Disclaimer

The views expressed by me on this blog are mine alone at the time of posting and do not necessarily reflect the views of any organization with which I am associated.

Tuesday, September 06, 2005

Katrina and the Airlines

Mark Tatge and Phyllis Berman pose the question, "Will Katrina Ground Airlines for Good?" in last week's article in Forbes. They argue that Delta is likely to be hit twice--by rising fuel costs and by its dependence on traffic in the affected areas. They judge Northwest to be near the brink, too. The second paragraph below tells us almost everything we need to know about the industry:

Now, the situation is at a breaking point. Not just for Delta, but for the entire industry. Katrina should reduce total refining output by 43 million barrels over the next two months, according to Lehman Brothers. That translates to about a 10% to 15% reduction in the supply of jet fuel. Oil prices, despite falling back slightly in the past day, are expected to stay above $70 per barrel until at least the end of the year.

Both Delta and Northwest have no hedges against exposure to rising fuel prices. AMR's American Airlines and Continental Airlines, although in better financial shape, have no hedges in place either. The only airline with significant hedging is Southwest Airlines, which holds hedges for 65% of its 2006 fuel needs--most of it at $32 per barrel, according to Lehman Brothers.

Checking the stock ticker, Southwest has a market capitalization of $10.9 billion. American is at $2 billion, and the total of Continental, Delta, Northwest, and United is no more than $1.5 billion. Given the thrust of the article, these relative magnitudes should come as little surprise.

8 comments:

Anonymous said...

All these "Katrina and" things sound like bad band names.

Anonymous said...

http://tinyurl.com/7ndn4

8 airlines may go to 4. hopefully there is a way to maintain competition and serve all parts of the country.

big airlines should have hedged. not doing so may be like a father of many kids neglecting to purchase life insurance.

ed said...

Are you suggesting that Southwest was smart, or just lucky?

I'm not sure there's any reason from basic economic theory that airlines should hedge, anyway, since this does not reduce risk for a shareholder holding the market portfolio. On the other hand, bondholders and other stakeholders (employees, managers) may like hedging if it reduces the risk of bankruptcy. In general I would (if anything) have expected the big carriers to hedge and Southwest not to hedge, since bankruptcy is not a near term risk for Southwest.

Anonymous said...

Insurance is an option. You exercise it when you need it. Big risks that can knock you out of business and that have a pretty decent chance of happening should be hedged.

Why wouldn't an airline have some sort of hedge for oil? Southwest was not "lucky". They were doing what was reasonable. Big carriers were basically negligent and incompetent. If you pay for insurance and never need it, consider yourself fortunate and blessed.

Lots of companies have interest rate swaps to manage interest rate risk. Should this practice be eliminated because shareholders can diversify away interest rate risk?

I've heard the shareholder argument about diversifying away risk and not needing managers to purchase insurance. Anecdotally I hear this from traders and from very young and green finance professors with no signficant work experience.

I've also heard extremely successful business people turned elder professors say "self insurance= no insurance"

See the theory of the fat tails-

Anonymous said...

I am not 100% certain that Southwest is the only airline that has used fuel hedges. I will do more digging later-

http://uk.biz.yahoo.com/050818/323/fpzji.html

Insurance is cheaper if you (eg, Southwest) buy it when you don't have a pre-existing condition-

Anonymous said...

one more:

If Southwest got in financial trouble, the govt would let them go under and they would not get bailed out by the govt. This is because of Southwest's size and the nature of SW's operation (serves smaller, underserved airports and tends to have more non-business-class and lower income people on the plane).

Big airlines expected a bail out. They had no incentive to avoid disaster so they did not.

What we have seen has been logical given the incentives provided by govt.

Anonymous said...

katrina may have been good for airlines (assuming no more shocks in near future).

the govt relaxed a bunch of regulations. the world is tapping reserves. oil prices (per barrel in US) have come down.

Anonymous said...

"I believe oil futures prices are the same for everybody. (On the other hand, if you need to borrow to buy the futures, this may cost more for some than for others.)"

The *initial* cost of entering into a futures contract is zero for most futures. Of course, down the road, the contract might produce positive or negative cashflows, so some amount of margin is typically required by the broker. However, the margin is very small in case of futures contracts.

Southwest did not purchase insurance against rising oil prices. An option would do that. A futures contract exposes the holder to price movements in both directions. Had oil sank to 16 (from the future-specified price of 32), Southwest would effectively be buying oil at 32, when everybody would have been buying at 16.