I think you and Larry may be onto something with the whole "pass-through" analysis, but I'm also wondering whether there is some point at which a duty to hedge could be inferred from the shape of the demand curve and the price elasticity of demand. Most of the limited reporting I've read on airline fuel prices suggests that the current fuel surcharges are depressing demand for air travel. At least that's what the airlines are saying. To be honest, that surprises me a little bit, because I would not have thought that there were all that many customers for whom a $10-20 fuel surcharge would change the "buy/not buy" decision. Of course, it's all about the marginal customer, and the papers may be talking about substantially higher ticket prices due to higher fuel costs that are only partially captured by the "fuel surcharge." (The "fuel surcharge" nomenclature is itself interesting, as is the extent to which it assists in making the "pass-through" strategy viable, but that's a discussion for another time.)

I'm inherently skeptical of explanations that absolve businesses for responsbility for their own failures, and there may be an interesting double-edged sword when an airline refuses to hedge the high fuel costs it publicly says drive demand for its services. You can't have it both ways, I'd think.

It seems to me that there might be a duty of care "break point" for airlines which should require them to hedge fuel at the point where they believe the demand curve slopes away unprofitably (or less profitably), but not before. Assuming they could accurately identify that point ex ante, a hedge would not be economically rational so long as the pass-through of fuel costs (whether explicitly in a "fuel surcharge" or implicitly in the overall price of the ticket) continues to work. Once you reach a fuel-cost-driven overall price level that is unprofitable (or, more aggressively, non-profit-maximizing), shouldn't the airline be hedging the risk that fuel prices will push ticket prices to or past that point?

The non-hedging airlines will argue that many factors drive demand, and that it's impossible ex ante to identify a fuel price level above which they should be fully or partially hedged. I'm not sure that works, primarily because I suspect they study the price elasticities of their various customer segments (from the almost perfectly inelastic full-fare business traveler to the highly elastic flip-flop wearing vacationer) EXTREMELY closely. Also, I suspect that the industry faces a fairly simple and relatively static supply and demand structure. Supply is more or less what it is, at least in the short term. Demand lies along a fairly predictable set of curves, absent a 9/11-type event that actually moves the curve as opposed to moving the equilibrium point along the curve (the impact of the macroeconomic cycle is a potential curveball here). Fuel is the single biggest truly variable cost in the short term (you can't decrease ground or air crew size because a flight is only half-full), and probably overwhelms other factors on the margins.

In that situation, it seems to me that the airlines' optimal strategy is to leave their fuel exposure unhedged (thus creating an opportunity for additional upside in the event of low fuel costs) until the "pass-through" effect is overwhelmed by decreases in demand. Beyond that point, you hedge. (I assume there are hedging instruments that will allow you to hedge various price levels -- there's usually someone out there willing to take the opposite side of most bets).

Of course, I don't know much about hedging in general, so maybe this wouldn't work. Still, it seems to me that flattening out the risk above a certain level makes sense, and given the way the airline business works, should overwhelm the "lose big, win big" strategy most airlines seem to be following with respect to fuel costs.

Christine -- For what it's worth, I've always believed that the conventional interpretation of Brane v. Roth misstates both the facts and holding of the case. In Brane, the board of directors determined to hedge the corporation's risk of loss from fluctuations in grain prices, then hired an employee unknowledgeable about derivatives, failed to inform itself of the basics of derivatives hedging, and then failed to supervise the employee. If the employee's actions had then caused liability for the cooperative through unauthorized or speculative trades, the case would have been unremarkable. Instead, however, the employee caused losses for the cooperative by failing to hedge a large portion of the coop's risk exposure, presumably because he didn't know what he was doing.

Because the court's reasoning is so unclear, many people have interpreted the case as imposing a fiduciary duty to hedge. But the better reading is that, once a board determines to hedge, it has a duty to inform itself about the basics of hedging strategies, hire employees competent enough to execute those strategies, and properly oversee employees in order to enjoy the benefit of the BJR.

Interestingly, many people have explored the opposite of the question posed by you and Larry. That is, many have questioned whether it is a violation of the duty of care for directors to hedge the corporation's risk exposure, because public shareholders are already diversified. For reasons discussed in this 1999 article, I argue that both sides are wrong -- decisions of whether and how much to hedge should be protected by the BJR, so long as made by a fully informed board in good faith --http://papers.ssrn.com/sol3/papers.cfm?abstract_id=110525.

In this case, it's not a fiduciary duty issue; it's just business. Remember, most other airlines are teetering on the edge of bankruptcy.
To oversimplify, when Southwest "hedges" what they do is enter into a contract with a counterparty that says "(1) if the average price of jet fuel for the second quarter is above $x, then counterparty will pay Southwest the difference between the average price and $x, multiplied by the number of barrels hedged; and
(2) if the average price of jet fuel for the second quarter is below $x, then Southwest will pay counterparty the difference between the average price and $x, multiplied by the number of barrels hedged."
In addition, Southwest pays the counterparty a fee for entering into the contract.
Now, Southwest is creditworthy -- that is, the counterparty isn't worried about repayment if prices go below $x. So the counterparty will enter into that contract with Southwest without requiring Southwest to post collateral.
If, on the other hand, Continental tried to enter into such a hedge, the following issues would arise:
(1) Continental would have to come up with the initial fee (not an insubstantial amount) out of available cash; and
(2) Continental would have to agree to post cash as collateral with the counterparty -- probably on a daily basis -- if it went underwater on the hedge (i.e., if jet fuel prices went below $x).
Set aside for a moment whether or not a sane counterparty would enter into this contract with Continental. There is no way that, given its cash position, Continental could commit to post the amount of cash collateral potentially required and the fees that would be required by the counterparty to compensate for Continental's bankruptcy risk would make the deal prohibitively expensive.
In other words, those who need to hedge most are least able to. Has nothing to do with management foresight or strategic savvy (except, of course, for Southwest's ability to keep out of financial straits in the first place).

Kim -- so, if the board of directors had not hired any person to do the hedging, would the board have not breached any duty? I understand what you are saying, but the manager didn't lose money on hedging, he just hedged small. So, it would be inconsistent to hold a board liable because they chose to hedge but hedged small but not hold the same board liable for hedging at all. What do you think?

Airlines' management and board should have carefully reviewed the implications of NOT hedging (which ultimately have resulted in thousands of job losses, salary cuts, liquidation of pension plans....).

Hedging would be costly for most airlines given their poor financial situation, but there will be financial intermediaries willing to take the other side at the right price and with the right guarantees in terms of marging and collateral. NOT hedging was an extremely risky decision that threatened to throw the airlines' business strategy down the drain (which is actually what ended up happening)

If most airline's management committees were to explain their reasons for reaching decision NOT to hedge, they would need to answer lots of questions.

Some shareholders and management may benefit from the decision of NOT hedging (some people like playing the lottery, but that does not mean that every firm should be playing the lottery with the shareholders capital). The boards and CEO should clearly explain why the made those decisions and provide a clear connection with shareholder value maximization.