Understanding Southwest's Hedging
I don't normally pay much attention to the quarterly earnings truth about enzyte reports of companies outside the energy sector, so I initially missed the confusion over the impact of fuel hedging on the third quarter results of Southwest Airlines. An article in yesterday's Washington Post brought this to light again, along with the effect of falling oil prices on the fuel hedging efforts of a diverse group of companies, including Coca Cola, Royal Caribbean Cruise Lines, and local heating oil distributors. The reporting on this subject illustrates two important points: commodities hedging is no free lunch, and understanding its full consequences requires more that a superficial look at the bottom line.

This morning I pored over Southwest's quarterly earnings press release to see what had happened. I was suspicious of the headlines suggesting that hedging had pushed Southwest into the red, because the average futures price of West Texas Intermediate crude oil for the quarter was $118 per barrel--hence ExxonMobil's record-breaking earnings--still well above the level at which Southwest was generally understood to have hedged its jet fuel. After some scrutiny, and to my considerable surprise, I concluded that both the Post and the Wall Street Journal in their earlier story on Southwest's earnings appeared to have misinterpreted some key aspects of the hedging results. Discerning that wasn't easy, since Southwest saw fit to report their earnings on both a GAAP (Generally Accepted Accounting Principles) and non-GAAP basis, and the intricacy of their "Reconciliation of Impact from Fuel Contracts" table forced me to jump-start some brain cells that have been dormant since my B-school financial accounting course.

Evaluating the benefit or cost of a hedge must include the result of the physical transactions it was intended to cover. In the case of Southwest, it appears that its unhedged fuel cost for the quarter--what it actually paid its fuel suppliers--was $1.387 billion. The hedges and related derivative contracts that settled in the quarter offset that by $448 million, reducing Southwest's effective fuel bill to $939 million. The problem that the Journal and Post focused on was related to future hedges, not those that unwound between July and September. Marking the company's total hedge portfolio to market resulted in an additional pre-tax cost of $247 million, reported as a special item. Factoring this in turned the company's modest operating profit of $69 million into a $120 million net loss, after tax. But it's not correct to say that hedging hurt Southwest. Had it not hedged at all, its after tax loss for the quarter would have been approximately $189 million, assuming it could have operated in the same manner. That seems unlikely, given the behavior of competitors with less active hedging programs.

But while the confusion over Southwest's earnings seems to arise from the requirement to recognize the reduced value of the future hedges still on its books as a loss to current income, this doesn't justify calls to set aside mark-to-market accounting. That special item should prompt investors to read the explanation Southwest has provided concerning its overall hedge portfolio, because it signals the prospect of further hedge-related losses in the future:

"In addition to our fourth quarter 2008 derivative position, we have derivative contracts for over 75 percent of our estimated 2009 fuel consumption at an average crude-equivalent price of approximately $73 per barrel; approximately 50 percent of our estimated 2010 fuel consumption at an average crude-equivalent price of approximately $90 per barrel; approximately 40 percent of our estimated 2011 fuel consumption at an average crude- equivalent price of approximately $93 per barrel; over 35 percent of our estimated 2012 fuel consumption at an average crude-equivalent price of approximately $90 per barrel; and have begun building a modest position for 2013."

That means that if oil prices remain between $60 and $70/bbl, then the effective cost Southwest will pay for jet fuel in future quarters could end up higher than that of competitors who didn't hedge or who hedged lower percentages of their expected fuel consumption than Southwest. Of course, that's not certain, either, because the price of oil might again rise above the level of their hedges.

The key to a successful hedging strategy is that companies shouldn't view it as a magician's hat out of which to pull larger profits, quarter after quarter. The benefit comes from reducing the volatility of earnings and enabling firms to continue operating more normally, when others have had to cut back drastically. Although this strategy could rebound on Southwest, if oil prices remain low for an extended period, falling prices may not hurt them as much as rising prices have hurt their less-hedged competitors, some of whom are now in a very poor position to capitalize on lower fuel costs.

Note: Energy Outlook will be on vacation next week, with postings resuming the week of November 10.

Labels: airlines, hedging, jet fuel, oil prices, southwest
¶ 11:37 AM
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Wednesday, October 29, 2008
Iran's Oil Shield Slips
Between the US election and the gyrations of the financial markets, some important implications of the declining price of oil haven't received the attention they deserve. A case in point is the effect on Iran's geopolitical posture, particularly with regard to its nuclear program. Many articles have considered the impact of lower oil prices on that country's economy and its influence in the greater Middle East. However, as global demand for oil slows and its price sinks toward $60 per barrel, the effectiveness of Iran's implied threat to suspend oil exports in response to aggressive sanctions or a military strike on its nuclear facilities also erodes. This should create an opportunity for some very assertive diplomacy by the next administration, backed by a much more credible recourse to force. Given the progress of the visible parts of its nuclear program, this could be our last chance to prevent Iran from developing nuclear weapons.

A recent Washington Post op-ed by two former US Senators, one from each party, described the threat posed by a nuclear-armed Iran, along with a set of principles for addressing this challenge vigorously and promptly. Several years ago I took a detailed look at the rationale for Iran to build an entire nuclear fuel cycle for civilian purposes and found it wanting. The world's second-largest natural gas reserves provide it with a much more cost-effective means of generating additional power for its economy, without exposing the country to international sanctions or potential attack. Notwithstanding the findings of a controversial US National Intelligence Estimate last year, the simplest explanation for Iran's tenacity in pursuing uranium enrichment is the option that creates for building nuclear weapons. Nor has the International Atomic Energy Agency been able to gather enough information within Iran to rule out this scenario. This interpretation also aligns nicely with Iran's extensive work on ballistic missiles, which without the extreme accuracy of US missiles looks like a very expensive way to deliver conventional explosives.

Until recently, Iran has held all the cards. With the US focused on wars in Iraq and Afghanistan, Iran successfully played off Russia and China against other UN Security Council members that sought tougher sanctions to back up their diplomatic efforts to halt the nuclear program. And as oil prices went from high to astronomical, the consequences of a disruption in Iranian oil exports became increasingly unbearable and unthinkable for the US and the world economy. While still potentially quite disruptive and hardly to be invited lightly, that prospect looks much less dire today.

Iran exports a bit more than 2 million barrels per day (bpd) of oil. For most of the last four years, that quantity exceeded the sum of global spare oil production capacity, rendering Iran's contribution indispensable. That is no longer the case. Just last week OPEC announced production cuts that could cover all but 900,000 bpd of Iran's exports, with further cuts in prospect. Any shortfall beyond that could be made up from the US Strategic Petroleum Reserve, which could supply the difference for up to two years, if necessary. Oil prices would rise, though prompt releases from the SPR would limit the magnitude of any spike. In other words, if the Iranian government has assumed that the dreadful prospect of an Iranian oil embargo was sufficient to deter any measures strong enough to force them to give up their nuclear program, or to disable it on the ground, they should reconsider. Their ace-in-the hole looks more like a 10 or a Jack, today.

These altered circumstances should not be construed as providing a green light for air strikes on Iran's nuclear facilities. That option should remain a last resort, due to its many adverse consequences beyond oil. At the same time, because this and a number of less-violent steps suddenly look feasible, it might induce Iran to negotiate, prompted by the realization that it has more valuable things at stake than a uranium-enrichment program, including the health of an economy that is critically dependent on oil revenue and on imports of petroleum products that its own refineries cannot produce in sufficient quantity to satisfy domestic demand without rationing. While not exactly a silver lining of the present global crisis, this constitutes an opportunity that Western governments cannot afford to ignore, because its consequences will endure long after the present financial and economic problems have been resolved.