Post on 18-Feb-2017
Knowledge Area Module 6: Investment and International Finance
Student: Thomas P. FitzGibbon, III Student’s Email: tfitzgib3@ameritech.net
Student’s ID#: 0378491 Program: PhD in Applied Management and Decision Sciences
Specialization: Finance
KAM Assessor: Dr. Mohammad Sharifzadeh Mohammad.sharifzadeh@waldenu.edu Faculty Mentor: Dr. Mohammad Sharifzadeh Mohammad.sharifzadeh@waldenu.edu
Walden University October 5, 2008
ABSTRACT
Breadth
The purpose of this KAM is to identify the theories associated with investments and international
finance with particular focus on the theories surrounding commodity market structures and
processes. The Breadth Component focuses specifically on the development of commodity
markets, the functions of commodity exchanges, the influence of cartels on commodity markets,
and finally the impact of nationalization of commodity producers. The market theories of
Adelman, Hartshorn, and Radetzki will be compared and contrasted on their perspectives on the
above topics.
ABSTRACT
Depth
In the Depth Section of this review, I will review and summarize the relevant issues related to
hedging strategies in commodity markets. Within that review, I will discuss the applicable United
States Government regulations and how they have applied to hedge funds, investors and creditors.
In addition, I will also discuss the applicable changes to previous regulations. Within the review, I
will examine the contemporary literature that discusses the hedge fund industry, relevancy of
government and investor oversight and the public perception of hedging practices. The intended
outcome of this review is to formulate a greater understanding of the hedging process and how
hedging may have an impact on end user commodity pricing.
ABSTRACT
Application
The Application Section will provide an overview of the potential strategies that airlines can use
to reduce operational costs. Within this review, we will focus the discussion on the strategies
related to jet fuel hedging and provide examples of successful hedging strategies of major
American airlines. Along with this, we will also discuss the other manageable airline costs, stock
and financial performance of the airlines, as well as the perceived impact of the September 11,
2001 terrorist attacks on the financial performance of the American airlines. The outcome of the
Application Section will be a review of strategies that are available for implementation, including
hedging, for use in the airline industry.
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TABLE OF CONTENTS
BREADTH………………………………………………………………………………………...1 Introduction………………………………………………………………………………..1 Overview of the Current Situation………………………………………………………...1 Historical Development of Commodity Markets………………………………………….3 Commodity Markets and Exchanges……………………………………………………...6 The Impact of Cartels…………………………………………………………………….16 Nationalization and Public Ownership of Commodity Markets………………………....20 Conclusion……………………………………………………………………………….27
DEPTH………………………………………………………………………………………...…3
0 Annotated Bibliography………………………………………………………………….30 Context of the Problem………………………………………………………………..…45 Government Regulation and Oversight of Commodity Markets………………………...57 Conclusion……………………………………………………………………………….68
APPLICATION…………………………………………………………………………………..7
1 Introduction………………………………………………………………………………71 Overview of the Current Situation……………………………………………………….71
Hedging or Speculation?....................................................................................................77
Implementing an Effective Hedging Strategy……………………………………………78 Which Airlines
Hedge?......................................................................................................81 The Impact of Hedging on the Value of an Airline………………………………………82 The Impact of the September 11th Terrorist Attacks……………………………………..87
Why did Southwest Succeed?............................................................................................91
Conclusion……………………………………………………………………………….92
REFERENCES………………………………………………………………………………..…96
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BREADTH
AMDS 8613: THEORY OF INVESTMENTS AND INTERNATIONAL FINANCE
Introduction The focus of this Breadth review will be on comparing and contrasting the theories of
Adelman, Radetzki, and Hartshorn as they relate to the theories associated with commodity
markets. Within the review, I will focus this analysis on the historical development of commodity
markets, the commodity exchanges, the impact of cartels on commodity markets, and the
nationalization and public ownership of commodity producers. Within the review, I will also
examine how the theoretical perspectives of Adelman, Radetzki, and Hartshorn apply to oil
markets.
Overview of the Current Situation When people think of commodities, they tend to focus on areas that are impacting their
daily lives. One of the most evident commodities in the news is that of oil and the significant
increases in oil prices over the past year. While many have their conclusions as to the cause of the
current increases, I will examine how there is likely no one specific answer to the question on
pricing in this or most commodity markets.
For the most part, the media, political pundits, and consumers have their own ideas as to
what the causes of the surge in oil pricing are. Some consider the basic theories of supply and
demand, blaming both consumers as well as the producers. Additionally, there is also a rise in
interest in the behavior of speculators or investors in the market, while others blame the federal
government for not acting in a more aggressive manner to manage the price or the markets. In
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the end, it is likely a combination of all of these factors that have lead to the increases over the
past year.
Furthermore, in reference to the consumers in the United States, it is clear that demand for
oil and gasoline has increased in recent years. This increase in demand is due to a number of
factors including the total number of vehicles in use as well as the average miles per gallon for
vehicles. Clearly, both factors are concerning, as vehicles have grown in both number and size,
the amount of gasoline needed to address demand is increasing, as such with supplies being
relatively constant, the equilibrium price for gasoline would increase.
In reference to producers, there are two distinct challenges they face. The first challenge
is the increase in global demand for oil from countries such as India and China. Secondly, as I
will discuss later, the need to focus on long term development of the market with the
understanding that oil is a limited resource and it can not last forever. Given the limitations of the
resource, the producers wish to focus more on creation of a long term revenue stream rather than
significantly increasing production now at the risk of using up the available resource much earlier
than planned.
Finally, in reference to the market, there is increasing focus on the performance of
speculators. Again, as I will discuss below, speculators focus on developing short term profit
between the time that the commodity is produced to the point that the commodity is delivered to
the consumer. The intent is to benefit from any changes in the commodity price in the timeframe
between production and delivery.
While oil is an example of a commodity in the news, the general theories of the commodity
markets are universally applicable regardless of the particular product being traded. Commodities
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are typically limited in their availability and there is normally a price difference between when the
commodity is agreed to be purchased and the time that the product is delivered. In addition,
commodities could generally be considered to be natural resources that have uniformity in quality
but are limited in their availability.
Historical Development of Commodity Markets Before we can effectively examine a specific commodity market like oil, we must first have
an understanding of the development of commodity markets in general. Commodity markets are
significantly different from a traditional market where the buyers and sellers immediately exchange
products or currency for products at a specific location. As mentioned above, one of the primary
differences between commodity markets and traditional markets is that there is typically a delay
between the agreement to purchase a product and the delivery of that product to the purchaser.
However, we must first understand the types of products that are exchanged in a
commodity market. As Radetzki (2008) states, the markets “supply unprocessed raw materials of
agricultural and mineral origin, along with fuels, electricity and potable water, for use by other
sectors of the economy” (Radetzki, p. 7). In other words, the intention of the market is to
provide an outlet for producers to exchange their goods that could then be used in another area
where the traded commodity is not readily available. Radetzki goes on to note that most
economies do not have access to all the necessary raw materials to sustain long term economic
growth (Radetzki, 2008) and must have reasonable access to acquire the raw materials that they
need in order to sustain and grow their individual economies.
Furthermore, once the market is established, the next step is the development of a
transportation process that would deliver the raw materials sold in the market to the consumers
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purchasing the goods. The issue of transportation was an early challenge for markets. The
markets could identify both the producer and the consumer of a particular raw material.
However, the challenge was in how to efficiently deliver those goods from the producers to the
consumers.
Clearly, markets have existed for centuries as a vehicle for the exchange of goods.
However, as producers began offering a wider range of products for sale, there was a need to
establish a larger market of consumers. While the market expansion is beneficial for both
producers and consumers, there was a need to develop a more effective transportation mechanism
to support efficient product delivery. With that, there were two periods of improvement to the
transportation process. The initial phase of this improvement took place in the latter half of the
nineteenth century and again later in the 1970’s (Radetzki, 2008). Furthermore, in reference to
the more recent improvements, the intention of the commodity producers was to create more of a
global market for their products. With the resulting improvements in transportation, this goal of
reaching a larger market was now achievable.
With an improved transportation process, commodity producers could begin a more
effective process of standardization of product and prices. Given the past history where markets
were either local or regional in scope, commodity prices were driven more by the dynamics of the
local economy rather than a global pricing model facilitated by the larger market available to
producers. However, this also required a need to effectively manage transportation costs within
the overall price of the delivered commodity.
As Radetzki (2008) notes, “shipping costs are akin to tariff barriers” (Radetzki, p. 12) in
that producers not only need to account for the production costs and profit, but they also must
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consider the shipping costs of the good in their final price to the consumer. While there were
efficiency gains over time in the transportation process which helped to alleviate the initial high
costs, there were still some things that the market must consider when determining prices.
Clearly, producers understood that to expand their markets they would need to provide efficient
transportation, but producers also needed to consider the impact those transportation costs would
have on the demand for their products. In the event that producers charged too high of a price,
accounting for transportation costs, they would likely find that there would be a very limited
market that would see the value for the produced good when such a significant percentage of the
final price was the result of transportation expenses (Radetzki, 2008).
Furthermore, along with efficiencies in transportation, producers also needed to consider
the technology used in the transportation process. Since many commodities are perishable goods,
improvements to food storage and refrigeration were also required. Without these improvements,
producers would run the risk of spoilage of the good prior to delivery resulting in the consumer
rejecting the shipment and the producer receiving no compensation for the product.
Finally, and this is particularly true in the oil markets, there was the vast increase in size of
the carriers over the past several years. In the discussion of the Suez Canal crisis, Radetzki
(2008) notes that, “the shipping industry’s response to the canal closure was to opt for specialized
huge bulk carriers, along with concomitant loading and unloading facilities, to permit economic
transport of low-value products” (Radetzki, p. 13). The intent with this is that while there was an
increased cost associated with larger carriers, that cost could be spread over significantly larger
quantities of goods resulting in a lower cost to market. Additionally, this provided an opportunity
for producers of lower value products to expand their market to a larger audience.
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With an understanding of the particular factors in product pricing, there is a need to
consider the competitive factors in pricing as well. Given that different regions or countries will
have varied costs of production, this factor should also be considered in overall commodity
pricing structure. Radetzki (2008) discusses this issue in examining the performance of European
food producers in the 1880’s, he notes that there was a significant reduction of consumption of
domestically produced goods since the market price of the imported good was much less in
comparison. In other words, even though the foreign producer had increased costs of
transportation, their final price was still less than the local competition. This difference in
production cost was primarily the result of lower labor costs of the foreign producer. As such,
the consumer focused on the price rather than the proximity of production when making their
buying decision. Ironically, this exists in most markets today where consumers are willing to
purchase foreign produced goods at a lower price and are rarely willing to pay a higher price
simply due to local production. This would be an example of Ricardo’s Theory of Comparative
Advantage in that countries will find a benefit in specializing in producing commodities that they
can do both efficiently and at a reasonable cost. By meaning, in the event that oil might prove too
expensive to produce, it would not be wise to produce them. Rather, it would be more effective
for that country to import oil and focus on other goods that could be used in trade or sale where
the proceeds would be used to produce goods not readily available (Radetzki, 2008).
Commodity Markets and Exchanges
Now that we have an understanding of the historical development of commodity markets,
we now need to examine the structure of commodity markets today. Commodity markets have
distinct differences when compared to more common markets reviewed above.
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First, there are a limited number of people that can participate in a commodity market.
Unlike traditional markets where anyone is welcome to buy and sell products, commodity markets
are limited in that both buyers and sellers must be approved by the market managers prior to
engagement. This approval process varies by exchange. However, at a minimum, the applicant
for membership must have an established business as well as the access to sufficient funds to meet
margin requirements as well as trade in the exchange. The result of this is that it can serve to
provide more consistency in the purchase and sale process and support more effective operational
standardization of the commodity market as well (Radetzki, 2008).
Secondly, most commodity markets conduct their negotiations electronically. Thus, both
buyers and sellers can negotiate the price for a product by electronic means rather than a face-to-
face negotiation. The benefit of this method is that both buyers and sellers gain a clear
understanding of the terms of the agreement as well as more efficient method of negotiating the
commodity price before closing a deal in comparison to an open market where buyers and sellers
meet in person to negotiate the price, without prior knowledge of the other side’s conditions.
Additionally, this also provides an opportunity for a wider variety of participants to engage in the
negotiating process. Therefore, with no requirement to be physically present to negotiate the
transaction, there is a broader market of participants who are able to buy or sell (Radetzki, 2008).
Thirdly, commodity markets are highly standardized in that there are specific quantities,
qualities, delivery dates, and payment terms that apply to particular commodities. When
examining how this standardization applies to the oil market, there are different types of oil such
as Texas Light Sweet Crude or North Sea Brent. Each type of oil has its own particular price
based in part on the end use of the product as well as any costs associated with the use of refined
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oil available for production of other products. In reference to payment and delivery terms, one
will often see the per barrel cost of oil discussed in terms of a ninety day delivery period. This
means that the agreed price of a barrel of oil is not for delivery of the product today, but is what
the buyer is willing to pay for that barrel once delivery ninety days from the date of the contract
(Radetzki, 2008).
Additionally, since nearly all commodity transactions are contract based, there is an ability
to transfer ownership of the contract prior to the actual delivery of the good to the purchaser.
Clearly, this is different when compared to most markets where the product delivery and the fund
transfer are done at the same or nearly the same time (Radetzki, 2008). I will discuss this
particular feature in later sections of both the Depth and Application reviews.
Finally, commodities’ markets also have a clearinghouse function attached to the market.
The clearinghouse provides a mechanism to settle transactions between the purchaser and seller.
Again, this would be different from a more traditional market where no clearinghouse exists as the
goods and compensation are exchanged at nearly the same time rather than with a delayed
delivery date that exists within commodity markets (Radetzki, 2008).
However, within this framework, there is an underlying process by which commodities
should be traded in commodity markets. There are certain criteria that are required of a product in
order for it not only to be considered to be a commodity, but to also meet the requirements of an
applicable commodity market. First, there must be a sufficient market of quantity of buyers and
sellers with adequate liquidity and product supply to sustain a continuous market. Secondly, the
producers must be able to tolerate and be adequately prepared for both hedging and speculation
functions. Thirdly, there should be sufficient price volatility in the market and prices should be
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reasonably elastic. Furthermore, the product under consideration must be easy to grade and be
homogeneous in quality so as to provide consistency in valuation. Finally, the product must be
storable so as to maintain its quality and grade from the point that the purchase is agreed upon
until the date the product is delivered to the purchaser (Radetzki, 2008).
For example, we could examine diamonds as a potential commodity for consideration for
sale in a commodity market. However, there are certain factors with diamonds that would meet
some requirements noted above, but fail on others. Clearly, diamonds would meet the test of
being easy and consistent to grade. There are grades on color, cut, and clarity that are generally
accepted. In addition, a diamond is easy to store and does not lose quality from the point of
production and sale to delivery. Additionally, diamond price could be considered fairly inelastic in
reference to supply or demand. But, diamonds fail on other requirements. First, the market for
diamonds is relatively small. There are very few producers of diamonds and very few buyers.
Typically, the buyers and sellers meet to negotiate a particular price on specific diamonds or a
price on a large quantity of similar stones. Second, since the market is tightly controlled by a
small number of producers, there is very little flexibility in supply.
This case of diamonds is quite in contrast to considering oil as a commodity. Clearly, oil
would meet all of the requirements noted by Radetzki (2008) in that there is a significant market
of buyers and sellers with the necessary liquidity to sustain a continuous market. Additionally,
especially today, the hedging and speculation process is very active. Thirdly, while crude oil is
reasonably managed from the supply side by cartels such as OPEC, demand for oil does have
significant variability both due to seasonal factors as well as due to increased demand from new
consumer groups. Moreover, oil does have a generally accepted grading system as discussed
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earlier. Finally, as highlighted above, oil is easy to store and ship to the buyer. As such, unlike
diamonds, oil would be a commodity that would be suitable for trade on a commodity market.
Furthermore, with the understanding of the commodity market and the products traded in
it, we must have an understanding of how transactions are processed in the market. There are
two different types of instruments used to conduct transactions in the commodity market, futures
contracts and options. A futures contract is an agreement to buy or sell a specific quantity of a
commodity for delivery at some specific point in the future. In addition to the structure of the
contract, it should also noted that when a buyer engages a seller with a futures contract it is not
necessary that the purchaser pay the purchase price in full at the time of the contract. However,
what is required is that the purchaser pays a margin or percentage of total price at the point of
agreement. This margin can differ based on the requirements of specific commodities or the
markets where the transaction occurs. However, in general, the purchaser is required to pay at
least 10% to 20% of the total price to the seller. Once the margin is agreed to, the margin
payment is then completed through the brokerage accounts of the parties in the contract.
Additionally, in event where there is a rise in the contract price, the buyer may be required to
provide an additional margin payment to maintain the percentage assigned. The intent is that the
percentage of the total value is maintained throughout the period. As with the initial margin
payment, any additional payments are settled through a brokerage account and maintained with
the clearinghouse of the market. (Radetzki, 2008).
On the other hand, options contracts are quite different. An options contract gives the
owner of the contract the right to buy or sell a contract at a given price. There are two types of
options contracts. The first type of options contract is a call option. The call option provides the
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owner of the contract with the right to purchase the commodity at the option exercise price at any
point prior to the expiration of the contract. This means that, the owner has the option to
purchase the commodity, but not the obligation. The other type of options contract is a put
option. A put option provides the owner of the contract with the right to sell a future contract a
future contract at a given price at any point prior to the expiration of the option. Regardless of
whether the contract is a put or a call option, the contract itself can also be sold to another party.
Ironically, the actual commodity is not necessarily traded at all. It is simply the right to buy
commodity or sell the futures at a given price that is traded. In effect, the contract itself could
also be considered a commodity as well (Radetzki, 2008).
As with any market transactions, there are risks involved. The primary risks that investors
wish to avoid are issues related to pricing. As with any commodity, price is based on supply and
demand of the commodity. If there is any shift in either factor, the price of the good will adjust as
well. For example, since there is a delay between the purchase of a commodity and its delivery to
the consumer, any price changes that occur during the production and delivery period need to be
considered when determining the risks associated with the transaction. This is where the idea of
hedging comes into play in the commodity market.
Even with this delay, some commodity producers will assume some of the downside risks
associated with price changes over the period of transporting the good to the consumer. For
example, in the early 1980’s, Saudi Arabia found that their exports of oil were steadily decreasing
to the world market. Realizing that they and the OPEC cartel were unwilling to consider price
discounts to spur demand, they were forced to consider alternatives to address the slumping
exports. Given that at the time it took over 45 days for their product to leave the gulf and get to
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markets in North America, Western Europe and, Asia, something needed to be done in order to
eliminate the price risk over the shipment period. With that, the Saudis elected to accept the risk
on their own. While there was an agreed price at the point of the contract, the Saudis decided
that it would be better to honor the price on delivery. As such, the actual price on delivery would
be the contracted price for purchase (Hartshorn, 1993). The result of this was that importers of
oil no longer had to bear the risk of price variations as this was now the responsibility of the
supplier.
While I will go into this in significantly more detail in the Application section of this
review, the primary goal of someone hedging is to mitigate the risks associated with price
changes. Typically, a hedger will take an opposite future position to that of the position of the
purchased contract. By meaning, the contract might call for a given quantity and price today, and
the hedged future contract will have that same quantity and delivery time of the original contract,
but will be at a different price. That price will then be an attempt to offset any changes that the
commodity contract might encounter prior to delivery (Radetzki, 2008).
Clearly, there are two different types of risk associated with price. First is that the price of
a commodity will go down, resulting in any remaining inventory going down in value as well. In
this event, the owner would execute a short hedge that would match up with the quantity and
delivery date that is currently in inventory. The idea with this tactic is that it serves to lock in a
current price that would safeguard against the risk of any additional downward trend in the
market price for the commodity (Radetzki, 2008).
The second type of risk is that the if the price of the commodity increases in the current
market, the price of the futures contracts associated with that commodity will also increase
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relative to the current market. In this case, the end user of the commodity may choose to execute
a long hedge of the commodity. As with the short hedge, the long hedge would also match the
quantity and delivery time of the original contract. Again, the intent with this tactic is to lock in a
specific price in the market today to offset any future changes in the value. However, one
particular issue with either a short or long hedge is that the purchaser also needs to consider the
margin expense associated with the transaction and whether that margin payment has any impact
on their overall decision to engage in this tactic (Radetzki, 2008).
Hartshorn (1993) also discussed the function of markets to address the risks associated
with price differences in oil. As mentioned earlier, as a commodity, oil markets function similarly
to most commodity markets. With that, the intent of hedging in the oil market is primarily
designed to “hedge trading risks between the time the deal is made and the time later than the
commodity has been delivered” (Hartshorn, p. 207). Again, the intention is to attempt to balance
any price changes over time and remove any risks associated with changes in the market price
between the time the contract is made and the time of the commodity delivery. Clearly, this is
less of an issue with shorter delivery times, but with all commodities, prices can have significant
adjustments even in short time periods.
However, one must also consider whether or not commodity markets are efficient. While
it is evident that there is nearly complete transparency in the market in reference to prices and
quantities (Hartshorn, 1993) what still remains unclear is whether the functions between the
contract agreement and delivery have any impact on the actual price of the commodity. As I
discussed above, commodity markets and traditional markets are quite different when it comes to
purchase and delivery.
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As an example, we can examine the significant increase in oil prices in 1979. While the
market did manage the overall price, Hartshorn (1993) and several other economists believe that
the price increase was due more to a perception of a lower supply than any objective factors in the
market. That misconception managed to drive prices even higher as speculators increased their
activities in the market hoping to gain a quick profit through the expected increases in prices for
oil even within the period of shipping the oil from producer to consumer (Hartshorn, 1993).
In a traditional market, the good and the purchase price are exchanged at the same time,
with that, there is no speculation on any future changes in the price. By meaning, one does not go
to a market such as a clothing retailer and agree to purchase an item, but get it delivered later.
Furthermore, one does not hold an option to purchase the item and then sell that option to a third
party at a different price. This would be akin to anticipating that the item will be discounted in the
future and paying the discounted price to the retailer today. If that was the case, there would be
one of two outcomes. The retailer would never sell the item at a discounted price or the retailer
would simply inflate the price much higher than needed today to account for the risks of a future
discounted price. Now, some would believe that the latter is what actually occurs in a retail
market. However, most large retailers will project what the market will demand and offer that
much for sale at full price, rather than offering too high a quantity knowing that they will always
have residual inventory that will be sold at a discount. In other words, the retailer will offer as
little as possible with the intent of selling all available inventories at the full price.
Furthermore, within an efficient market, information must be readily available and be of
reasonable quality. This is another area where Hartshorn (1993) questions the performance of the
oil market. There are very few places that oil can exist before it gets to the consumer: ships
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transporting the material, storage tanks, or in the ground. It is the latter that is of highest
concern. As oil is not visible until it is pumped out of the ground, many question the validity of
the estimates of remaining quantity. Clearly, this would call into question the accuracy of supply
estimates. As with most traditional markets, quantity or inventories can be counted or at least
fairly estimated. The same can not be clearly said of commodity markets. Given that supply is a
key determinant of price, one would be justified in questioning whether or not the data used in the
market. In the end, as Hartshorn notes, “it is only on the average that open market prices, spot,
forward or futures, could be hoped to offer the best possible prediction of what will actually
happen” (Hartshorn, p. 219). Adelman comments on this as well in questioning that “future
scarcity cannot possibly explain the current price of oil on the international market” (Adelman, p.
373). Given this, both could conclude that with an inability to accurately predict what future
supply or demand will be and how the market should respond to these unknown variables.
Finally, it is also unclear as to whether a market system can even handle the complexities
in a commodity exchange. Notwithstanding the number of buyers, sellers and processes, many
would consider this to be well beyond the scope of what a market system could support.
However, there are just as many that would say that a market system is likely the only system that
would support the level of complexities in a commodity exchange with the inherent flexibility that
most market systems can efficiently accommodate (Adelman, 1993).
The Impact of Cartels
Now that we have an understanding of the structures and processes of commodity
markets, the next step in the discussion involves the impact of cartels on commodity markets.
Both Hartshorn (1993) and Adelman (1993) wrote extensively about the impact of cartels in the
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oil market. As such, I will discuss the specific dynamics of the oil market and the actions of
cartels on the overall performance of this commodity market.
However, before I discuss the specifics of cartel practices, we must first understand what a
cartel is and how it functions. Cartels are typically formed by an agreement either between firms,
or in the case of oil, between countries to jointly manage the production, pricing, and distribution
of a commodity. As it relates to oil, the Organization of Petroleum Exporting Countries (OPEC)
is the most well known cartel. OPEC was formed by the major oil producing countries with the
intent of standardizing general production and pricing strategies and the resulting stabilization of
pricing that would result from the standardization. Prior to the existence of the cartel, prices and
processes were varied between countries. The result of the inconsistency was that prices were
different for different oil producing countries and there was limited collaboration on an overall
strategy to manage the oil market.
As such, one of the first steps upon the establishment of the cartel was to create a ceiling
and quota system to manage production and pricing (Hartshorn, 1993). The intent in this was
that while each country could produce a certain daily limit of oil, the focus of the cartel was to
examine the total production of oil both within and outside of the cartel so as to control the price
offered to the consumer. However, the existence of the quota system does not necessarily imply
that all cartel members will adhere to the requirement.
For example, during the first Gulf War, all country specific quotas were suspended.
Primarily the reason behind the action was to address any concerns in the market, but also to
compensate for the loss of production from Kuwait and to a limited extent, Iraq. While this was a
formal suspension of the quota by the cartel, the idea of imposing the quota system again after the
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war was not initially successful. In fact, “even before that war several member countries had been
paying no more than lip service to the system, and most had been exceeding their quotas”
(Hartshorn, p. 169). As such, while there was a system in place to manage output, the actual
members were still performing to their own individual interests rather than those of the cartel.
Along with the need for quotas, the underlying intent in managing output was to tie the
perceived demand in the market to that of the actual volumes produced. The idea with this
strategy was that there would be very limited excess inventory and this could also serve to
manage the price as well. While there were several organizations who would publish their
estimates of demand, including OPEC, the key issue with those estimates is that they would often
times underestimate the actual demand in the market (Hartshorn, 1993). The result of that was
that even with the quotas, the actual demand was higher than the supply provided by the cartel
and other producers.
Ironically, even with this mismatch between lower supply and higher demand, prices
remained consistent immediately after the conclusion of the first Gulf War. However, what was
clear was that if there was a benefit to an individual country to produce more beyond their quota,
as was the case during the Gulf War, it was clear that individuals would continue to do this if it
served their individual economic benefit. What was of significant concern to most member
governments was a continued frustration in OPEC’s lack of ability to effectively manage the
overall production of individual cartel members (Hartshorn, 1993).
However, in order for a cartel to effectively function, the individual members must focus
on the needs of the group and not simply on their individual needs. Clearly, any supplier would
normally wish to sell what they have available to sell and not be restricted by a quota system
18
where they would be forced to keep in reserve any excess inventory that could be sold, but would
be restricted from sale by an existing quota determined by the leaders of the cartel. This leads to
the temptation to sell the inventory in spite of the cartel’s requirements which would then lead to
further erosion of the cartel and make the entire cartel weaker and less able to control market
price for the product (Adelman, 1993).
But, this is not meant to say that the cartel is solely dependent on member compliance to
manage available supply and price (Radtezki, 2008). The cartel still has several alternatives to
effectively test the market at a given price. For example, in the past, Saudi Arabia has taken steps
to raise the prices slightly to gauge market reactions. These slight increases provided insight into
whether demand could be sustained at a higher price. Once they were able to sustain demand,
they would then have an opportunity to set that tested price as the new price. In addition to
having a member of the cartel test the price, the cartel could also utilize pricing tactics instituted
by the multi-national oil companies. While the oil companies would follow a similar process of
testing demand, the cartel could then use this information and market response to in turn make
their own price adjustments as well. With either option, the intent is to ensure that supply of the
good does not exceed demand (Adelman, 1993).
Furthermore, what is ironic in the actions of OPEC as a cartel and their management of
supply and pricing is that there does not appear to be any policy of the cartel as it relates to
pricing. By meaning, most of the focus on the cartel has been on production of available supply
to the market, with the intent that controlling supply would then lead to management of overall
pricing. However, OPEC has not come to an agreement as to what they wish to do with pricing
in the future. While there have been discussions in the past about increasing pricing to the
19
market, those talks stalled and no agreement was made. As such, the cartel tends to focus on
managing supply to as to not provide more than demanded, but also to balance that supply against
the available reserves for future sale (Adelman, 1993).
Finally, one must also acknowledge the other non-revenue benefit that cartels receive.
That benefit is the political clout of controlling a resource. Clearly, OPEC is an example of the
amount of political benefit they receive (Adelman, 1993). Since OPEC controls a commodity in
high demand throughout the world, their control of the commodity as a resource has downstream
impacts on the world economy. Furthermore, many believe that the first Gulf War was less about
the sovereignty of Kuwait, but more about the control of oil that Iraq would possess had the
invasion of Kuwait gone without a response. Obviously, this outcome was not something that
consumers, primarily the United States, were willing to accept. Additionally, the other producers
within the cartel were also unwilling to accept the greater influence that the government of Iraq
would possess in the workings of the cartel.
In conclusion, Adelman, Hartshorn, and Radetzki would all agree that the most effective
way for the cartel to succeed is to not only manage prices and supply, but to maintain the
members compliance with those standards. While some would argue that OPEC as a cartel has
encountered many challenges in maintaining adherence to supply quotas specifically related to
non-compliance by certain member states, overall the cartel has been successful. They have
managed to maintain their long term reserves while meeting their projected market demand with a
price that has significantly increased over time allowing all members to benefit from the market
growth.
Nationalization and Public Ownership of Commodity Production
20
Now that we have an understanding of general market functions and the impact of cartels
on commodity markets, I will now focus on the impact that government ownership of commodity
producers has on the global market. In summary, nationalization occurs when a government
elects to assume ownership of production facilities that were at a time privately owned. In some
cases, the government will compensate the private owner for their investment while in others the
government simply takes over the property and strips the private owner of any equity in the
facility.
Furthermore, state ownership of commodity producers is not uncommon. In many
markets like oil, the majority of the producers are the governments. However, relative to
commodity producers in general, state ownership is prevalent in the developing world. While
many of these state owned producers began their operations in the 1960’s and 1970’s, the intent
was to tap into the natural resource and invest the revenues into the further development of the
country and benefit the citizens of that country (Radetzki, 2008).
Within the commodity producers owned by governments, there is a significant portion
related specifically to mineral and energy resources. Clearly, there are a number of reasons why
these particular commodity groups are more popular than others. First is the perception that
mineral wealth is sovereign to the country. In other words, there is a certain perceived value of
utilizing a natural resource that is part of the land that the country occupies. Secondly, that the
extraction and processing of the resource is seen as a strategically importance for the country and
its citizens (Radetzki, 2008). With that, the governments instill a sense of ownership among the
citizens, and consider private ownership to be ‘taking’ a resource away from the people of the
country.
21
Additionally, countries would also look at nationalization as a purely economic exercise in
that instead of a private entity gaining the revenues and profits from the resource, those profits
would in turn go to the government. Clearly the thought behind this is that with increased
revenues from other sources, the government owner could either take the revenues and invest in
items such as infrastructure improvements and education, or relieve the citizenry of tax
obligations originally payable to the government prior to nationalization of a commodity
producer. In either example, the intent was to gain a new revenue source that would be held and
managed by the government.
However, government ownership of a commodity producer can cause some conflicts of
interest as well. First, in nearly all situations, the government is not only the owner of the
production facilities but it is also the source of the laws governing the production of the
commodity. Clearly there is a conflict in that it would be difficult for a government to establish
laws or requirements that may limit their access to the resource or related revenues. Along with
that, the opposite would be true in that the government may also be lax on regulations to
encourage more revenues regardless of any external limits that may be necessary to have in place.
The result of this is that the government tends to focus its production management to align with
the social goals of the country rather than the need to maximize profit, like privately owned
companies (Radetzki, 2008).
Secondly, government ownership can also imply certain political influence on the industry.
This is evident by examining the recent nationalization of several oil facilities in Venezuela. In this
example, President Hugo Chavez was motivated by some of the manners discussed above. First,
he felt that it was in the people’s best interests that the oil revenues be maintained by the
22
government rather than foreign owned oil producing companies. Secondly, he was able to exert
perceived control over his political adversary, the United States Government and capitalize on the
general public support for his political perspectives. Finally, while President Chavez was willing
to negotiate a purchase price for the production facilities with the private owners, the companies
had little choice but to accept the terms offered or receive nothing at all. In addition, to make
matters worse, in situations where local governments offered little or no compensation for the
facilities, the previous managers were rarely willing to provide any technical assistance to the new
owners (Radetzki, 2008).
Furthermore, this also has significant implications for the efficiencies of the newly
nationalized organizations. As Radetzki (2008) discusses, there are two different types of
nationalized organizations, those that were founded by the local governments and those
organizations that were once private but are now controlled by the governments. While there are
differences, in either example, the initial operations of the organizations tended to be significantly
less efficient when compared to similar privately owned organizations. While there are several
reasons why this is the case, the most predominant appears to reside with the lack of expertise of
the managers or leaders of the organization. Ironically, this issue is still true where the operating
facilities already existed and there was far less need for start up costs or processes (Radetzki,
2008).
However, one would expect that most major corporations, especially those in commodity
industries, would hire managers who have relevant experience and education that is related to the
industry or function. However, the common practice in several nationalized commodity
producers was to hire employees that had the right political connections and not on skills or
23
experience. As such, positions were hired based on political favors or connections. Resulting in
placing individuals in leadership roles who did not possess any related skills to effectively run the
organization they were now responsible to manage (Radetzki, 2008).
The result of this lack of experience and focus on the nationalized organization resulted in
three negative impacts on the overall financial performance of the organization. The first, as
discussed above, is that the lack of experience will inherently lead to a lack of efficiency of the
operation. Secondly, with the new focus of the organization no longer on profit and reinvestment
but on social development, there is a risk that the production facilities may fall into disrepair.
Finally, with a lack of emphasis on cost management, over time, the organization will see a
reduction in overall profit and eventually find that they will need to charge a premium for the
commodity simply to break even against increased costs (Radetzki, 2008).
However, what is also troubling is that many nationalized organizations also risk losing
their motivation to be financially viable. When the organization is, in effect, absorbed into the
overall structure of the government, the managers of the organization would likely come to the
conclusion that whether they operate at a profit or loss is meaningless since they will always have
access to any additional funds from the government. Secondly, since the revenues gained are
transferred to the government’s overall budget, they will no longer have access to funds to
improve their product mix or expand into new markets. In the end, they no longer become an
income generator for continuous improvement, but an income generator for government
programs (Radetzki, 2008).
While not a completely nationalized organization, several members of OPEC are
government owned and operated. Hence, it would be appropriate to examine their performance
24
in detail to gain an understanding of the efficiencies of nationalized commodity producers. This is
especially evident when comparing the production of the nationalized oil producers against those
operated by private companies.
Throughout the global expansion between 1979 and 2005, the global capacity expansion
of the private enterprises resulted in a capacity increase of nearly sixty percent. However, in the
same period of time, the OPEC capacity as a group actually declined by three percent (Radetzki,
2008). Given this, there are two potential reasons why this lack of improved capacity resulted.
First is that this could actually be an intentional strategy by OPEC as I discussed above, in that the
strategy could be that OPEC is intentionally managing capacity to a lower level so as to sustain
their reserves farther in the future. Secondly, this lack of capacity growth could simply be a result
of an inefficient operation typical to that of other nationalized commodity producers.
However, what is interesting is the more recent trend where nationalized organizations are
now approaching private companies to establish partnership agreements. This is especially true of
OPEC. As OPEC went through a wave of nationalizations in the 1970’s, they quickly realized
that they no longer possessed the expertise in building their capacity to meet increasing demand in
the world markets. As such, several OPEC nations began to solicit assistance and partnership to
improve their performance to meet market needs. This need for outside expertise was mainly
driven by particular failures in the initial steps of nationalization. Furthermore, the most evident
failure was how the ownership of the oil industry was distributed shortly after nationalization
(Hartshorn, 1993).
However, this return to a limited partnership between the individual country and private
producers is not always beneficial. Clearly, there is a benefit to the specific member country that
25
sees a need to enhance the existing technical skills to increase future capacity. However, that
improved capacity from the nationalized company may not be beneficial to the performance of the
cartel (Adelman, 1993). As stated, the cartel operates within a quota system for the commodity
as well as for individual member countries. With that, the cartel as an entity would see little
benefit from the improved performance of the industry within a specific country. Additionally, in
the long term, the member country may not be able to gain any tangible benefit from the
operational improvements if they are still subject to capacity limits from the cartel.
Furthermore, while there is no law that forces a quota system on an individual nation, in
order for the cartel to succeed and control the market, adherence is key. Clearly, there is a benefit
that the cartel possesses when the members have a nationalized industry. That benefit is control.
Rather than the cartel being forced to work with a group of profit motivated private corporations
focused on their investors’ interest, nationalized organizations speak with one voice that
represents the member state. This leads to an opportunity within the cartel to manage the
production of the nationalized industries within the reigns of a smaller group when compared to
the influence and demands private owners may place on the cartel. This allows higher producing
members such as Saudi Arabia to exert more pressure on the other member states to further
control the available supply (Adelman, 1993). Given this, at least as it relates to the oil industry,
there is a reasonably complementary relationship between the nationalized producers and the
cartel as they both wield significant control of the industry both at the local level within a member
country and at the level of the cartel.
The failure in ownership distribution lies with the process of assigning ownership to
controlling families in many of the OPEC countries. As with the case with other nationalization
26
efforts, the level of expertise of the new owners was irrelevant in the assignment process. While
this is different than assigning management to those with more political influence than experience,
the result was nearly the same. The challenge the member states quickly faced was that the new
owners lacked any significant technical expertise to effectively manage oil production (Hartshorn,
1993).
This is not to imply that governments received no revenue prior to nationalization. As
with most commodities, governments still had the ability to levy for taxes and royalties against the
private producer. As such, there was still revenue to be had. However, what was clear is that if
the government actually owned the production and revenue of the commodity that revenue would
go from a percentage charged to a private owner to all the revenue associated with the
commodity sale. In addition to the full access to the revenue, they would also be able to fully
control the resource and its distribution to the market (Hartshorn, 1993).
Additionally, as discussed earlier, one of the primary strategies that OPEC possesses is its
need to manage their reserves so as to get a long term revenue stream. With that, there was more
incentive to nationalize the resource rather than let it remain in private hands. This is primarily
due to the structure of leases and licensing agreements the private companies had with
governments prior to nationalization. Within the structure of the agreements, there was a
specified time period that the agreement was in force. As a result, private companies would try to
not only quickly recover their infrastructure costs, but to also make as much money as possible
before the agreement expired (Hartshorn, 1993). Clearly, this is in contrast with the strategies of
OPEC. Likely, the individual member governments recognized that there was a greater
27
temptation for the private company to exploit the resource quickly rather than the member
government’s need to maintain a long term revenue stream.
Furthermore, especially as it relates to OPEC, most of the member countries receive a
significant portion of their operating revenue from the sale of a small set of commodities to the
market. When examining the economic structure of a majority of the Gulf state members of
OPEC, there is a heavy reliance on oil production and sale to support other government
investments. As such, any swings in oil prices can have a significant impact on the country’s
ability to effectively invest in other areas of need. With that, there is a tendency to have a higher
need to manage the resource not only as a cartel, but within the operations of the individual nation
as well. This further enhances the previous topics of member production compliance within the
OPEC cartel where individual members would often ignore quotas where local events drove the
need to increase production (Hartshorn, 1993).
Conclusion
There are very clear differentiating factors with commodity markets that one would not
readily see in a traditional market where consumers and producers meet. However, the
underlying theories associated with these markets are quite consistent between Hartshorn (1993),
Adelman (1993), and Radetzki (2008). The basis for commodity markets is similar to other
markets in that a produced good is exchanged for payment of that good.
However, where these markets differ is primarily related to their structures and controls.
Since commodities are considered natural resources, they are not readily available everywhere in
the world. As such, the commodity is controlled by those that possess access to exploit the
commodity and make it available for sale.
28
When examining the oil markets, there are many external influences on the industry. The
most evident of those influence lies with the control of production and pricing that is limited to a
small group of governments, cartels and private producers. This control allows the group to have
a broad influence on the global economy like no other commodity since the dependence on oil is
much higher in comparison to other commodities available for sale.
Additionally, an example of this economic influence is on producer nations such as Russia.
In the Soviet era, there was barely enough oil produced to sustain the needs of the Soviet Union,
let alone any outside consumer wishing to purchase from the country. Some may say this was
related to an inefficient state ownership of the industry, while others may conclude that there was
no interest on the part of the Soviet Union to sell oil to a global market or at least to non-Soviet
Bloc member states.
However, resulting from the fall of the Soviet Union, the oil producing companies were
converted to private ownership entities. While there is clear evidence that the initial private
offering was fraught with corruption forcing government action to take control of the industry
again, that does not necessarily imply that the result was not positive. However, by examining the
economy of Russia today, it is much stronger than it was less than ten years ago. There is a
significant wealthy class of citizens who are clearly benefiting from the economic improvements.
While there is still a poor population, the problems of the Soviet era appear to be abated by the
significant growth of the economy.
While there is growth, the concern of over-reliance on oil revenues as the driving force to
the economy still exists. This opportunity, if utilized to make other investments, may serve to be
a guide for other countries who are producers of limited commodities to further invest in long
29
term development. In the end, there are two paths a producer can implement: developing the
resource to benefit a limited group, or to make the investments in infrastructure or other
industries to prepare the country for the point where either the commodity as a resource is no
longer available, or the market of the commodity is no longer interested in its purchase.
As we continue with the Depth Section of this review, I will focus on the processes related
to hedging and speculation on the impact of markets in their overall function and pricing
strategies. Within that analysis, I will discuss some of the current areas of concern about the
impact of hedging and speculation in oil markets.
DEPTH
AMDS 8623: CURRENT RESEARCH IN INVESTMENTS AND INTERNATIONAL
FINANCE
Annotated Bibliography Preiserowicz, J. (2006). The new regulatory regime for hedge funds: has the SEC gone down the
wrong path? Fordham Journal of Corporate & Financial Law, 11(4), 807-49. In this review, Preiserowicz (2006) provides a summary of several regulatory changes as
well as proposed changes to govern individuals involved in both hedging and speculation practices
in commodities markets in the United States. In addition to the summary, the author also
provides a detailed historical summary of several issues that are now forcing the consideration of
stronger government oversight into the industry.
Additionally, the author also provides a detailed synopsis of the hedging process as well as
the strategies involved in considering hedging as an investment tool in the commodity markets.
Within that summary, he also discusses the structure and processes of hedge funds and how the
funds operate within the market.
Furthermore, the author provides a lengthy summary of some of the primary issues where
the existing regulations do not effectively meet the needs of hedgers and speculators. Specifically,
the issues surrounding off shore transactions and the lack of effective reporting were of high
concern. The primary issue with this challenge is that there is a lack of insight into the volume of
transactions for specific commodities. With that lack of insight, there is concern that the markets
have a risk for manipulation which has a downstream impact on the entire economy for several
commodities.
31
Given that lack of insight, the United States Government is examining a wide range of
steps, including regulations, that could serve to not only provide better control of the market, but
to also gain access to a greater amount of market information. The thought behind this is that
with a more informed investor and market, the pricing can better align with projected supply and
demand of commodities.
Abumustafa, N.I. (2007). Hybrid securities and commodity swaps; tools to hedge risk in emerging stock markets: theoretical approach. Journal of Derivatives and Hedge Funds, 13(1), 26-32.
In this review, Abumustafa (2007) discusses some of the factors in the trading of financial
derivatives. Along with this, he also discusses how derivatives are used in a similar process to
hedging in that they are used to attempt to mitigate price risk of the underlying security.
However, they are different in the aspect that they are not typically based on commodities,
but are focused more on financial instruments such as equities or bonds. However, they do have
certain similarities with commodities in that there is an option structure as well as the ability to
convert the derivative into equity at the holder’s discretion.
While financial instruments are a more common form of derivative, there are options for
commodities as well. As the author discusses the process of commodity swaps where the price
paid from the buyer to seller is based on the price of an underlying commodity. In this strategy,
an investor would use the commodity swap in areas where the investor wishes to utilize a hedging
strategy, but is unable to implement the strategy with a futures contract.
Additionally, the author discusses several examples of non-equity based derivatives in the
market, credit derivatives and credit default swaps. Like other derivatives, these instruments are
also used to mitigate risk. However, this is different in comparison to other instruments discussed
32
above. In the example of credit derivatives and credit default swaps, the buyers and sellers are
transacting the credit risk itself. Simply put, these instruments focus more on the risk of default
rather than the risk of a change in price. As such, the focus is more on assessing and pricing the
derivative on the risk of default of the portfolio itself.
Williams, O.M. (2008). Hedge funds: regulators and market participants are taking steps to strengthen market discipline, but continued attention is needed. GAO Reports.
In this summary and testimony to the House Committee on Financial Services, Williams
(2008) provides a summary of the growth of hedge funds since 2001 both in trading volume and
in value. Specifically, the author discusses some of the more recent performance indicators on
hedging strategies related to loans, credit derivatives and distressed debt trading that has
significantly increased.
Along with the summary, the author provides an overview of the general strategies for
hedging and how those strategies can impact the overall performance of the market as well as the
values of the underlying commodities or securities. In addition, the author also discusses several
opportunities for greater government oversight and the development of additional regulations
noting several examples where a lack of oversight led to failures among several brokers.
In addition, the author also examines examples of where a weak or ineffective risk
management strategy on the part of the investor may have also spurred on several failures.
Furthermore, there is also a discussion of the interconnection between investors and banks ay
have a downstream impact on bank performance as well. By meaning, hedge funds typically work
with banks to establish lines of credit which can then fund the investment strategy. However, in
the event where the investor fails, the investor defaults on the financing causing the bank’s
33
financial standing to deteriorate. As such, the author provides some insight into the risk
management oversight that lenders are beginning to implement that can better address their risk
management by closely monitoring the investments that the hedge fund is making.
Herbst, M. (2008, May 7). Hedging Against $200 Oil. Business Week Online, 2-2.
In this article, Herbst (2008) discusses some strategies that commodity consumers can use
to effectively address the risks of future price increases. While this article focuses on the
strategies used by Southwest Airlines to mitigate the risk of jet fuel, the strategies could be
applicable to other commodity consumers as well.
In addition to the strategy summary used by the airline, the author also provides a
summary where Southwest was not only able to mitigate the risks of a price increase, but actually
resulted in an operating profit to the airline. This was then compared to the strategies and
financial results of other airlines that did not effectively prepare for the price increases.
Furthermore, the author also provides an in depth summary of where the latest demand
trends for oil are progressing not only in reference to quantity, but also specific countries where
demand has increased. Specifically, the author notes that both China and India, while still
considering developing countries, have been responsible for a significant part of the new demand.
The result of this is that while supplies have not necessarily increased, the quantity demanded by
the market has increased significantly.
With that, organizations like Southwest executed their strategy of purchasing future
contracts for oil and jet fuel that were at a significantly lower price than the actual market value at
the time of delivery. While they were expected to pay a margin payment to secure the price, the
34
cost savings as well as future profit outweighed any risks associated with a reduction in price that
would have been less than their contracted price on the futures contract.
Thompson, S. (2004). Great Expectations. Rural Cooperatives. 71(4), 14-18.
In this article, Thompson (2004) discusses the impact of ethanol on gas and oil prices as
well as the impact ethanol production has on the cost of corn. Additionally, the author provides
an overview of the ethanol production process and how corn producers are managing production
at a local level.
Of the key challenges noted by the author is that while there is significant demand for
ethanol as a fuel substitute that does not necessarily imply that everyone who produces ethanol is
successful in the effort. In fact, as the author notes, there is a significant investment in production
facilities that are required in order to effectively produce sufficient quantities for purchase. It is
those larger facilities that seem to succeed where the smaller facilities have not received a benefit
from the surge in demand.
In addition, the author also discusses strategies where the corn producers are also
operating in hedge strategy with their resource. The hedge in this effort is that they see that they
can produce ethanol at a more profitable amount in comparison to producing corn for sale on the
commodity exchange. What is interesting is that, with the exception of variations in processing,
the input resource, corn, is the same in either aspect. However, the producers expect that there
will be more demand for ethanol rather than corn and focus their production on that commodity
rather than corn. That withstanding, there is still a balance that is necessary. This is primarily due
to the fact that on a cost per mile basis, ethanol is still more expensive than traditional gasoline,
and until that becomes closer to the same cost, the market for ethanol will be limited.
35
Kase, C.A. (2006). Preparing to manage energy costs: basics for small to mid size companies. American Ceramic Society Bulletin. 85(11), 31-33.
Kase (2006) provides an overview on the hedging process as well as the processes
associated with formulating a hedging strategy in commodities markets. As an introduction, the
author provides an overview of the basis for hedging, that is to formulate a prediction for the
future. However, as the author notes that while speculators may indicate that they based their
strategies on market fundamentals, the author questions how fundamentals could apply when a
hedger is betting on the future rather than basing that strategy on known items.
In reference to strategy formulation, the author first discusses the idea that the investor
must first decide how much exposure or risk they are willing to take in the process. While
investors do have the ability to purchase options and pay a margin, the investor should still have a
thorough understanding of their total risk of their strategy before executing the agreement with
the seller.
Along with that, the author also provides a summary of different investment strategies
such as ‘scaling in’ that allows investors with an opportunity to invest in increments over time
rather than investing everything at once. In addition, there are also options where the investor,
depending on the level of purchase they are making in the market, can also choose to invest on
their own, or potentially invest in a consortium of other investors.
Finally, the author provides an overview of different techniques that an investor can use to
determine their risk versus reward so as to guide them on certain investment opportunities. The
intent is that the investor then has access to fairly reliable information that will give them a fair
assessment of particular investment options that meet their individual income goals.
36
Hill, P. (2008). Speculators accused of dictating oil prices. Washington Times, The (DC). Hill (2008) provides an overview of the recent discussions involving the potential impact
that speculators and hedgers may be playing in artificially inflating the price of oil in the market.
Along with this, the author provides some selected statistics summarizing the growth of
speculation activities in exchange volume leading up to the current market.
Within this, the author also provides some comparative data indicating the change in the
price of oil in comparison to the changing price of the stock market. As noted in the text, while
the oil markets surged, the stock market was losing value over the same period of time.
Furthermore, the author also discusses some potential actions that the government could
take that might serve to lessen the influence of speculative activities in the market. The goal of
these potential regulations is not only designed to curb further growth of these activities, but also
to have an impact on the fluctuation of oil prices in general.
While many would consider this to be controlling a free market, the intent is that if the
majority of the price increase is due to speculative activities, then a curbing of those activities
should serve to bring prices more in line with the prices that the market, free of speculation
activities, would consider as the appropriate value for the commodity.
Herbst, M., Coy, P., & Palmeri, C. (2008, 9 June). Speculation but not manipulation. Business Week, 26-29.
In their article, Herbst, Coy, and Palmeri (2008) discuss the potential impact of increased
trading of oil futures on upward overall market price of oil over the last few years. Their
perspective is that the role of speculators could simply be to make a quick profit, but they also see
that effort as serving to sustain the continued upward growth of the oil price.
37
In addition, the authors also discuss some of the reaction from politicians in the federal
government and their quick judgment to assume that the increase in oil costs is solely the result of
speculators attempting to profit from the market. They go on to further comment that while this
perspective may have some merit, some of those speaking out may be attempting to use this for
political favor rather than to search out a specific reason or reasons for the increase.
As the authors discuss, speculation is likely a part of the process, but the intent of the
speculators is not simply to gain control of the market. As summarized, the intent among many
speculators is to hedge against inflation or loss in other areas that are not seeing the same level of
growth as oil.
Along with the role of speculators, the authors also identify other potential reasons for the
increase in oil costs. For example, they note the growing demand in developing countries as their
economies develop and demand for oil increases. In addition to new markets, they also discuss
the issues of limited growth in supply and the time that is needed to identify locations and extract
oil from new areas and that this can certainly adjust supply in the long term, it will not address the
significant increase in demand and the negligible increases in supply production. In conclusion, it
is more likely that it is a combination of several factors, including speculation that has led to the
current high oil price.
LIEBERMAN, J., CHAIRMAN, C., & AFFAIRS, C. (2008). COMMODITY SPECULATION AND RISING FOOD PRICES. FDCH Congressional Testimony
In his opening statement to the Senate Homeland Security and Government Affairs
Committee, Senator Joseph Lieberman (2008) focuses his remarks on introducing the need for
further research on whether food price increases have been driven by speculation in the
38
commodity markets. While it is clear that there are many factors that impact overall prices for
commodities including imbalances between supply and demand, the contention is that while this
may exist, the problem is made even worse by the activities of speculators attempting to benefit
from the price surge.
Additionally, Senator Lieberman also discusses that many new investors are participating
in trading activities in commodity markets. Clearly, there are individual investors and hedge
funds, but we are also seeing an increase in more traditional investors such as pension funds
investing in these markets. The concern is that with the significant increase in activity, there could
also be an artificial increase in market prices for the commodity.
Finally, Senator Lieberman also discusses some of the previous legislation and existing
regulations that are designed to manage the commodities markets so as to avoid any single
investor or group from having a controlling stake in a commodity. However, from his
perspective, it appears that while the regulations have some effectiveness, it is likely that they will
need to be updated to better address the current conditions of the market.
Farrell, D., & Lund, S. (2008). The world's new financial power brokers. McKinsey Quarterly, 2008(1), 82-97.
Farrell and Lund (2008) discuss the shift in wealth related to the performance of the oil
markets since the year 2000. The notion that the authors review is that there is has been a
significant shift in wealth to not only the oil producing countries primarily in the Middle East, but
there has also been significant growth in deposits for banks based in Asia.
The result of this shift is that investors in hedge funds are now finding a new source of
funds from outside of the United States. Given the high levels of liquidity now available in these
39
regions, hedge funds now have access to banks and individual investors that are willing to extend
credit to a higher degree in comparison to previous sources of funds. As such, not only do hedge
funds have a new funding stream, but the cost of that funding has dropped as well.
Along with the improved investment in commodities, these players are also becoming
involved in areas such as credit derivatives that the banks can use to mitigate existing risks in their
portfolios. Clearly, giving them access to a new investment tool that can serve to benefit their
overall risk profile. Ironically, several of the Middle East investors are taking their investment
gains from oil sales and investing those revenues in investment funds that do further commodity
investing. In other words, potentially taking their own profits and executing hedging strategies
that may actually be pushing the price of oil higher.
However, while the performance of hedge funds is generally improving, there continues to
be significant concern that as hedge funds grow in size, there could be a greater risk to the entire
market if prices should go down. This is not only due to the decrease in portfolio value, but also
due to the amount of borrowing that hedge funds use. In other words, the concern is that in the
event of a downturn, the creditors may call for the credit to be repaid, thus destabilizing the
market.
Williams, O.M. (2007). Energy derivatives: preliminary reviews on energy derivatives training and CFTC oversight. GAO Reports.
In testimony to the Subcommittee on General Farm Commodities and Risk Management,
Committee on Agriculture for the House of Representatives, Williams (2007) provides a summary
on the oversight activities of the Commodity Futures Trading Commission (CFTC) on the
commodity markets in the United States.
40
In the summary, Williams provides details as to the increase in participation from managed
money investors and hedge funds as seeing energy futures as a new investment option. This
resulted in increases in investment funds in areas such as oil, natural gas and ethanol. The intent
being that as demand for these commodities began to increase, that prospects for growth in the
value of these commodities as an investment was evident as well.
However, what was of significant concern was that these types of options transactions are
exempt from CFTC oversight in that the markets where the transactions occur are not subject to
any regulatory authority. Further, these transactions can take place outside of regular exchange
markets as well as in overseas exchanges that are not subject to government oversight. With that
lack of visibility, it was unclear as to the total impact that these transactions can have in the
establishment of a market price for the commodity.
Along with that, Wilson also discusses the lack of oversight on the trading of derivatives
not only for the reasons discussed above, but the fact that there is a lack of clarity on the value of
derivatives. While the value should be tied to that of the underlying assets of securities
composing the derivative, the issue of the variations in the underlying instruments can cause
difficulty in valuing the derivative itself. Additionally, since the commodity is rarely delivered to
the investor, Wilson questions the reasoning behind the investment. In other words, is the intent
to only make a short term profit off a growing market or does the investor truly wish to consume
the commodity.
Finally, Wilson also reviews some applicable hedging strategies related to energy markets.
From the consumer’s perspective, the intent of hedging is to lock in a price today rather than risk
a price increase if the commodity was purchased at delivery. This gives the consumer the
41
advantage of making a relatively low risk investment to offset the potential of a significant
increase in the future price of the commodity.
Velotti, J.P. (2006). Regulators seek to curb energy funds. Long Island Business News, 53(35), 1A-57A.
In this article, Velotti (2006) provides a summary of where the new demand in oil future
investment is coming from. Historically, it was the oil companies that would purchase oil futures
with the intent of taking delivery and refining the oil for use in other areas such as gasoline.
However, what is clear is that while there continues to be demand from oil and gas
companies as well as other end users, hedge funds are now increasing their participation in this
market. While the author does state that hedge funds are looking at this as an investment tool and
not as an end user, he also concludes that the activities from hedge funds may also be influencing
the final price that the end users pay.
Furthermore, at the time of publishing, the author notes that the role of speculators alone
could be driving the price of a barrel of oil by as much as $25 per barrel. Clearly, this is resulting
in a short term gain by investors making further increasing their participation.
The result of this activity is that oil becomes more expensive for the end users to purchase.
That increase in cost is then pushed to the consumers of the refined products on the market. In
other words, if there is an increase in cost to the oil company, they will then pass that increase to
the refiner. Therefore, when we examine the increase in costs of end products such as gasoline,
the author tasks us to consider that the role of speculators, in part, is causing the increase in
commodity costs to all users after the product is produced.
Willams, O.M. (2006). Futures markets: approach for examining oversight of energy futures. GAO Reports.
42
In his summary to the Committee on Energy and Commerce of the United States House of
Representatives, Williams (2006) provides his comments to address some of the concerns related
to the increase in the per barrel cost of oil as well as increases in the cost of natural gas. In his
conclusion, he notes that while market influences do have some impact, it is clear that this is no
longer the primary reason for the latest commodity price increases.
Furthermore, he notes the increased in the participation of hedgers, speculators and
brokers as having an impact on the commodity price. As he notes, the role of these investors is
causing downstream price increases for commodity distributors and end users of the commodity.
With that, the intent of the planned research by the General Accounting Office (GAO) is to
determine whether these investment activities are causing prices to increase, and if so, what the
extent to which those increases are impacting the overall market price for the commodity.
In addition to that effort, the GAO will also investigate whether any of these practices are
serving to potentially manipulate the market and control the overall price performance. While the
Commodity Futures Trading Commission (CFTC) does have oversight on certain markets, their
oversight is limited where the activities of hedgers and speculators are concerned. As such, the
results of the research may involved recommendations for policy and regulatory changes to more
effectively manage market activities.
Siddiqi, M.A. (2004). Swings and roundabouts. The Middle East, February 2004(342), 38-43.
In this summary, Siddiqi (2004) discusses some select strategies by the Organization of
Petroleum Exporting Countries (OPEC) in their efforts to manage supply of oil that may actually
be less than the quantity demanded by the market. In a strategy that applies to most commodity
43
cartels, they find that the most effective tactic in managing price is to manage the supply of the
good available to the market. Along with this, the lack of insight into the true reserve quantities
provides an opportunity where the perception of scarcity of the commodity can artificially drive
up the price.
However, this perception of a lower supply as well as quota limits managed by OPEC is
not the only reason why the market price of oil is increasing. As Siddiqi discusses, there are other
external factors such as the roles of hedgers and speculators, as well as political conflicts in the
region that are also impacting market price.
In addition, the author also reviews how the deceasing exchange value of the United
States Dollar is also impacting the price. Since oil is traded in dollars, the value of the dollar has a
direct impact on the market price. By meaning, while producers are able to reasonably maintain
their costs, a lower value of the dollar will result in the producer spending more dollars for the
same expense. As such, the method of recovery of that cost increase is a higher cost to market.
Additionally, producers also need to consider the purchasing power of the declining dollar in
converted to their local currency. As we see, the recovery of the exchange rate loss is seen in an
increase in the per barrel cost of the commodity.
Finally, Siddiqi discusses the challenges that cartels such as OPEC have in managing
adherence to their quota scheme by individual countries. Clearly, as prices for a commodity
increase, it would be in an individual cartel member’s best interest to sell more and gain a benefit
from the increased price. However, in order for the cartel to succeed, compliance with quotas
will be key to that success. As such, OPEC will continually manage the overall quota and
underlying member adherence to meet long term revenue objectives.
44
Edwards, F.R. (2006). Hedge funds and investor protection regulation. Economic Review, 91(4), 35-48.
In this summary, Edwards (2006) discusses some of the potential regulatory actions to
address the changes in commodity markets. These proposed changes are designed to not only
better protect end users, but also to protect those investing in hedge funds.
The intent with this effort is designed to address incidents of fraudulent activity by some
hedge funds managers where there were concerns about the financial integrity of specific hedge
funds as well as concerns related to protecting investors. Furthermore, of specific note was the
lack of available or reliable information that was provided by hedge funds to their investors. In
some examples noted by the author, the information was often incorrect or in some cases,
inconsistently disseminated to investors. The result of this was that there was a greater risk of
investors making incorrect decisions based on questionable data from the hedge fund manager.
In addition, the author discusses potential conflicts of interest between the broker and
investor in the process. By meaning, the broker could be more concerned with his own or his
firm’s benefit and less on any risks that the customer may have in the opportunity. As such, the
broker becomes more of a sales person and less of an advisor to the investor as the investor’s
interest no longer carry the same weight as other factors.
Finally, of specific concern to the author is the fact that hedge funds have the ability to
operate with nearly no regulation or oversight. They can transact on foreign markets, they can
take concentrated positions on specific securities as well as have nearly unlimited access to credit
as well as leverage. The result of this is that there is a potential for a hedge fund to control
45
significant portions of a particular market or commodity. And, in the event of failure, can cause a
significant negative impact on market overall market performance.
DEPTH ESSAY
The idea of hedging and speculation in commodity markets has become a greater concern
in reference to the impact that these activities have on the price of particular commodities. With
that, in the Depth Section of this review, we will discuss in greater detail some of the primary
processes related to hedging and speculation. These topics will include a detailed discussion as to
the impact that hedging has on price, the general processes related to hedging along with existing
and potential United States Government regulations applied to commodities markets. In order to
provide some context to the discussion, I will focus on the performance of oil within the greater
context of hedging and speculation issues.
Context of the Problem
Since 2001, we have witnessed significant increases in commodity pricing for most
commodities in the energy sector. As examples of related commodities, we can consider different
varieties of oil, natural gas, ethanol, and diesel fuel. While there are many opinions that relate to
the cause of the recent increases in commodity pricing, the most common cause discussed appears
to be the impact of speculators and hedgers in the market.
Clearly, the debate on this issue has been contentious, with several parties blaming each
other for the increase. To make matters worse, there is a perception that speculators and hedgers
are simply involved in the process to make a quick profit and capitalize on a bad situation. While
that may be true in some cases, what should be considered is that there are likely a range of
reasons why we now see the significantly higher prices for energy commodities. Thus, it may be
46
more beneficial to take a more global approach to understand all of the market forces and
influences on the establishment of market price for these commodities.
Hedging Process and Strategy Development
First, to give some context of the process, the strategy of an investor executing a hedge is
to lower the risks associated with future changes in price of the commodity they are investing in.
Along with that, hedge funds are often willing to accept risks that other financial institutions may
not be willing to accept in their investment strategies, focusing instead on investment options such
as equities or bonds (Williams, 2008). For example, an investor might forecast that a particular
commodity will increase in value in the near future. With that, the investor would execute a
hedge strategy to fix the purchase price of the commodity to something less than they project the
future price to actually be. For example, a natural gas distributor might choose to fix the
contracted option price at the current market price if they feel that the market price will be higher
at the point of delivery. Then, when the delivery is scheduled to occur, the distributor will then
pay the price on the contract regardless of what the actual market price at delivery. As such, in
the event where the price actually does increase between the period of the agreement and delivery,
the distributor realizes a lower actual expense since they were able to purchase the commodity at
a lower price.
This does not make the assumption that the distributor will pass that savings on to the
customers purchasing their products. As with all businesses, there are two tactics that can be
applied in these situations. First, the company could simply take the benefit of the cost savings
and realize the improvement on their overall production costs. Secondly, the company could also
take the expense reduction and reinvest the funds in additional options for future delivery. In
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either example, the overall hedging strategy does not change. The goal is still to mitigate the risks
associated with potential near term commodity price increases rather than simply purchasing
goods for immediate delivery on the current market rates.
Furthermore, as I will discuss in greater detail in the Application section of this review,
there are also opportunities for end users to profit from these activities as well. As an example,
we can see some of the hedging tactics used by Southwest Airlines in their hedging strategy
related to jet fuel costs. Southwest was able to accurately predict that oil prices along with the
refined jet fuel would increase over time starting in the year 2000. Expecting this, Southwest
elected to invest some of their profits in purchasing options for jet fuel that now are priced slightly
less than one-third of the current price of oil. Clearly, they were able to save money by having the
opportunity to purchase the commodity at a much lower price than the market value at the time of
delivery. However, they were also able to report an additional profit of over thirty million dollars
as a result of their effective investment strategy (Herbst, 2008).
Hedging can also apply to those who are purchasers of a commodity that is then converted
to a secondary use by another party. An obvious example of this is the relationship of oil and
gasoline. Generally, a gasoline refiner will purchase oil from an oil producer and then refine that
oil into gasoline for sale to the market. Since the refiner is a customer of the oil producer, they
also want to gain a benefit from locking in a price. Much like the Southwest example I discussed
above, refiners also often attempt to lock in a potentially lower price by executing an option
contract to purchase oil at a fixed price for later delivery. In the event of an increase in the price
of oil, they would also benefit from the locked price in the option contract (Wilson, 2008) and
48
either improve their profit margin with the lower oil price or potentially pass some of that savings
to their customers.
In addition to end users of commodities, commodity producers can also use hedging
strategies in their production. As an example, we can look at some of the more recent strategies
initiated by corn producers. As a commodity, corn has multiple uses, but it is primarily known as
either a food product, gasoline additive, or gasoline substitute. For years, most corn producers
focused on producing for the market that considered corn to be a food product as this was the
product in the most demand in the market. However, starting with some mid-western states in
the United States, local governments began requiring that the corn derivative ethanol be offered
to consumers as an additive to gasoline.
In order to address this new market demand, corn farmers began to form small
cooperatives that would take the corn and produce ethanol in limited quantities to meet the small,
regional demand. However, as the use of ethanol began to increase to a broader range of the
United States as well as globally, there was a need for many large corn producers to make a
choice between focusing production on ethanol as there was a much better profit potential in
comparison to food production. This is another form of a hedge strategy. The producers were
hedging their production with the belief that ethanol prices would continue to increase where corn
as a food product was stagnating in value (Thompson, 2004).
This is not meant to imply that all corn producers would be successful in the switch from
food production to ethanol production. What was not considered were the production costs
associated with ethanol production and how that would impact overall profits for the corn
producers. As a result, those cooperatives that were able to form large organizations turned out
49
to be more successful in ethanol production. This is primarily due to the significant facilities costs
associated with the refining facilities. Those larger organizations could spread the operation costs
over a larger group of investors who were also high quantity producers of the product. As such,
while many organizations entered the market, the larger organizations were able succeed where
smaller organizations failed (Thompson, 2004).
While the market was growing, corn producers were not able to maintain their market
domination for long. The primary issue was that the market quickly realized that corn was not the
only option available for refined ethanol. As an example, we can consider the ethanol production
in Brazil as a viable substitute to ethanol produced in the United States. The Brazilians were able
to refine ethanol from a readily available commodity, sugar cane. Along with having relatively
easy access to harvest sugar cane, the Brazilians also had the advantage of lower labor costs along
with lower refining costs. The result of this was that ethanol was available from sugar cane at a
much lower cost than ethanol produced by corn farmers.
To make matters worse for the corn producers, even with the significant transportation
costs from Brazil to the United States, Brazilian produced ethanol was still cheaper in comparison
to the value corn producers were charging the market. Furthermore, since ethanol as a
commodity is not sensitive to the source of production, corn or sugar cane, the market identified a
much larger supply available resulting in a decline in value of the commodity. This decline
resulted in significant expense to the corn producers as their profits nearly evaporated as there
was much more supply available for purchase (Thompson, 2004).
Ironically, the shift from food production to ethanol production also had an impact on the
price of corn as a commodity. As the supply of corn was used in higher amounts for ethanol
50
production, there was less supply of corn available for food production. What was not anticipated
though was that corn was not only used for human consumption, but was also used as livestock
feed as well. As such, as corn became more expensive, this also had an impact on livestock,
primarily hogs and cattle, on the market as well. Since it was now more expensive to feed
livestock, the cost of livestock production increased and that cost increase was passed to the
market. This also provided a profit opportunity for hedgers and speculators in other commodities
outside of oil, corn and ethanol (Lieberman, 2008).
As a result, hedgers and speculators began investing in options that would allow them to
short sell ethanol with the expectation that the value would continue to decline. In instances such
as this, the hedger still profits from the decline in value, but the producer continues to lose money
as the value of the commodity declines. As if this was not enough for the farmers, we are now
seeing that there is less acceptance of ethanol as a long term substitute for gasoline. In the
beginning ethanol was thought to be better for the environment and more efficient for use in
automobiles. However, as we now see, there is significant research that actually indicates the
opposite, that ethanol is less efficient, more expensive and has limited environmental benefit.
With that, it is likely that the long term demand for ethanol will continue to decline causing more
financial burden for the producers (Thompson, 2004).
In general, the role of speculators in the market is significantly different in comparison to
end users using wise financial planning to better manage future costs. Speculators focus more on
accessing the benefits of an increase in cost so as to make a profit based on changes in market
value for a commodity. Additionally, it is in the rare case that a speculator ever takes final
51
delivery of the commodity. As such, their intent is simply to make a financial gain based on
market changes.
The volume of speculation continues to grow in significance in the performance of the
market. Specifically as it relates to the oil markets, speculators are now controlling over 40% of
the futures contract business (Hill, 2008). As a result of the increase in participation from
investors, it would be safe to conclude that those activities may have an impact on the final market
price of the good. In addition to the volume of oil contract participation, speculators are also
involved in other commodity markets which from 2007 to 2008, has grown by nearly one trillion
dollars (Hill, 2008). Again, not only is the contract volume increasing but the value of those
contracts has also grown significantly.
Clearly there is a reason behind this activity. As most equity markets began to lose value
as regional economic performance began to decline, investors needed to locate a new avenue for
their investment. As such, they turned to commodity markets as a new profit opportunity.
Furthermore, along with more funds, general trading volume also increased. As evidence of this
increase, trading volume in the year 2000 was approximately 500 million transactions, in 2007
that volume increased to over 3 billion transactions, a six-fold increase (Hill, 2008). The result of
this investment shift was that equity markets continued their decline while at the same time,
commodity prices began to increase.
However, this is not meant to imply that it is just a few Wall Street firms that are involved
in this process. Since the prices have continued to increase at a much stronger rate in comparison
to other investment opportunities, the variety of commodity investors has also increased. Along
with the institutional investors such as those found on Wall Street, we are now seeing pension
52
funds, insurance companies and other financial investors entering the market to capitalize on the
performance (Lieberman, 2008). As I discussed above, the increase in new market participants,
especially participants with significant investment funds, this can also cause prices to increase as
demand for commodities increases.
Furthermore, as an indication of the investment trends, we have also seen a significant
increase in the ratio of long positions in the market. As I discussed in the Breadth Section of this
review, long positions enable investors to profit when prices rise in comparison to the option
price. Additionally, when comparing positions in long positions to those of actual commodity
traders, the long positions now compose nearly two-thirds of market activity in comparison to less
than one-quarter ten years ago (Lieberman, 2008).
What is interesting in this situation is that the commodities markets were originally
established to create a mechanism for commodity producers and consumers to meet and negotiate
a price and delivery date for the commodity. However, with these recent trends toward a higher
proportion of speculative practices, there is less interest among most market participants to
actually purchase and receive the produced good. As I mentioned above, the focus appears to be
more in line with the exchange of options to purchase or sell rather than actual exchange of the
commodity. Thus, it may be safe to conclude that the options are becoming the latest form of a
commodity in the commodity market.
From the consumers’ perspective, the increased expenses related to oil and gas purchases
are not necessarily going directly to the oil producers. With the heavy volume of speculative
investment, the higher costs paid by the end user are being funneled into hedge and other
investment funds (Farrell and Lund, 2008). This would be contrary to the markets prior to the
53
onset of hedge activities in that the costs paid by the consumer were typically returned to the
producer of the commodity rather than the producer and a third-party hedge investor as we see in
the market today.
Along with the entry of new investors such as pension funds and Wall Street firms in the
commodities markets, we are now seeing an influx of money from outside of the United States in
the trading activities. As hedge funds continue to grow, they continue to need more credit to
invest in the markets. While in the past, most of that credit came from banks, the new funds are
being accessed from the major oil producing countries in the Middle East as well as several large
Asian banks (Farrell and Lund, 2008). Like other investors, these new participants follow a
strategy of investing in options that provide the most upward potential for profit. However, some
would consider it to be ironic that Middle East oil producers could be speculating in the oil
markets. In other words, they may be creating a situation where they are not only gaining a
significant profit from the point of production and contracting, but they also gain access to
additional profits resulting from their additional speculative investments.
However, this increase in the availability of credit may have a risk as well. As hedge fund
managers and firms find that they are depending on outside credit available from banks and other
investors, there may be a point in time where they will no longer have access to credit at the level
they currently possess. Additionally, as credit becomes more the norm for payment in options
markets, the market itself could become too leveraged on credit resulting in a higher risk of
collapse of a fund for non-payment of outstanding credit obligations (Farrell and Lund, 2008).
While banks and other investors have certainly improved their oversight of credit issuance to
54
better refine their individual risk management strategies, the risk of default still remains and can
become a more predominant issue as access to credit increases.
As discussed above, the strategy of a hedger or speculator is to profit from price
fluctuations in markets. In general, prices are established by a balance of the available supply
against the quantity demanded by the market. What the speculator wishes to benefit from is to
project demand or supply changes and how those impact the price. The hedger profits either by
contracting to purchase the commodity at a lower price than the current market value at delivery,
or to sell the option at a higher price in comparison to a lower current market price.
Again, in examining oil as a commodity, we can see that there has been a significant surge
in demand while supplies have been consistent (Herbst, Coy and Palmeri, 2008). The result of
this is that with more demand, the prices will naturally increase. With that, even with no
speculative or hedging activities involved, there would be a price increase due to a mismatch of
available supply and quantity demanded. However, as external economic factors such as increases
in global inflation rates and the declining value of the United States Dollar, speculators looked at
other investment options for their funds that could hedge against their equity investments that
were either losing money or seeing minimal improvement in value (Siddiqi, 2004).
Given the economic conditions, hedgers identified the oil markets as an option to maintain
growth. Investors correctly forecasted the growth in global demand for oil specifically from
developing countries like China and India, and felt that futures options in oil would be a more
effective investment (Herbst, Coy and Palmeri, 2008). While many would consider this activity to
potentially be an effort to manipulate the market for a short term gain at the consumer’s expense,
the practice is generally legal as an option for investors (Herbst, Coy and Palmeri, 2008).
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Along with the variety of methods to trade commodities on the market, there are also
other types of instruments that can be used in hedging strategies. Financial derivatives are
instruments where the underlying security is not necessarily a commodity. For example,
optionally convertible securities provide owners with the opportunity to convert the security to a
specified number of shares of common stock within the company (Abumustafa, 2007). While
some would consider this to be nearly the same as a stock option that could be found as part of an
employee compensation plan. Stock options provide an opportunity for the holder of the option
to purchase shares at the option price after a pre-determined future date.
For example, an employee could receive the option to purchase one thousand shares of
company stock at $10 per share. In the event that the actual market price of the company stock is
more than $10 per share, it would be wise to execute the purchase as the holder would have the
ability to purchase the shares at a price that is lower than the market value. In the event that the
holder did execute the purchase at that price, they could choose to keep the shares, or
immediately sell the shares at the market price and receive the difference between option price and
market price as profit. Furthermore, if the market price is less than the option price, it would not
be a wise decision to execute the option as the option holder would be better served in purchasing
their shares on the open market at a lower price. However, unlike optionally convertible
securities, stock options can not be sold between the original owner and a third party.
Optionally convertible securities also provide increased flexibility for the issuer in
comparison to stock options as well. For example, in times of market sensitivity, investors
typically become quite concerned with a company’s performance when additional shares are
issued to the open market. Investors would likely get the impression that the finances of the
56
company are not as strong and they need additional funds. Secondly, where company assets
remain the same and more shares are issued, the value of the shares on the open market would be
considered to be of lower value as there is a wider share of ownership (Abumustafa, 2007).
However, when a company issues optionally convertible securities, they receive the benefit
of additional access to funding without the risk of negative market perception. The reason behind
this is that since no additional stock is issued, the perceived value of the stock would not
necessarily change. As these securities are simply options to convert to actual shares at a later
date, the only risk the company has is that there is a risk of conversion at some point in the future
and they would need to address any changes in market perception at the time of conversion.
However, the issuer also has the option to call the securities after a set period of time that forces
the conversion to the underlying security. As such, the company receives the benefit of the
improved cash flow without the stigma of negative market perception (Abumustafa, 2007).
From the holder’s perspective, there are benefits as well. As discussed above, they have
the option to sell the security to a third party as well as convert the option to shares at their
discretion. Along with that, holder also has the option to collect dividend or interest income until
the point of conversion into company stock. This is especially beneficial to holders of optional
convertible securities that do not have a call option. In this case, the holder can collect dividend
or interest income into perpetuity without risk of the issuer calling the option (Abumustafa,
2007).
However, there are also derivative instruments that do have ties to commodities. An
example of this is a commodity swap. With a commodity swap there is an agreement between
two parties where one party agrees to make a series of payments to the second party where the
57
payment is based on the value of a commodity. The payments are based on a fixed price that is
agreed to in the contract. Commodity swaps are typically used as a hedge when a futures
contract is not an available option for the investor (Abumustafa, 2007).
Government Regulation and Oversight in Commodity Markets
Now that we have an understanding of some of the complexities of options markets,
speculation and hedging strategies, I will now review some of the existing government regulation
and further discuss its impact on options markets and investment strategies.
Among the most well known regulations that govern the securities industry is the
Securities Act of 1933. In the act, the government is not only establishing the Securities and
Exchange Commission (SEC) as the regulatory and enforcement arm of the government, but also
serves to establish guidelines for market operations. Within the act, companies and investors have
a clear framework for the issuance and purchase of shares as investment options available to the
public. Additionally, the act defines the level and frequency of public disclosure of financial
performance of the company. Simply put, the SEC is attempting to “protect the average investor”
(Preiserowicz, p. 813).
However, in relation to hedge funds, the act does not specifically cover these activities.
The challenge that the act faces in situations with hedge funds is that the act focuses more on
individual investment of company shares available to the public. Hedge funds do not necessarily
provide this option. In addition, hedge funds are not subject to any disclosure requirements
typically found in a public company. As such, most hedge funds are considered private
investment partnerships where there is limited membership to those investors deemed to be
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accredited with sufficient funds to participate in the fund. Clearly, these accredited investors
would not be defined as average investors under protection from the SEC (Preiserowicz, 2006).
Along with the qualification requirements of investors, hedge funds are not necessarily
required to register with any government agency which provides them with an opportunity to
operate without any government regulation or risk of legal violations (Preiserowicz, 2006).
Clearly, there is a concern with this as without any government oversight investors could be
making very risky investments as there would be virtually no protection in the event of
inappropriate conduct of a hedge funds leadership. Beyond that, investors would have either very
limited or no access to the underlying performance of the fund as the fund managers would have
no obligation to disclose the information.
The Investment Company Act of 1940 was implemented to further regulate investment
markets. The primary purpose of this act was that it required companies with a primary purpose
in facilitating securities investment to register as an investment company with the SEC
(Preiserowicz, 2006). On its surface, this would appear to provide some level of regulation for
hedge funds as by definition, hedge funds facilitate security investment. However, even with this
regulation, there are still exceptions where hedge funds would not necessarily be subject to this
act.
However, if a hedge fund has no more than one hundred members and does not make
public offerings for investment, they are not required to register as an investment firm with the
SEC (Preiserowicz, 2006). Again, as is the case with the Securities Act of 1933, if a hedge fund
intentionally limits its membership, the rules would not apply. Thus, the results for an investor
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would be the same, a lack of required financial disclosure of the hedge fund and a potentially blind
investment from the investor.
As the regulations continued to evolve, the government made another attempt at market
regulation by the implementation of the Investment Advisors Act of 1940. While this act does not
regulate the investment company itself, it does regulate the individual advisors within a firm. In
the act, any individual who receives compensation for providing assistance or advice to investors
of securities is required to register with the SEC as an investment advisor (Preiserowicz, 2006).
However, hedge fund advisors have an exception under this rule as well. In the event that
an individual advisor has less than fifteen clients along with not offering to assist the general
public in their investment activities, the advisor is not subject to the act and not required to
register with the SEC (Preiserowicz, 2006). While with the acts discussed above, there is no
requirement for disclosure of fund performance, in this circumstance, there is no requirement for
the advisor to disclose their qualifications, historical performance or any other factor to a
potential investor. Clearly, this is quite risky from the investor’s perspective in that they could be
receiving advice from an advisor who is either in no informed position to provide the advice or
could very well have provided historically bad advice to previous investors.
Along with this exception, there is an underlying exception that could also apply to hedge
fund advisors. That exception is the definition of ‘client’ within the act. Normally, we would
consider an individual person to be a client. However, in the act, a client can also be a fund that
has underlying investors. Those underlying investors could be limitless as the act only defines the
fund as the client, and not any other beneficiaries of the fund. With that, as long as the advisor
manages no more than fifteen funds, regardless of the amount of total individual beneficiaries of a
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fund, in the eyes of the law, that advisor only has fifteen clients (Preiserowicz, 2006). This
exemption is significant in that the unregistered advisor could control the investments of a
limitless amount of individuals.
Among the well known investment market regulations is the Securities Exchange Act of
1934. While the government and the SEC implemented this Act to further regulate markets, this
Act still provided exceptions for hedge funds. Within the Act, there is a requirement that would
require firm registration in the event that there were more than five hundred clients and a value of
more than $10 million (Preiserowicz, 2006). However, even with this tighter regulation, there is
an obvious exemption for hedge funds. That exemption lies in the total amount of members
required for registration. In order to effectively avoid registration, a hedge fund could simply
limit membership to less than five hundred members. As such, regardless of the value of the
fund, as long as the membership was limited to less than the act requires, they would not be
subject to any registration requirements.
Given the continued attempts by the government and the SEC, there is clearly a need to
reassess the applicability of the existing regulations as they pertain to hedge funds. As such, the
SEC is now focusing on evaluating the specific concerns in discussion so that may serve as a basis
for the development of future oversight strategies. Along with this, the intention of the enhanced
regulations was to further protect investors in these funds as well as add financial stability to
hedge funds (Edwards, 2006).
The first concern from the SEC involves the significant growth of the hedge fund industry
and the related risks associated with continued growth to financial markets. As hedge funds
continue to grow, their dependence on available credit from outside investors continues to
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increase. With this reliance on credit, there is a risk that other non hedge fund investments may
find that there is less access to funding as hedge funds may be interpreted by the market as being a
better investment. Thus, we have a situation where the credit market could be focusing too much
on one particular investment opportunity and ignoring others that may be more reliable investment
instruments. Secondly, as the credit market invests more credit in hedge funds, there is an implied
risk where there could be a negative impact on the overall credit market in the event of failures of
hedge funds (Preiserowicz, 2006).
Secondly, there is significant concern about the lack of financial disclosure of hedge funds.
As I briefly mentioned earlier, as hedge funds are not subject to the existing SEC regulations for
investment firms or advisors, there is no requirement that either party disclose the valuation of the
hedge fund portfolio. While it is in their best interest to report some valuation information in the
process of soliciting new investors in the fund, there is no requirement of any sort of outside audit
of the portfolio or any validation of the conclusions of the fund managers (Preiserowicz, 2006).
For the individual investor, there is an inability to validate whether or not the information
provided by the fund manager is true or not. While the investor could certainly make some
assumptions about the validity of the valuation, but by no means does that imply that the
information is correct.
Additionally, there is also no requirement for fund managers to disclose their overall
investment strategy to investors. Again, it is likely in the best interest of the fund managers to
provide some level of detail when soliciting new investors, but that disclosure does not mean that
the stated strategy will be continued for any period of time in the future. As such, while a fund
manager may disclose the current investment strategy of the fund that does not imply that the
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manager may elect to change that strategy in the future. Since there is no requirement to disclose
the strategy at all, there is also no requirement to disclose change in the strategy (Preiserowicz,
2006). From an investor’s perspective, this would be challenging in that without the disclosure,
the investor would have difficulty in assessing whether or not the existing or future investment
strategies of the fund are in line with their personal investment strategies.
Along with the lack of disclosure requirements, there is also a significant risk of a conflict
of interest on the part of the fund manager. As an example, in the event that an individual
manager is responsible for multiple funds, they may choose to take a loss on one to the benefit of
another. Clearly, those investors only participating in the former fund would not benefit.
However, the fund manager could benefit as there would be improvement in the performance of
the latter fund. In addition to this example, hedge fund managers could also implement strategies
that may be in their own personal financial interest but are not in the interest of other investors.
By meaning, investment strategies would be based on what would drive income to the fund
manager instead of the fund investors (Preiserowicz, 2006).
Ironically, for the most part, the majority of a fund manager’s compensation is not tied to
the performance or profit of the fund. Generally, hedge fund managers receive two percent of the
value of the assets of the fund and an additional twenty percent of any profits received by the fund
within the assessment period (Williams, 2008). With this, in the event where a fund may lose
money in a period of time, the only risk for the fund manager is their loss of the share of the
profits as they would continue to be compensated on the overall value of the assets of the fund.
While there is clearly a risk of loss in overall asset value, the fact that the advisor could still have
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high compensation for managing a poorly performing fund could be difficult for investors to
comprehend.
Given these issues, the SEC is considering a wide range of new regulations that would be
directly related to the management of hedge funds and potentially address the existing exemptions
afforded to hedge funds. The first of those options is to consider hedge funds as private funds. In
order to effectively define a hedge fund as a private fund, the SEC provided guidance on how
hedge funds would be recognized under this response. First that hedge funds would otherwise be
considered to be investment companies as defined by the guidelines under the Investment
Company Act of 1940. Secondly, investors would not be permitted to withdraw their investment
within the first two years of the investment in the fund, and third that the investment is being
offered based on the skills of the fund manager. The intent behind these very specific definitions
of a private fund was to better tie the characteristics of a hedge fund and related processes and
avoid additional regulations for other investment entities such as banks, insurance companies or
venture capital pools that would not normally be registered with the SEC (Preiserowicz, 2006).
Additionally, as I discussed above regarding the Investment Advisors Act of 1940, hedge
fund advisors previously had an exemption related to the total number of clients in their fund. As
discussed above, hedge fund managers would simply be required to consider clients to be
something as simple as the total number of funds they managed. As long as that total number did
not exceed fourteen clients, they would be exempt from the regulation and not required to register
with the SEC as an investment advisor. As such, the SEC adjusted their regulations to consider
the sum total of all investors in all funds a hedge fund manager may have as a client. With that,
the fund manager would be required to register as an investment advisor based on the total
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number of individuals who were investors directly with the fund manager or investors in any
subordinate funds under the hedge fund manager’s control. This look-through provision was
previously an exemption for hedge fund managers in the Investment Advisors Act of 1940, the
response by the SEC was to remove this exemption and require that hedge fund managers register
as investment advisors with the SEC (Preiserowicz, 2006).
Additionally, the SEC developed the Recordkeeping Rule to address the lack of audit or
reporting requirements previously available to hedge funds. Given that hedge fund managers
would now be required to register as investment advisors, along with that requirement, they
would now also be required to keep and provide to their investors, their audited financial results
to their investors, but also disclose those results in any promotional materials that would be used
to market their fund to new investors (Preiserowicz, 2006).
Also within the requirements for all registered investment advisors, the hedge fund
managers are now required to adjust their performance fee processes under the new Performance
Fee Rule. In this rule, hedge fund advisors can only charge performance fees to qualified clients
as defined in the Investment Company Act of 1940 and could no longer charge performance fees
to investors that did not meet the criteria of a qualified investor. Previously, hedge fund managers
had the ability to charge performance fees to all of their clients under their previous exemptions.
While there is a grandfathering process that did apply to this rule, any new clients or new funds
would be subject to this requirement (Preiserowicz, 2006).
In tandem with the new Recordkeeping Rule, hedge fund managers will also be subject to
the Adviser Custody Rule that requires that all registered investment advisors provide third-party
audited financial results of their funds performance. However, hedge fund managers who have
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other funds as clients may have difficulty adhering to this rule. This is due to the requirement that
the financial disclosures must be made within 120 days of the end of the fiscal year. As such, in
the event that a hedge fund manager has other funds as clients, the manager may not get the
financial results of the underlying fund until the 120th day, which would then be quite difficult for
the fund manager to adhere to this requirement since they would also be subject to the 120 day
rule. However, the SEC recognized this and did provide an exception which would provide the
hedge fund manager an additional sixty days to provide their audited results (Preiserowicz, 2006).
Now that we have established the processes and regulations of hedge funds, I will now
examine the current strategies that hedge funds and their investors implement. First, prior to
discussing those strategies, it is appropriate to review some of the causes for several recent hedge
fund failures.
The most predominant reason for hedge fund failures was a lack of market discipline in
their operations as it relates to not only the risk management strategies of the funds, but the risk
management strategies of the investors and those firms providing credit to the hedge funds
(Wilson, 2008). In the fervor to enter the growing hedge fund market, many investors entered
blindly hoping to receive the same perceived benefit their peers received from participating in
these activities.
While initially many hedge funds were quite successful in their strategies, the lack insight
into a fund’s risk management strategies resulted in the eventual financial failure of several firms
as well as the investors and creditors of those firms. As I discussed earlier referencing the new
SEC regulations related to performance and recordkeeping disclosure requirements, there was a
risk that a hedge fund could be taking very risky investment opportunities with the hope of a
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financial gain, but in the event of a loss, there was limited ability for an investor to be aware of the
failure until it was too late to act.
As an example of this, we can review the issues related to the trading of Collateralized
Debt Obligations (CDOs) in the mortgage market. CDOs are packaged mortgages that are
available for purchase by an investor. The assumption prior to the mortgage crisis was that CDOs
were generally accepted to be of high quality as there was a perception that since there was a
minimal chance of borrower default, the risk related to the investment would be limited.
However, what was not known was the quality of the underlying mortgages within a CDO. By
meaning, a lender creating the CDO could package mortgages that were of high perceived quality,
low quality, or a mix of the two. Regardless of the mix, CDO investors had no insight into the
actual quality of the underlying mortgages as there was no expectation that this information be
disclosed to investors purchasing CDOs. Furthermore, to make matters worse, most CDOs
contained mortgages that did not have an opportunity to become delinquent, as these loans were
typically packaged and sold shortly after origination, often before the first payment was due.
This is nearly analogous to strategies related in commodity based hedge funds. In that,
investors and creditors had virtually no access to the underlying investments managed by the fund.
However, as I discussed above, for many investors, this did not appear to be of concern. The
primary motivation of many investors was to enter the market soon enough so as to not lose an
opportunity to profit from the surge in growth.
Now that the failures have occurred and the lessons are beginning to be learned, investors
and creditors are now revisiting their investment strategies related to hedge funds. While some
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investors and creditors have simply exited the hedge fund market completely, those that remain
are becoming much more conservative on their investment strategy.
As I discussed above, the first step in the process was to refine the risk management
strategies and the supporting systems and processes of the investors. As such, the SEC began a
process of identifying the appropriate risk management systems in their assessment of hedge
funds. Those systems included “market, credit, liquidity, operational, and legal and compliance”
(Wilson, p.19). The intent of this assessment was to gauge whether the hedge fund had the
appropriate systems in place to effectively determine whether an effective risk management
strategy existed as well as whether the managers had access to the systemic information to
determine adherence to the risk management strategy.
Along with the risk management strategies of hedge funds, investors also became more
risk averse as a result of several hedge fund failures. As such, investors significantly increased
their due diligence processes related to providing funds. These due diligence processes require
that the hedge fund under consideration provide adequate financial reports indicating historical
performance as well as insight into their current and future investment strategies. With this
information, investors and creditors could better understand whether the pending investment
would fit within their, now enhanced, risk management strategies. For example, if the disclosure
reported that a hedge fund appeared to rely to heavily on a specific commodity or other industry
within their strategy, the investor may consider this to be riskier as there would be a greater risk
associated with changes in a performance in a concentrated investment strategy (Wilson, 2008).
Building on the due diligence requirements, creditors also began requiring that hedge
funds post collateral to secure the credit in the event that the hedge fund defaulted (Wilson,
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2008). Clearly, this is contradictory with the past operation of creditors where collateral was not
required to secure the credit line as credit was simply extended to hedge funds with very limited
oversight. Furthermore, the collateral provided would also be required to meet certain standards
as well. For example, hedge funds would be required to provide cash or cash-equivalent
instruments or highly liquid securities that had minimal risk of loss and could be quickly liquidated
in the event of failure (Wilson, 2008).
Given the wealth of new regulations and the significant changes to credit requirements, the
remaining hedge funds were forced to re-evaluate their overall strategies. Prior to several failures,
hedge fund managers would insist that they were using market fundamentals to guide their
hedging strategies. However, as we are now aware, many fund managers were focusing less on
historic performance and market fundamentals, but were focused more on trying to speculate on
what the future fundamentals would be (Kase, 2006). Clearly, the concern about this was that
managers were nearly guessing the future. While many managers would insist that they based
their predictions on market performance, we can again consider the failure of the mortgage
market and hedge funds that were heavily invested in CDOs, that traditional fundamentals may
not have been applied and led to the failure of many funds.
Conclusion
While there is a lot of contention as to who is the blame for the recent hedge fund failures,
the general unease with hedge fund investments, and the surge in commodity prices, there are
many parties that share some of the responsibility for the crisis. First, the lack of applicable
government regulation on hedge funds and their managers that provided many exemptions that
the funds could easily access and avoid government oversight. Secondly, hedge managers and
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advisors for their apparent lack of foresight into the risks that they assumed in their strategies
which resulted in a downstream negative impact on the financial standing of their investors and
creditors. Finally, the oversight of investors and creditors in their limited application of realistic
risk management strategies and effective oversight of hedge fund performance and strategy. In
the end, it was likely a combination of all of these factors that led to the weakening of the hedge
fund market.
Finally, we also need to understand how the processes of hedge funds and speculators
have on consumers. As I discussed earlier, there were some consumers such as Southwest
Airlines who were able to execute an effective hedge strategy in oil that also provided a benefit to
their customers related to price stability. However, those consumers who directly purchase
gasoline are feeling the pain of significantly higher prices at the pump. While some analysts
consider that the activity of speculators is a primary reason for higher prices (Velotti, 2006) with
the perception that speculators are artificially increasing the price of oil to make a quick profit that
is paid by the consumer, there is clearly more to the picture than the act of speculators alone. As
I have discussed above, speculators likely have some influence, however, there are also other
instances of speculation through hedging that have provided a benefit to consumers as well.
In the Application Section of this KAM, I will focus on detailing effective hedging
strategies that airlines, like Southwest Airlines, can implement to better address potential future
increases in oil and jet fuel pricing.
APPLICATION
AMDS 8633: PROFESSIONAL PRACTICE: APPLICATION OF INVESTMENTS AND
INTERNATIONAL FINANCE
Introduction
As we see in the current financial crisis facing air carriers in the United States, the
significant increases in the price of oil is quickly having a downstream impact on the cost of jet
fuel for the airlines along with increases in costs passed down to consumers. Clearly, this has a
negative impact on the economy as a whole. Not only does this impact the regular business
traveler, but it also impacts business costs related to companies who operate at a national or
international level. As such, along with the costs consumers face when flying, they also see an
increase in cost of goods that are manufactured and shipped to the customer.
With this, we need to establish a thorough understanding of not only how oil and fuel
costs are directly tied to the economy, but what actions consumers can take to better address
future price changes. As such, I will focus this application review on first gaining a stronger
understanding of what the current situation is in oil and fuel markets and then identify particular
strategies used by airlines to effectively address price changes for their fuel expenses.
Overview of the Current Situation
As discussed above, many airlines in the United States have been plagued by significant
increases in the cost of oil and the impact that cost has on jet fuel. The result of this cost increase
has forced airlines to determine ways to recover the increased costs from their passengers. While
airlines could simply increase fares, which they did, that action alone was not effectively
addressing the continued increases in costs. Additionally, airlines also needed to consider the fact
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that continued increases in airfares would eventually result in lower passenger traffic resulting in
reductions in revenue against the continued cost structure.
While increases in fares were the first step that the airlines implemented to address cost
increases, they found that consumer tolerance for higher prices continued to decline as the
national economy began to suffer. The next step beyond fare increases was to determine other
sources of revenue that were clearly smaller in comparison to other options that appeared to be
more palatable to the consumer. One of the first tactics, and one that was well reported in the
media, was to begin charging customers for their second checked bag. The intent from the
airlines’ perspective was likely to test the market to determine whether customers would accept
this fee. This tactic had a dual benefit for airlines. They identified a new revenue stream as well as
addressing the impact that baggage has on the weight of the plane and the fuel usage related to
that weight.
As with many tactics related to any costs increases, once one airline implements the
change, the other major carriers quickly follow suit. While the tactic was initially set to charge a
fee for a second bag of checked luggage, leaving the first checked bag at no charge, this failed to
meet the increased cost burden of the airlines. As such, we find that, with the exception of one
major airline, all the airlines are charging a fee for every checked piece of luggage. While the cost
structure is different where the first piece of luggage is typically less expensive than the second or
subsequent checked items, consumers are now bearing, and are accepting this new fee.
Along with fees for baggage, airlines also began charging fees for options such as window
or aisle seats as well as upgrade fees for seating in the exit rows. Again, items that were
considered free in the past now had additional fees attached. Beyond the additional fees, several
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airlines began charging higher prices for items such as meals and beverages or in many
circumstances, dropping beverage service completely from certain flights.
However, the airlines could not simply focus on developing or enhancing new revenue
streams to address their growing operating costs. They also needed to examine how they
operated their flight schedules. For many years, it was common to board a plane and see plenty of
open seats that went unsold. Clearly, given that the operating costs were nearly the same, having
a half empty aircraft directly impacted the cost per passenger. With that, airlines also focused on
the efficiency of their schedule so as to improve their passenger capacity performance.
Given the capacity concerns, the first step that the major airlines took was to scale back
the amount of flights per day. By examining the peak capacity performance of certain flights, the
airlines could identify which particular flights could be suspended or permanently cancelled. The
projected result of this being that the remaining flights would have more passengers and the airline
could operate more efficiently. However, the airlines still needed to be conscious pushing
customer tolerance to a point that they would no longer travel. As such, the flight reduction was
done gradually to continually test customer demand to the level that we currently see with the
major carriers.
Along with improving their cost per passenger related to fuel consumption, the schedule
reduction also resulted in other operational costs reductions as well. Clearly, with fewer flights,
fewer employees were needed. With that, the airlines were able to reduce their staffing costs by
early retirement, layoffs and terminations. While this does not specifically impact the operating
costs of a particular flight, these reductions served to reduce overall salary and benefits costs of
the airline.
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However, even with the improved revenue streams related to increased fees and fares
along with the cost reductions in place, the major airlines are still struggling. As the cost of oil
and jet fuel continues to be a larger burden on the airlines, there continues to be an inability to
properly address what is now the largest single cost of operating a flight. For many of the major
airlines, the jet fuel cost is approaching forty-percent of the total operating cost of a flight. While
some long haul flights do not see this high of a ratio, the shorter flights which are the majority of
an airline’s schedule, continue to see excessive costs related to fuel consumption.
This puts the major airlines in a very precarious situation. They can not risk a negative
impact to customer retention by further increases in fees or fares nor can they continue to take on
more debt or financial losses related to jet fuel costs. With that, the airlines need to engage in a
strategy that can not only address the current situation related to fuel expenses, but to better
prepare for any future changes in fuel costs.
However, we also need to understand that the major airlines are not the only consumer of
jet fuel. In fact, there is another user who actually consumes more jet fuel than any individual
airline, that user is the United States Air Force. However, the Air Force does not have an
opportunity to recover additional fees or revenues like the airlines. As such, the Air Force needs
to consider methods of maintaining costs along with providing appropriate projections on
budgeting for future terms.
Given the restrictions the Air Force encounters when it relates to expense management,
they have proven to be unsuccessful in their attempts to effectively manage increasing jet fuel
costs. There are several reasons why this is the case. However, the most predominant reason for
the failure to manage fuel costs is the inability of the government to correctly predict what future
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prices will be. Since the past performance has shown that the government tends to underestimate
the actual fuel costs, the inaccuracies result in the Air Force either reducing or delaying expenses
or going back to the government to ask for supplemental funds to recover the costs (Spinetta,
2006).
Much of the discrepancy is due to the budgetary structure of the United States
Government as it relates to effective planning for changes in jet fuel pricing. In examining the
current structure of budgeting, the first stage of the process involves the Office of Management
and Budget determining the cost estimates for jet fuel consumption for a budget year. From there,
the OMB estimate will go through several stages to determine an estimated price per barrel of jet
fuel. Then that budget is sent to the Department of Defense for further adjustments with final
distribution to Air Force for their operational budgets. Beyond the fact that there are multiple
parties making adjustments and forecasts to the actual cost per barrel, what appears to be more
troubling is the focus of that estimate being based on oil futures pricing (Spinetta, 2006).
Furthermore, by focusing their price estimates on oil futures pricing, the OMB risks the
frequent price fluctuations related to activities outside of the market. For example, in the event of
war or other calamity that can not be forecasted by the markets or OMB. The result of this is that
more often than not, the OMB estimates for jet fuel pricing are significantly lower than the actual
cost at the time of purchase. As discussed above, this forces the Air Force to locate other funding
sources that could make up for the unexpected price adjustment.
Clearly, the intention of any commodity pricing strategy, for airlines or the government, is
to work towards establishing a stabilized price for the commodity. With both the airlines and the
Air Force attempting to better manage future costs, the need to stabilize this expense continues to
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be significantly relevant to their continued operations. With a stabilized price, the airlines can
better determine future expenses and have appropriate access to funding to manage their
operations. The same is true for the Air Force, in that they can better manage budget
expectations and meet their overall service objectives.
While from a financial perspective, there is clearly a benefit to establishing a stabilized
commodity price. However, that does not imply that this is something simple to determine. As
discussed above, the actions of the Department of Defense and the OMB clearly failed in the
attempt to determine what the stabilized price should be. While they did agree on what they
thought the stable price was, they were consistently inaccurate in that estimate. Thus, while the
intent existed to stabilize the price, the failure to do so accurately failed to effectively manage the
cost.
Given the inability for most airlines and other jet fuel users to develop an effective pricing
strategy, there is a need to implement a hedging strategy to better manage increasing jet fuel
costs. While the airlines have been hedging for many years with reasonable success, there is
significant concern that a government entity, the United States Department of Defense, in their
consideration of hedging to address jet fuel costs. While the Air Force is a significant user of jet
fuel in comparison to other major airlines, their usage is insignificant insofar as the total market
for jet fuel is concerned (Spinetta, 2006). With the projected lack of influence the government
could have on the commodity market, there would be little concern from the other market
participants on the government’s participation. However, that does not imply that the
government would then enter the market.
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Given the public perception of hedging and commodity markets, other members of the
government may see such actions as risky in that the investor may actually lose money in the
effort and it may still not address the Department of Defense’s need for a stabilized market price
for jet fuel. The general population may also see this action as a highly risky use of government
funds as well. This is where the perception of the market does not necessarily correlate with the
actual performance of the market (Spinetta, 2006).
As discussed above, the intention of a hedging strategy is not to necessarily make a profit,
but it is to provide some level of stability for the price over a period of time (Morrell and Swan,
2006). If we examine the performance of some of the airlines who did not implement a significant
hedging strategy, we would see examples where several major airlines were paying consistently
higher jet fuel prices in comparison to their competitor airlines. One specific example of note is
the hedging strategy of Southwest Airlines. Through 2003, Southwest hedged nearly forty-three
percent of its jet fuel needs for the following operating year. This was nearly three times the
average of all of the major airlines operating in the United States. Only one other airline, JetBlue
was hedging at a similar level. Clearly, when looking now at the level of profitability of the major
airlines, Southwest clearly used jet fuel hedging to its advantage when managing overall operating
costs (Spinetta, 2006). While other airlines entered and exited bankruptcy, Southwest has
maintained strong economic performance in a period where operational costs are increasing
significantly.
Hedging or Speculation?
Of the many ironies in the public perception of hedging by companies is the idea that
hedging and speculation go hand-in-hand. This could not be farther from the truth. In fact, if an
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airline does not hedge jet fuel to the best method possible, they are in fact speculating on the
future price of jet fuel (Spinetta, 2006). What we must first understand is that the act of hedging
makes solid business sense. It makes something as unpredictable as jet fuel pricing more
predictable and easier to manage from an operational perspective.
While the end result of hedging is not to make a profit or avoid a loss, as the long term
financial impact of a hedge is zero (Morrell and Swan, 2006). No gain or loss on the investment.
The benefit of being able to anticipate the future cost is the underlying benefit of a hedging
strategy. This is true even from a valuation perspective in that airlines who can establish an
accurate budget reportable to the investor will have the perception of being reliable and worthy of
future investment. Beyond that, investors appreciate consistency in operating costs and incomes.
We can see this with the consistent profitability of Southwest Airlines along with their consistent
stock performance in comparison to their peer airlines.
However, first we need to understand the impact that airlines have on the market. Again,
the intent is not to make a profit but to have a reliable cost stream into the future of the hedge.
While this is certainly a benefit to the operation, it does not mean that an airlines stock will surge
in value simply due to a hedging strategy. Investors consider a wide range of reasons which
involve costs, profit and operating strategies that continue to evolve with the needs of customers.
Thus, the purpose of the hedging strategy is to avoid a future risk of wild cost fluctuations and
provide financial stability to the operation.
Implementing an Effective Hedging Strategy
As discussed in the Depth and Breadth Sections of this review, there are several methods
of hedging the price of a commodity. As it relates to jet fuel, the typical strategy involves the
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setting of a forward contract for the purchase of jet fuel. The forward contract allows the airline
to purchase a certain quantity of jet fuel at a given price for delivery at some point in the future.
This agreement allows the airline to determine the cost well before delivery. This is also ideal
from the producer’s perspective in that they have a purchase commitment that allows them to
assume the income at the delivery date.
However, there is also risk associated with this type of transaction. As these contracts are
not set in an organized commodity market, there is a risk of failure to deliver at the time
designated in the contract. For example, in the event that the airline or the producer goes
bankrupt and fails to pay or deliver the jet fuel, there is no commodity market that would govern
the transaction. However, in reality, this is true of any direct contract between a buyer and seller.
There is always a risk that one of the parties will not fulfill their end of the contract.
In order to address this, some airlines may choose to simply enter into a futures contract
that is completed through a commodity exchange. By transacting through an organized
commodity exchange, third party investors can be involved in a transaction in the event either the
airline or producer does not fulfill the requirements of the contract. Ironically, only one percent
of the hedged oil in commodities markets are delivered to the initial futures purchaser. Since the
primary focus of the commodity investor is for the investment value of the contract, the existing
contracts are often reversed near the point of the scheduled delivery (Morrell and Swan, 2006).
On the other hand, airlines may also consider the use of derivatives in their fuel hedging
strategy. Unlike futures contracts that commit a buyer and seller to a particular quantity and price
with a stated delivery date, derivatives give the holder the right to purchase at a given price
(Morrell and Swan, 2006). The result of this is that there is a much lower financial commitment
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of the holder as they are not purchasing the actual commodity. Given that this is simply a right of
the holder, there is no obligation for the airline to actually purchase the fuel. In the event that the
airline wishes to execute the right to purchase, the agreement would then be converted to a
futures contract with the specific price and delivery terms (Morrell and Swan, 2006).
However, more recently airlines have engaged in a process where they use combinations
of put and call options in order to have a price that is in a range of available prices from the
producer. In this event, the airline would purchase a call option that would that would protect the
holder from a resulting price that could be above the strike price of the fuel. In addition to that
effort, the airline would also sell a put option that would provide protections where the market
price was actually lower than the strike price of the option. While there is a cost associated with
this, the option premium, the airlines see a benefit in this process as there will be a known price
range for the fuel when purchased (Morrell and Swan, 2006).
Finally, airlines will also engage in swap contracts that allow airlines to purchase fuel at a
specific price but with deliveries over a period of time. This is an ideal option for airlines in that
they are able to purchase the fuel based on projected need. In effect, a swap agreement is a set of
multiple futures contracts. For example, the airline could make a swap agreement where they
would receive a given quantity of fuel per month for a year or more. Within that agreement, there
would be a specific price for the fuel for delivery, much like futures contracts. However, where
swaps differ from futures contract is that the swap price and the market price are considered at
the point of delivery. In the event that the market price of the fuel is lower than the swap price,
the producer would pay the airline the variance multiplied by the quantity of fuel scheduled for
delivery. On the other hand, if the market price for the fuel is actually higher than the swap price,
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the airline would pay the producer the difference in price multiplied by the quantity for delivery
(Morrell and Swan, 2006).
Which Airlines Hedge?
Now that we have an understanding of the major hedging processes and options, I will
now discuss which airlines hedge their jet fuel acquisitions. As I discussed above, the major
categories of jet fuel users are the airlines and the military. In this discussion, I will examine the
non-military jet fuel users. As such, we can classify the airlines into two categories government
owned or sponsored airlines and publicly traded airlines.
First, I will examine those airlines that are either owned or funded by their home country
governments. In several cases, these government owned or operated airlines are faced with
similar restrictions as I mentioned earlier related to the fuel pricing strategies of the United States
Air Force. However, there are also examples, specifically the airlines operated by the People’s
Republic of China that are required to purchase their fuel from government owned producers.
Outside of the People’s Republic of China, other state owned airlines are permitted to hedge on a
limited basis if the airline can justify a hedging strategy to their government managers (Morrell
and Swann, 2006).
When examining the hedging strategies of some of the major American airlines, we can see
that there is a stark difference in planning. When referencing the hedging strategies through 2004,
the airline with the largest percentage of hedged jet fuel was Southwest Airlines with eighty-two
percent of their needs hedged. The next closest airline was Delta Airlines with thirty-two percent
of their fuel hedged with other airlines with no hedging strategy at all (Morrell and Swan, 2006).
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Clearly, hedging a majority of their fuel needs is a long term strategy of Southwest
Airlines. Additionally, it is evident that this strategy is paying off for them in that they remain the
only American airline that has maintained a profit over the past twenty years. While there are
likely some other reasons for Southwest’s financial success, it is clear that their effective cost
management is a major component of their success.
We can also see how a lack of a hedging strategy has a negative impact on some of the
other major American airlines. When we examine the strategy of the top two American airlines,
United and American, we see that a lack of a fuel hedging plan has impacted their financial
performance. Using United Airlines as an example, their lack of a hedging strategy has likely led
to their continual financial losses and subsequent bankruptcy filing.
The Impact of Hedging on the Value of an Airline
As I have discussed above, the ability for an airline to effectively manage their expenses
does have an impact on the financial performance of the company as well as the perceived value
of that company to investors and creditors. Even though the hedge itself is not designed to result
in any profit or loss, an airline’s exposure to fluctuations in cost does impact their ability to
stabilize costs. According to Carter, Rogers and Simkins (2006), their research shows that “the
airline firm value is positively related to hedging of future jet fuel requirements (Carter, Rogers
and Simkins, p. 54).” In other words, the market perceives a value premium when an airline
executes a hedging strategy.
Additionally, there is a negative relationship between increasing prices in jet fuel and stock
price (Carter, Rogers and Simkins, 2006). The result of this is that the behavior of the investor
market tends to hold that if there is a perception of profit decreases due to increased costs, the
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investors profit potential is limited. As such, they tend to sell off their investment in the airline.
Ironically, many investors stop short of examining an airline’s hedging strategy, if available, and
focus more on the perception that a commodity cost, regardless of airline, will result in lower
benefit to the investor.
As I have discussed before, a hedging strategy allows an airline to effectively lock in fuel
prices over a period of time. The additional benefit that the strategy has is that it also allows the
airline to also manage their long term investment strategy as well (Carter, Rogers and Simkins,
2006). For example, if an airline can predict their costs, they will also be able to budget for
acquiring new aircraft, routes or other resources that would be necessary for future expansion.
The same can not be said for those airlines that do not hedge in that they can not risk committing
to operational growth expenses with the risk of an increase in fuel expenses. Simply put, non-
hedging airlines can not commit a single source of funds to multiple needs.
Clearly, investors would have a negative perception of a company that can not manage its
expense nor invest in future growth. Instead, what results is that investors need to consider
whether they invest in an airline with sustained financial and operational growth or an airline that
is forced to restructure expenses as jet fuel costs increase. This is why we now see that investors
approach airlines like Southwest in comparison to other airlines like United and American who
either have limited or non-existent fuel hedging plans.
However, jet fuel risk is only one of several risks that airlines have in their operations.
Other risks include currency risks and interest rate risks. While currency risk only involves a
limited number of airlines that operate in multiple countries, interest rate risk occurs with any
airline that has any bank or bond debt in use to support their operations. While interest rate risk is
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a concern and can have an impact on the financial standing of an airline, that amount of risk is
negligible compared to jet fuel risk (Carter, Rogers and Simkins, 2006).
Additionally, there is also a positive market perception when an airline can hedge jet fuel
at a price that results in a lower price in comparison to the price available on the open market.
The market perceives this as a beneficial investment in that the airline would have the ability to
receive the jet fuel at a lower cost in comparison to not having the hedge in the first place. Again,
this could be considered counterintuitive in that a hedge should have a net present value of zero
dollars, the market clearly has a different interpretation of the meaning.
The typical result then is that if the market perceives a particular airline stock to be of
better value than a competitor, they will then invest more in that airline. This action then provides
the airline with more funds to invest in building their operation. Additionally, it also puts that
airline in a better position to efficiently compete against other airlines.
There are two primary tactics that an airline will use to utilize available funds to improve
its performance. First of those options is the purchase or lease of new aircraft. This tactic has the
benefit of not only modernizing their fleet but to lower maintenance costs associated with older
aircraft. The former reason is especially true in times where fuel costs are increasing.
When an airline has an opportunity to modernize their fleets, they have the option to either
purchase or lease new aircraft and retire older aircraft by means of sale to other airlines or if the
aircraft is beyond its useful life, airlines will simply sell the aircraft for dismantlement. In either
option, the benefit is a reduction in comparative operating costs from the old to the new aircraft.
In the event the airline chooses to lease aircraft instead of an outright purchase, nor the
lease expense or the value of the aircraft as an asset do not appear on the balance sheet of the
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airline. The benefit with this is that since the aircraft is not owned by the airline, the actual debt
the airline carries is understated thus appearing lower to investors (Carter, Rogers and Simkins,
2006). With that, investors will have the perception that the airline is carrying less debt and may
be perceived as a better investment. However, what is likely more tangible to investors is the
operational efficiency benefit of a newer fleet.
Along with the greater access to funds as a result of expense management and cash
inflows from investors, stronger airlines also have the opportunity to either acquire or consolidate
with other airlines (Carter, Rogers and Simkins, 2006). As an example, we can review the
acquisition of TWA by American Airlines in 2001. At the time, American was considered a
financially strong airline that was in need to grow to compete with United Airlines. American had
sufficient access to funds for the transaction as they were able to acquire TWA with their existing
cash on their balance sheet. The benefit that American received was the addition of a new hub in
St. Louis, Missouri as well as TWA’s existing aircraft fleet and their complementary routes that
would enhance American’s position as a competitive airline (Carter, Rogers and Simkins, 2006).
Currently, we are now seeing another increase in airline mergers and acquisitions.
However, the current environment is no longer focused on stronger airlines purchasing weaker
airlines. Nor are we seeing these mergers occurring on a cash basis either. In today’s market,
airlines are focusing more on options that will bring greater efficiency as well as complementary
route structures.
The first of these acquisitions was between US Airways and America West Airlines. In
this case, both airlines were struggling with increases in operating costs as well as loss of revenue.
However, there was clearly a complementary route structure. US Airways had a solid footing in
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the eastern portion of the United States with hubs in Pittsburgh, Pennsylvania and Charlotte,
North Carolina. America West Airlines had a solid presence in the southwestern portion of the
United States with their major hub in Phoenix, Arizona. However, since neither airline had
sufficient cash available to fund the merger, they turned to outside investors to purchase stock in
the new merged airline.
Another example of an airline merger in progress is between Northwest Airlines and Delta
Airlines. Again, this was an example of two airlines that were facing significant financial
problems. Both Delta and Northwest had recently emerged from bankruptcy and needed to take
drastic action to continue competing in the market. As was the case with the US Airways and
America West Airlines merger, there is a complementary route structure. Northwest maintains
hubs in Minneapolis, Minnesota, Memphis, Tennessee and Detroit, Michigan. Delta maintains
active hubs in Atlanta, Georgia as well as Salt Lake City, Utah. However, there is one additional
benefit in routes that provide an enhancement to this merger, that benefit being the significant
international route structure between the airlines. Northwest has historically maintained a strong
presence in Asia and Delta has a strong presence in Latin America and Europe. Additionally, both
airlines participate in the Skyteam loyalty program.
Along with the complementary route structure, the airlines also consider the benefit of
greater operational efficiencies after the merger. As with any merger of similar companies, the
merged companies have the ability to identify operational redundancies such as staff or routes.
While this should serve to solve some of the resulting company’s financial challenges, it will likely
be a significant period of time before the financial benefits of the merger will offset the current
financial challenges of either company.
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However, within all of these strategies, there is a perception that effective capital
investment by an airline will improve the airline’s value to the investor (Carter, Rogers and
Simkins, 2006). The theory behind this is that if an airline has funds available that are invested in
the operational growth of the airline by tactics such as jet fuel hedging, modernization of aircraft
and beneficial acquisitions, the market perceives these actions an enhancing their investment.
Along with that, the investor also perceives that by making these capital investments the company
is better positioned to address future changes in the industry and maintain financial growth.
The Impact of the September 11th Terrorist Attacks
Some may consider the events on September 11th to be the downfall of the major
American airlines. Notwithstanding the cessation of air travel for the week immediately following
the attacks, the reluctance of Americans to travel by air for the months after the attacks did not
improve the situation either.
However, while many thought that the attacks started the downturn in financial
performance of the major American airlines, the truth is that the financial challenges actually
began well before the attacks occurred. Along with quickly increasing fuel costs in the three years
prior to the attacks, the airlines also experienced increases in labor costs as well as reductions in
passengers (Kim and Gu, 2004). This resulted in nearly all of the major airlines reporting losses
prior to the attacks.
Along with the financial challenges of the airlines, the economy in the United States was
also on the decline prior to the attacks. As many economists would conclude, the United States
was already in a slight recession as early as March, 2001 after a significant period of economic
growth (Kim and Gu, 2004). Thus, the resulting decline in the financial performance of the
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airlines caused the recession to worsen shortly after the attacks and continued for well over a year
after the fact.
While the United States Government did take quick action to provide both loans and
direct compensation to airlines immediately following the attacks to provide some form of
stability, the funding did not have significant impact on correcting the financial downturn of the
airlines. Again, this was due to the direct losses of the attacks, but was also due to the poor
financial conditions of the airlines prior to the attacks. While the assistance certainly helped
mitigate some of the losses the airlines incurred, it did not satisfy all of the losses currently on the
books (Kim and Gu, 2004).
The result was that several airlines, including United Airlines and US Airways were forced
to file bankruptcy in order to reorganize their existing debt (Kim and Gu, 2004). While most of
these airlines did emerge from bankruptcy in better financial positions, it was only a short time
later when jet fuel prices surged, that the airlines found themselves in another predicament that
they were ill prepared to address.
In their analysis of weekly returns both sixty weeks before and after the attacks, Kim and
Gu (2004) provide clear evidence that there were few examples where an airline that had positive
returns prior to the attacks had negative returns after the attacks. While returns did drop for all
American airlines, the vast majority of the airlines that were losing money after the attacks were
losing money before as well. In fact, there were only three national carriers that swung to a loss
after the attacks. Those airlines were American Airlines, Frontier Airlines and Southwest Airlines.
The remaining national airlines simply saw increases in their existing losses in the sixty months
after the attacks. Ironically, if we examine the hedging strategy of American and Southwest, we
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would also see that these airlines hedged much higher proportions of their fuel needs in
comparison to the other major carriers (Carter, Rogers and Simkins, 2004). This might also serve
as a validation that there is a link between an effective hedging strategy and positive financial
returns.
Along with the analysis of changes in return for the major airlines, Kim and Gu (2004)
also reviewed the stock price fluctuation in the sixty months prior to and after the attacks. Here
we see similar indications of financial concern among the major carriers. While all of the major
airlines did see a significant increase in the standard deviation of the stock price, two carriers,
United Airlines and US Airways saw their standard deviations nearly triple in the sixty months
after the attacks. This would be compared to Southwest Airlines that witnessed an increase of
0.0072 in the standard deviation of their stock price. What this means is that the stock price of
most of the major American airlines was much more volatile after the attacks in comparison to
Southwest Airlines whose stock was hardly volatile prior to the attacks saw little change in that
volatility afterwards. Again, this could be based on the market’s perception that Southwest was a
wise investment both prior to and after the attacks.
Along with the perception that Southwest Airlines was considered a less risky investment,
we should also consider what was driving the higher volatility in stock price for the other major
American airlines. Clearly, investor behavior would indicate that if uncertainty in a company
exists, an increase in the price volatility of the stock will also exist. As it pertains to airlines,
investors pay close attention to fluctuations in the market itself and deteriorating financial
performance of the airlines (Kim and Gu, 2004). Thus, we see much higher volatility in stock
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price for airlines that were further weakened as a result of the attacks along with the deterioration
of their financial condition before and after the attacks.
Secondly, as I mentioned before, the increases in labor and fuel costs served to further
deteriorate the financial condition of the major carriers. To make matters worse, when several
airlines began to improve their financial performance, the price of jet fuel began to surge
significantly. Thus, limiting their potential to build upon the improving performance in the years
after the attacks (Kim and Gu, 2004).
Finally, we also need to examine the level of debt that airlines have assumed to address
their mounting financial losses. Since the attacks, most of the major airlines have continued to see
significant financial losses and have been forced to take on additional debt in order to cover their
mounting financial losses over the past few years. As Kim and Gu (2004) note in their research
that the average debt to capitalization ratio of the major airlines is now in excess of ninety percent
with a total debt approaching $90 billion. This has also had an impact on the Standard & Poor’s
credit ratings of the major airlines in that, with the exception of Southwest Airlines, the remaining
national carriers now have a debt rating that is considered speculative. Furthermore, this poor
rating makes a bad situation even worse as those with lower credit ratings are forced to pay
higher interest rates on new debt due to the increased risk associated with repayment.
Why did Southwest Airlines Succeed?
Now that we have an understanding of the financial performance of the airlines prior to
and after the September 11th terrorist attacks, I will examine the major reasons why Southwest
Airlines appears to have effectively remained ahead of other national airlines in financial
performance.
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First, Southwest was able to easily control their operational costs. The airline has
consistently hedged at least a majority of its overall jet fuel needs at a significantly lower price in
comparison to the market (Kim and Gu, 2004). This has allowed the airline to effectively lock in
their future fuel costs for anywhere between one to two years ahead of their current needs. As I
have discussed above, this stability in pricing allows Southwest to better predict future expenses
and accurately budget future expenditures with little risk of unforeseen increases in operational
costs.
Additionally, Southwest has also efficiently managed labor costs. While most of
Southwest’s employees are unionized, the airline maintains a strong relationship with the unions
and their employees. The result of that positive relationship is that the airline has never faced a
strike or lengthy disputes with the unions. This has allowed the airline and the unions to quickly
negotiate new contracts with its unions. While there have been disagreements in the past, the
strong working relationship between the airline and the unions has allowed the airline to run more
efficiently in comparison to other major carriers.
Furthermore, Southwest Airlines is one of the few airlines that offer a route structure that
is referred to as point-to-point. In this model, Southwest focuses their routes from city to city
rather than a hub-and-spoke model followed by most of the major airlines that centers their
operations on regional hubs that serve specific regions of the country. The benefit with
Southwest’s model is that they are able to better serve custom needs by focusing their routes on
high demand destinations rather than forcing customers to fly through and change planes at a hub
that can serve to lengthen travel time. From the customer’s perspective, this can be seen as more
convenient in comparison to major carriers.
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Along with this model, Southwest typically operates at secondary airports in the United
States. A clear example of this is Chicago’s Midway Airport. While nearly the same distance
from downtown Chicago as O’Hare Airport, Midway airport offers airlines significantly lower
gate and operating fees in comparison. Southwest can then utilize that savings for investment in
other areas of their operation.
Finally, Southwest Airlines operates only one type of aircraft, the Boeing 737. This allows
the airline to maintain lower costs for maintenance and training as they do not have a need to
service multiple types of aircraft. This would be in comparison to United Airlines which operates
nine types of aircraft from two manufacturers and American Airlines which operates eight types of
aircraft from three manufacturers. This allows Southwest to maintain a much lower parts
inventory as well as staff that are focused on maintaining a single type of aircraft.
Conclusion
As I have discussed, the options that American airlines have are limited in reference to
attempting to address the deteriorating financial condition that most face. Those two options
would be to lower their labor costs and hedge fuel costs for the future. By lowering the labor
costs, the airlines can trim one of their largest expenses further. However, there is a point where
the labor unions and employees will not accept any additional decreases. We are already seeing
this today where labor unions are simply striking, slowing down their work or calling in sick and
forcing the airline to take further action. Even with reductions in labor costs, there is a minimum
amount of labor that is needed for a flight to commence. There are minimum requirements on the
amount of flight attendants on a flight as well as the requirement to have a full flight crew.
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While there is also non-flight crew related labor such as customer service representatives
and baggage handlers, reductions in that labor expense can have a direct impact on customer
retention. By meaning, continued cut backs in customer service staff mean that customers will
have to wait longer to purchase a ticket or make any changes to an existing reservation. The
result of that is that customers would have the perception that the airlines are not providing
proper service and would then consider doing business with another airline. Secondly, in
reference to baggage handlers, any reduction in that labor cost would have a relative increase in
the amount of lost or delayed baggage or longer waits at the airport to retrieve luggage from an
arrived flight.
In both of these situations, there will likely be a reduction in customer retention where
customers will simply fly with another airline on their next trip. In a highly competitive industry
like the airlines, the risk of losing a customer to a competitor results in the need to increase other
expenses such as marketing or enhancements to existing reward programs to encourage high
volume customers to maintain their relationship with the airline. Thus, airlines need to examine
how those potential labor related costs reductions would be offset by other operational expenses
that would be related to maintaining the existing customers of the airline and attempting to grow
business where possible.
Thus, this leaves us with the only remaining option that airlines have to address their
increasing costs. That tactic is jet fuel hedging. As I have discussed above, the benefits to jet fuel
hedging are quite clear. While hedging is not designed to create a profit for the airline, it does
give them an avenue to effectively manage costs into the future rather than simply paying the spot
price for jet fuel on the open market. We can see this clearly in the discussion of Southwest
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Airlines. Southwest is able to accurately predict future jet fuel expenses which directly reduces
business risk.
However, this does not imply that airlines should simply start purchasing futures contracts
for jet fuel. The best option for airlines would be to enter into a collar that would at least provide
a specific and predictable range of prices. While the airline would not be able to predict the exact
price of the future delivery of fuel, they would at least have a set range of prices that would be
accurately predictable. Again, much better than simply purchasing jet fuel on the spot market
where the market is determining an airline’s fuel expenses.
However, regardless of the strategy, the national carriers need to implement a strategy that
balances continued operations with customer expectations. Clearly, the airlines have nearly
tapped the existing market on additional fees in an attempt shore up revenues. Additionally, given
the customer response to those fees, continued customer retention is starting to be a concerned as
the tolerance for more fees is near an end. Given this, the only remaining option for airlines is to
address their operating costs that they have the ability to reduce quickly. Without this effort, we
will see airlines continue to struggle.
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