Monday, November 30, 2009

Southwest Airlines Weathers Tough Times By Hedging Fuel

While larger carriers stockpile cash for the coming winter, Southwest Airlines is positioning itself for strategic growth and long-term sustainability. Much of the airline’s success can be attributed to the company's low cost model. Its fleet is made up solely of Boeing 737s and offers only coach seats. The company’s value proposition is simple: "a primarily short-haul airline that flies directly from city to city, with product model and the lower costs." Despite its thin margins, the leading discount carrier has continued to earn money while political risks and financial crises threaten other carriers' survival. The main source of this advantage has been that Southwest is hands down the best oil price hedger among airlines worldwide.

Utilizing a variety of investment strategies, Southwest has for a decade locked in the prices it pays for jet fuel years ahead of its use. This financial arrangement has protected it from drastic increases in crude oil prices and dramatically cut its fuel expenses. Since 1998, Southwest has saved $3.5 billion from what it would have paid for fuel at market rates, equal to more than three quarters of the company's profits over the last decade. Its competitors have not been so lucky, paying over $3.15 a gallon while Southwest averages about $2.35 a gallon.

This huge advantage will disappear as Southwest's contracts expire over the next 5 years. With extremely high prices over the last 2 years, Southwest didn't buy any significant hedging contracts between 2007 and 2008. Southwest Treasurer Scott Topping says "its successes have produced a crucial benefit: time to adapt its determinedly low-cost business model to paying full market price for jet fuel if necessary." Although Southwest’s days of double digit growth rates have passed, the nation's leading domestic passenger carrier is the only airline still in the black. As other airlines slash prices, schedules and employees, Southwest is poised to gain market share.

Major fluctuations in oil occurred in 2003, reaching the upper $20s and mid 30s, doubling and tripling the prices in 1998 and 1999. Throughout that period, Southwest paid over 25% less than its rivals with smaller hedges. But Southwest didn't stop there. Southwest also hedged a larger percentage of its fuel than the majority of its rivals, in by doing so, remained profitable from 2001 through 2005, a historic industry downturn, in which the industry lost more than $35 billion total.

Strategizing for sustainability, Southwest continues to use its financial strength to hedge aggressively. Over 70% of Southwest's fuel needs for 2008 were hedged at $51 a barrel, while, by contrast, American only hedged 34% of its fuel needs for the year at $82 a barrel. How the company will weather continuing recessionary woes and rising oil prices remains to be seen. Now if only airlines could run on bio-diesel….

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