Hedging Against $200 Oil

For the financial whizzes of Southwest Airlines, it just gets more expensive to buy protection as oil prices keep climbing

Oil is getting pricier by the minute. A barrel of the benchmark West Texas Intermediate crude hit a record of $123.80 in intraday trading May 7, before settling at $123.53. And look out: on May 6, investment bank Goldman Sachs said oil prices could hit $200 within the next two years as limited supply growth and rising demand causes a “super spike”.

That’s not welcome news for airlines. Rising jet fuel prices


“We would like to see more coverage, and we’re reviewing our options,” says Scott Topping, treasurer of Southwest and manager of its hedging program. “The fundamentals still point to the risk of higher prices; we feel we need to [hedge].”

A hedge is a financial instrument that allows investors to lock in certain prices to act as insurance against the possibility that the open-market, or spot, price of that commodity will rise. If the price then rises, the company gets a financial payoff that cushions the blow of higher prices. In this way, investors can actually make money using hedging as insurance, giving them an advantage over competitors in the marketplace.

Southwest is currently the only major airline with most of its fuel costs hedged at lower prices, largely because it is the only large carrier with the cash flow to do so. For 2008, 70% of its fuel needs are hedged at $51 a barrel. That means that while competitors have to contend with spot prices hovering around $120 a barrel, Southwest can buy oil at less than half that. Access to this discounted price means Southwest feels less pressure to pass on higher costs to customers, which could afford it more market share as competitors hike ticket prices.

Business Week