Download - Price Uncertainty on Jet Fuel
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.