HOW SOUTHWEST AIRLINES

ADDRESS THE PRICE UNCERTAINTY

ON JET FUEL

Irving Rivera

802-03-6561

Wilfredo Robles

802-02-6129

ININ 6030 Advanced Engineering Economics

Mayra Mendez PhD

Agenda

Introduction

Glossary

Key Concepts

Methodology

Strategies

Conclusions and Recommendations

Introduction

The main objective of this paper is to introduce and

ponder a few techniques that airlines like southwest

use to deal with the price uncertainty of jet fuel.

In this paper we will explain the uncertainty on oil

prices and what causes its volatility and how

Southwest address this risk utilizing different hedging

strategies like buy and sell future contracts and or

options.

Glossary

Price Uncertainty

the chance or speculation that the price of an asset will change.

Hedging

is any strategy designed to offset or reduce the risk of price fluctuations for an asset or investment.

An option

is a financial derivative that represents a contract sold by one party (option writer) to another party (option holder).

Futures contract

consist out of an agreement that upon expiration you will get delivery of the hard asset.

Spot prices

the prices paid for oil here and now.

Futures prices

prices paid for contracts promising the delivery of oil at a future date.

Southwest

Southwest Airlines is the largest domestic carrier.

The marketing strategy of the company is to have the

lowest possible fare price.

Jet fuel is the second largest operating expense for

airlines, after labor cost.

Southwest maintained low operating expenses, primarily

through it’s extensive fuel hedging strategy.

Price Uncertainty on Oil

Causes

Demand

Weather

Speculation

Dollar Value

Production Cuts

Geopolitical Events

Transportation Bottlenecks

Effects

Economic Activity

Investment

Consumption

Unemployment

Raise the Good and Service Prices

Transportation Cost

Profit Margins

Explain as the changes between the Spot prices and the Futures

prices paid for contracts promising the delivery of oil at a future

date. These prices are benchmark by West Texas Intermediate,

Dubai or OPEC.

Hedging

Key aspects

Hedging is used to reduce risk.

Hedging is not about making a profit, but about removing uncertainty by minimizing loses.

Hedging can be profitable when is used sparingly and effectively.

Benefits

Minimizes price risk.

Improves firm value.

Reduce risk of financial distress.

Reduce the firm’s cost of capital.

Manages the volatility of earnings.

Increase ability to make profitable investment opportunities.

Hedging is any strategy designed to offset or reduce the risk of

price fluctuations for an asset or investment. Hedge requires the

purchase of a second asset with a negative correlation to the first.

Methodology

1) Chose the topic

Price Uncertainty

2) Search the data base of the university looking for

papers on price uncertainty in the oil market.

Proquest

Science Direct

The format use for this work is the same use as the

International Journal of Production Economics.

Methodology cont.

3) Analyze the selected papers; we will mainly use

papers as reference of our study

David A. Carter et.al, (2007), Southwest Airlines Jet

Fuel Hedging-Case Study.

Hui Guo et.al, (2005), Oil Price Volatility and U.S.

Macroeconomic Activity, Federal Reserve Bank of St.

Louis Review, 87(6) pp. 669-83.

4) At the end we will made conclusions,

recommendations and future research consideration.

Strategies

I. Do nothing.

Here they take what the market gives them; if oil

goes up the hike prices and cut cost and if the price

goes down the lower the fares.

Pros Cons

No upfront cash costs. Unlimited market risk.

Strategies cont.

II. Hedge using a plain vanilla jet fuel or heating oil

swap.

An example of this is when the a refiner of jet fuel

and the airline make a contract that state; I (the

airline) will buy you (the refiner) X amount of fuel, at

Y price during, for a Z period of time.

Pros Cons

Cash flows occur monthly which more

closely matches of the actual fuel

expenditures.

Liquidity may be a concern if

Southwest wants to unwind the position

early.

No upfront cash costs. Limited ability to benefit financially if jet

fuel prices decline.

Strategies cont.

III. Hedging using options

What they do is they buy the jet fuel and married with

a put. They also buy a call that give the right to buy

the fuel on agree upon price.

Pros Cons

Greatest flexibility for all alternatives. Basic risk.

Upside price protection and firm benefits

from declining prices.

High upfront cash costs in the

form of option premiums.

Strategies cont.

Zero-cost collar is established by buying a protective put while writing an out-of-the-money covered call with a strike price at which the premium received is equal to the premium of the protective put purchased.

IV. Hedge using a zero-cost collar strategy.

Strategies cont.

Pros Cons

High flexibility Basis risk.

Upside price protection and firm still benefits from

declining prices until the put strike price is

reached.

Low or zero upfront cash costs.

Strategies cont.

V. Hedge using a crude oil or heating oil futures

contract.

Airline use this deal to create a positive investment

income capital to pay for actual jet fuel this way

softening the blow of higher prices.

Pros Cons

Low upfront cash

costs.

Basis risk.

The firm does not benefit from

lower prices.

Contracts are marked-to-market

daily.

Backwardation & Contango.

Conclusions and Recommendations

The price paid for jet fuel can significantly impact earnings and the ability of the Southwest to remain competitive with other airlines.

Southwest’s policy of providing air travel at the lowest possible fares demands strict cost management, making hedging a must.

Hedging reduces the risk associated with price fluctuations. Hedging allows a firm to set a fixed price now for any flying ticket in the future.

The zero-cost collar option strategy is the most favorable for the company because it lower cost and well know volatility capping the upside and downside of their risk.

Conclusions and Recommendations

Volatility future research may consider

How long the contract agreement should be valid.

Jet fuel oil consumption must be reduce to

contribute with the company’s efficiency and

environment.

Stochastic Models to determine if the price will

decrease or increase.

References

Carter, David A., Simkins, Betty J., Rogers, Daniel A., Treanord, Stephen D., 2007. Southwest Airlines Jet Fuel Hedging-Case Study.

Guo, Hui, Kliesen, Kevin L., 2005. Oil Price Volatility and U.S. Macroeconomic Activity, Federal Reserve Bank of St. Louis Review, 87(6) pp. 669-83.

Hamilton James D. “Historical Causes of Postwar Oil Shocks and Recessions”, The energy Journal, January 1985,6(1).pp.97-116

Shrestha, G.B., Pokharel, B.K., Lie, T.T., Fleten, S.-E., 2007. Management of price uncertainty in short-term generation planning, IET Generation-Transmission & Distribution, doi: 10.1049/iet-gtd:20070177.

Stock, James H. and Watson, Mark W. “Forecasting Output and Inflation: The Role of Asset Prices.”Journal of Economic Literature, September 2003,41(3), pp. 788-829.

Wikinvest, (2009, ) OIL, http://www.wikinvest.com/concept/Oil_Prices. Access November 15, 2009.