Fuel Hedging in the Airline Industry: The Case of Southwest Airlines

Executive Summary

From December 21, 1998 to September 11, 2000, jet fuel prices increased 255%, from 28.50 cents/gallon to 101.25 cents/gallon. While jet fuel prices have declined from their highs, at a price of 79.45 cents/gallon, they are still significantly above the December 1998 lows. With the future price of jet fuel being unpredictable, Southwest has decided to implement a trading strategy in an effort to mitigate its exposure to adverse price movements in jet fuel. To do this, Southwest has settled on 5 possible strategies: (1)Do nothing; (2) Hedge using plain vanilla jet fuel or heating oil swap; (3) Hedge using options; (4) Hedge using a zero-cost collar strategy; or (5) Hedge using a crude oil or heating oil futures contract. The merits and demerits of each strategy are discussed in depth below.
After evaluating the possible scenarios, it is our recommendation that Southwest implement a hedging strategy that involves a combination of the jet fuel swap and the heating oil swap. The combined strategy will allow Southwest to achieve the lowest net jet fuel costs, while limiting the risks associated with the strategies individually, such as counterparty risk for the jet fuel swap and basis risk for the heating oil swap. Concerning the split between the two strategies, a 50/50 even split is recommended.

Why Hedge?
Hedging is a financial strategy that enables airlines or other investors to decrease their exposure to changes in prices for commodities, such as oil, by agreeing to buy or sell the commodity an explicit future price at a specific future date. For airlines, hedging consists of quantifying a company’s future fuel costs, and then taking action to limit that company’s exposure to volatility, and, thus increases in fuel costs.
In general, hedging reduces exposure to