Southwest Airlines’s Hedges

Michael Giberson

“We don’t know where the price of crude is going to be,” says [Southwest Airlines’s Chris] Monroe. But, he adds, “I think we have to be generally bullish just because we’re trying to protect against an increase … So we have a little bit of a bias that prices may go higher.”

He chuckles that he and [former SW treasurer Scott] Topping, longtime colleagues and friends, used to describe themselves as the “most conflicted” managers in the building — although low fuel prices would benefit Southwest overall, it would mean their carefully crafted hedging strategy wouldn’t pay off as well….

Still, “In my heart, I would love lower prices,” says Monroe. “Lower prices are good for everybody in our country, and especially good for an airline.”

From, “The ‘Fixer’ at Southwest Airlines,” CNBC.

Notice that Southwest trades crude oil options and other derivatives even though they are not in the physical crude oil market. Proposals that aim to limit trading to parties with “true” commercial interests in the underlying commodity could inadvertently trip up quite reasonable hedging strategies such as pursued by Southwest. (Presumably they find the liquidity available in the much more heavily traded crude oil markets attractive compared to trading in the less liquid jet fuel markets even though the crude oil price is an inexact proxy for the price of jet fuel.)

In related news, Delta Air Lines is buying a refineryfrom the Phillips 66 unit being spun off of ConocoPhillips. According to Dana Blankenhorn at SeekingAlpha, “Delta Refinery Deal All About Southwest.”

(I’m still with the skeptics on this deal. Is is really going to be cheaper for Delta to own a refinery and make jet fuel than just buy jet fuel in a reasonably competitive market? Another way of asking the question, why does Delta think it can do a better job of running the refinery than ConocoPhillips did? Surely contract-based cost management as practiced by Southwest will be more flexible and adaptable to changing conditions than Delta’s ownership of an aging refinery near Philadelphia.)

6 thoughts on “Southwest Airlines’s Hedges

  1. I’m also baffled on the Delta deal. I think a strong case can be made that over the long term, physical hedges outperform financial hedges, but that’s an argument to own a stake in low-cost oil fields, not to own a refinery. Refining is the low-margin, crappy part of the oil business that oilCos have to do so they can monetize the much higher margin upstream oil fields. Setting aside whether Delta is going to be a good refinery operator (a huge set-aside), even if they run it well it doesn’t provide them with any real insulation from volatile crude prices. Maybe I’m missing something, but it sure seems dumb to me.

  2. I’m with Sean on this one. I fail to see how Delta makes money on a refinery Conoco Phillips could not operate profitably. Also, jet fuel is just one fractional “cut” of the refinery output. The remainder of the output must be marketed as well; and, Delta has no existing capability to do that marketing.

    It would be interesting to look back 10 years from now and see how Delta’s actual performance cpmpares with their current prediction. I’d bet the answer is “not well”.

  3. The Delta refinery deal is curious. It might make sense if they were thinking of experimenting with blends of inputs and trying to make jet fuel out of that. Having a bunch of jet engine test beds available makes it practical to do trial and error testing of blends. An airline could save a lot of money if they could blend in 20% of some cheaper feedstock into their fuel and right now just about any fuel feedstock is cheaper than crude oil.

  4. I gave this some thought and it’s obvious that an airline should not run a refinery and I assume the folks over at Delta know that too so why would they buy this refinery?

    One thing an airline does know is how to predict future jet fuel prices (not well but probably better than others). Buying a jet fuel refinery could be a good profit source in the future but an airline doesn’t know how to run a refinery.

    From what I understand this is one of the refineries that is scheduled to shut down because of the large operating expenses and aging equipment. Is this because the current operators don’t have the capital to upgrade the plant and require management rejuvenation? Building a new refinery in the US is very difficult and almost impossible to do on land that isn’t already zoned for such. Refineries need to be located with easy access to crude oil and a refined product distribution network. The CP plant definitely has that.

    Harold Geenen believed that he could manage any industry because managing is managing but that’s true only to a point. If the refinery is below that point, Delta can come in and implement some of its proven management strategies, invest some cash as capital and flip the business like a carpenter would flip a house. So Delta wouldn’t be getting into the refining business but more like rescuing a refinery and getting some special perks along the way.

    Perks could include special blends of jet fuel, ability to make special deals with other airlines for in kind services and good like gate and runways slots and who knows what else.

    Delta may also have the ear of politicians and leaders in that area that could cut down on the external overhead that the current plant can’t. The “Cost of doing business” may be less for Delta.

  5. Virginia doesn’t go far enough. This will be a good example for ManEc textbooks of the next decade. It’s what happens when you have a lawyer who doesn’t understand transfer pricing making management decisions based on accounting data.

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