July 09--Even levelheaded business writers use the words "bets" and "wagers" to describe how big airlines use futures to hedge the price of jet fuel, but they can't be blamed for misunderstanding this basic concept if Delta Air Lines CEO Ed Bastian talks about it the way he did with the TV camera rolling.
"We've been burned" by hedging, he said on Bloomberg TV in May. When pressed on why Delta isn't eager to lock in fuel prices with a hedge now that oil prices seem cheap, he replied, "I don't get paid to make those types of bets."
Last year buying jet fuel was 23 percent of Delta's operating expenses, and in the prior year it was more than 35 percent. If the CEO isn't paid to make informed choices on this whopping cost line item, it would be interesting to know who the Delta board of directors thinks is getting paid to do that.
The whole idea that hedging oil price risk is some kind of wild bet with an airline's money is baffling, because a hedge is about lowering risk. Putting on a hedge is about as basic as things get in commodity markets. It usually means buying an asset where the value moves in the opposite direction from the value of an asset you already own.
Minnesota farmers do this all the time. They know they'll end up "long" many thousands of bushels of corn in the bin by Thanksgiving, and so many hedge that risk by "shorting" corn early in the growing season by selling a futures contract.
A collapse in corn prices by fall would be offset by the gains on the futures contract.
Airlines have the same problem as a farmer, only in reverse as big consumers of a commodity rather than a producer. Every year big airlines burn a staggering amount of jet fuel, about 4 billion gallons last year just for Delta.
No one even needs a calculator to know the size of the hit to pretax income from a $1 per gallon increase in the jet fuel cost.
Airlines have tried to drain some of that price risk out of their operations through futures contracts and other derivatives, and Southwest Airlines Co. has earned a reputation for being savvy about its trading.
While it may be unfair, the company that seems to be portrayed as anything but savvy is Delta.
Delta, the dominant airline at Minneapolis-St. Paul International Airport, last week announced $450 million in losses to settle its remaining 2016 fuel hedge contracts. That news followed by only a couple of months the interview on Bloomberg in which Bastian said trading losses on oil price hedges in recent years had already reached $4 billion.
Delta executives have known for a long time that they needed to get better at managing hedging, according to a book excerpt published in 2014 by Fortune magazine.
In this colorful account, a Houston oil trader accepted a $1 million signing bonus and big salary to move to Delta's Atlanta headquarters to take over its fuel hedging program. The writer described how in job interviews Delta executives including Bastian were blunt about how ineptly they'd managed fuel hedging.
But hiring this experienced trader was one of the moves of Delta's that backfired, as his tenure at the company was cut short amid a probe by a Federal regulator of commodities trading in his personal account.
"In hedging, there are lots of different flavors and types these things can take," said Ed Hirs, a University of Houston energy economist. "I think what Delta was doing was engaging in swaps," a relatively complex private derivative in which two parties agree to pay each other differing amounts based on the price of an asset.
Hirs turns out to be a regular critic of Delta's hedging record, including having emerged as one of the skeptics when Delta said in 2012 that it would buy a shuttered oil refinery near Philadelphia.
This acquisition was, and is, a head-scratcher. If the problem is oil price volatility, how can owning an unrelated refining business really help unless it has its own oil wells?
It's a little like a brewer worried about price swings in the barley market deciding it's a good idea to buy a barley mill -- having somehow failed to realize that the miller had to buy barley from farmers, and at Lord only knows what price next fall.
A Delta spokesman confirmed last week that it has unwound its last fuel hedge, and declined to comment on Bastian's choice of words in the TV interview. It's important to note, though, that Delta's rivals including American Airlines Group have also largely stopped hedging, American's president this spring telling the Wall Street Journal that "hedging is a rigged game that enriches Wall Street."
And here's the odd part. If the airlines weren't betting before, they sure are right now. Taking all the price risk in a commodity is called going naked, and that's what these companies have decided to do. They are betting on oil staying relatively cheap, and they are betting big.
"Ill-conceived and arrogant," Hirs said, of this approach.
He explained that oil happens to be one of those commodity markets in which even small shifts in how much gets supplied to the market can move prices up and down by a lot. That's because most consumers of oil have few practical alternatives.
A commuter who buys a gas-guzzling SUV when gasoline seems cheap can't just elect to walk the 20 miles to work because the price of gas doubles, just like Delta can't decide it's now too expensive to fly an Airbus A330 to Europe and instead squeeze 300 ticketed passengers onto a 170-seat plane.
By Hirs' calculation, just a 2 percent reduction in oil supplied to the market every day could increase oil prices by half. A more significant disruption, perhaps from an act of terrorism, could create the kind of price shock that would remind economists of what happened during the 1970s Arab oil embargo, when prices nearly quadrupled.
"So why go naked into a volatile commodities market?" Hirs said. "Unless they just like the idea of going back and forth into bankruptcy."
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