship between Brent crude oil and refined products based on market prices as of April 22, 2013.   Table  11-­‐Southwest  Fuel  Derivative  Data       Airline Jet fuel as a % of Operating Expenses Years Jet Fuel Hedged Average % of Next Year Hedged Std. Dev of Next year Hedged Fuel Passthrough Agreement Charter Operations AirTran Alaska Air American Continental Delta Air Frontier Airlines JetBlue Airlines Southwest Airlines United Airlines US Airways Average 18.84% 13.92% 11.97% 15.14% 12.20% 15.58% 2000-2008 2001-2008 2000-2008 2000-2008 2000-2008 2002-2008 29% 36% 23% 13% 37% 17% 8 16 12 13 23 15 0 0 0 0 0 0 0 0 0 0 0 0 16.07% 2002-2008 22% 17 0 0 14.51% 2000-2008 69% 28 0 0 12.30% 2000-2008 10% 12 0 0 9.69% 14.02% 2000-2008 23% 28% 17 0 0   Table  12-­‐U.S.  Airline  Industry  Hedging  Data  by  FASB     55  
  • REFERENCES Raghavan, S. (2010). Advanced case studies in corporate finance with application to aviation & aerospace industries. (5th ed.). New York: Linus Publications,Inc. Retrieved October 12, 2013 from http://www.financialsense.com Retrieved October 12, 2013 from http://www.finance.yahoo.com Retrieved October 12, 2013 from http://www.cnbc.com Retrieved October 12, 2013 from http://www.longviewfunds.com Retrieved October 12, 2013 from http://www.investopedia.com/articles/07/contango   56