Wednesday, March 4, 2009

When "hedging" is just speculation

United's fuel hedging strategy has all the marks of some smooth-talking consultants or bankers.  Way to go, United.

"In both 2008 and 2007, an increase in jet fuel prices was the primary reason for higher mainline and United Express fuel expense and aircraft fuel cost per gallon, as highlighted in the table below. The price of crude oil reached a record high of approximately $145 per barrel in July 2008 and then dramatically decreased in the second half of the year to approximately $45 per barrel at December 31, 2008. This significant fuel price volatility drove the Company’s total fuel hedge losses of more than $1.1 billion in 2008.


"The volatility of and increases in crude oil prices, a weakening economic environment and a highly competitive industry with excess capacity have created an extremely challenging environment for the Company. The Company’s cash flows and results of operations have been adversely impacted by these factors as indicated by its net loss of $5.3 billion during the year ended December 31, 2008." - United Airlines 2008 10-K, 2 March 2009


Chris said...

Just because a hedge looses money doesn't mean it's speculative - it may be doing exactly what it is supposed to do or could be just be a bad hedge.

The 10K mentions using collars - these basically look in a fuel price for a buyer or seller. It also appears that UAL did very little hedging in 2007 or 2006.

I'm guessing UAL started a large scale hedging program that locked in fuel prices near the market peak - and had to pay out on the put options as prices fell during 2H.

I don't understand why they used collars since they would want to capture the benefits of falling prices. The only explanation I can come up with is they wanted a hedge book that was extremely cheap to run and they didn't see any way prices could fall (or their trade consultant or commodities broker rooked them...).

Just buying the calls would have been a much better (if more cash intensive up front) strategy.

JonM said...

I basically agree with Chris -- a loss on hedges when prices come out below expectations is exactly what a successful hedging strategy should give an airline, to be made up by increased margins from the lower fuel prices. The extent of the increased margins and hence the appropriate size of hedge will depend on how sensitive airline fares are to fuel prices.

On the other hand, a collar (or simply locking in future price) is a natural contract for doing this rather than a straight call, so that you are still hedged when the price falls.

Chris said...

JonM, a collar does give you more certainty about the price - with the added benefits of less up front cash and lower MtM volatility (i.e. smoother P/L in the hedge book).

But a naked call would let a buyer capture the value of lower prices - no need to hedge against that.

Wednesday, March 4, 2009