It's not self-evident that executives should be hedging like this. Hedging contracts are somewhat costly, and shareholders should be able to factor in the risk when considering airline stocks, and can hedge themselves (or go long on oil and gas stocks). I worry that the SW story will encourage executives to make more bets, at least half of which will go the other way.

The best argument, I suppose, is that hedging does reduce the risk of bankruptcy, and United et al are busy showing us just how costly bankruptcy can be.

I am not sure what lesson I am supposed to learn from the fact that Southwest has a much higher market cap than other major airlines. In the industry where most companies are heavily leveraged (and where, some argue, it makes a lot of sense to be heavily leveraged), market cap doesn’t tell me much. A brief trip to Datastream shows that in 2004, American made 3 times as much in total sales as Southwest, and Delta made 2.5 times as much as Southwest. Likewise, in 2004, American had almost twice as much in total employed capital as Southwest; both American and Delta had more than twice as much in total assets as Southwest, and so forth. To be sure, Southwest is the only major airline that showed profit, but “small but profitable” surely doesn’t have the same ring as “largest-market-cap and profitable.” Despite its market cap, Southwest isn’t nearly as big as the rest of the pack.

Disclosure: I passionately hate Southwest for its no-seat-assignment system, which generates Soviet-like surreal experience of hostile lines before boarding.

Victor raises an interesting point, but shareholders' ability to hedge is almost always sub-optimal. Unless I hold a huge position in Southwest, I can't buy a futures contract that is likely to correspond in magnitude to my investment. Similarly, going long on oil stocks is sub-optimal because, as we all know, many things influence stock prices besides the price of the underlying commodities that the companies sell.

Because the management of Southwest is in the best position to know (1) what fuel consumption costs will be, (2) what the company's exposure to price fluctuations is under its purchase contracts, and (3) the most effective hedge against such fluctuations, it is entirely appropriate for them to hedge against these known risks. As a (very small) investor in Southwest, I appreciate it!

A quick response to Kate: no one is forced to buy a Southwest ticket. I happen to like the company, even though the lines can be a pain. (By the way, the "lines" still exist, albeit in a less tangible form, with other carriers. The difference is that, while with SWA, customers who show up first get the first pick of seats, with competitors, customers who buy tickets first get to pick.)

The main reason I like SWA, besides the fact that it's usually a lot cheaper than its competitors: SWA's customer service is unparalleled in the industry. I've flown SWA and AA roughly the same number of times, and have never had a problem with SWA that wasn't fixed. With AA, however, I've seen at least a half-dozen instances of corporate irrationality. So, given a choice, I will almost always choose SWA over AA. Due to these sorts of considerations, SWA has a very loyal customer base, which in turn improves SWA's prospects compared to other companies in the industry.

Victor,

Good point; it's one mystery of corporate finance: why do firms owned by diversified shareholders engage in hedging? One answer is that while shareholders are diversified, executives aren't--they want to reduce the probability of being fired, an event correlated with poor performance.

As you say, this gives them an incentive to take bets. That's one reason the SEC requires the "Quantitative and Qualitative Disclosures of Market Risk" aka item 7A in the 10-k. Whether those disclosures are effective in aiding investors is another story.

It's nice to see that my first professor at the GSB is saying nice things about Southwest (Thanks prof. Roulstone).

Two things to add: First, the hedging gains look like (and are) the result of a tremendously smart strategic move, but one needs to look further back than the near-term. Gary Kelly, CEO, prior CFO instituted the hedging strategy years ago.

It was simple insurance and if I remember correctly, cost $13M per quarter or something like that. It takes a lot of foresight to be willing to eat that kind of cash for "insurance", but the guys at the top of LUV apparently know that this industry is cyclical, unlike the guys at the top of UAL.

For example, UAL, over the last 30 years has always ordered new airplanes at the top of the cycle and taken delivery at the bottom.

The hedging wasn't a last-minute bet-the-farm move, it went on for years with nothing to show for the expense other than the comfort of locking in supplier prices for a vital commodity that has no substitutes.

My point is, it's not like LUV woke up one morning, rolled the dice and won big, hedging appears to be simply a part of the very simple business model.

Second, the poster that mentioned the leverage ratios of the airlines is on the right track, after doing some back-of-the-envelope calulations after a lecture on optimal capital structure, I realized that LUV may be considered under-leveraged. It's likely a corporate-culture thing and I'm not going to argue with success, but ROIC is not where it should be and since LUV is profitable, LUV is paying lots of money on taxes for profits with (relatively) small deductions for interest expense.

To the poster who "despises" Southwest for the open seating policy, this explanation may or may not change your mind, but you might scratch your head and feel less adament about your feelings.

Other airlines have assigned seats. They also have a passenger hierarchy that includes frequent-flyers of various ranks, such as platinum, platinum-double-diamond, platinum-double-diamond-elite-presidential,
etc.

So now it's time to board: they have assigned seats, so these money-for-nothing and chicks-for-free elite status folks are on their cell (hands-free, of course), waiting in line at Starbucks and will certainly walk on at the very last second. This means that the airline has to set an arbitrary cut-off time to close the doors, usually ten minutes prior to departure. This makes the boarding process excruciatingly slow, generally 40 or 50 minutes.

Now think economic theory, "People respond to incentives." At Southwest, the first to arrive gets the best seat. These same type-A personality elite flyers with briefcases line up 30 minutes prior to boarding opening up, quivering with anticipation, clutching their A boarding cards, enabling Southwest to complete it's boarding process in 25 minutes total. There's no cut-off time to board, if the plane leaves at 12:00 and you show up at 11:59, on you go, you just get a center seat.

It has been said that adding just 5 minutes to this "turn time" system-wide would require Southwest to purchase one additional $42M airplane. Here's UAL with 50 minute airplane turns, competing with LUV's 25 minute turns--due to this, there are fewer assets required at LUV, greater utilization of the assets (divide the lease rate by hours flown per month), all sorts of asset utilization advantages.

This boarding process is certainly inconvenient, but that's the (economic) price you pay for a $79 ticket.

One last thought: Prof. Roulstone required us to attempt to uncover UAL's true leverage using the SEC filings for the year 2000. It was a difficult assignment, requiring analysis of off-balance-sheet debt, capital v. operating leases, equipment trust certificates, etc. After I finished the assignment I tried the same analysis on LUV.

As I looked through the SEC filing, I actually laughed out loud. The LUV filing was so open, simple and well-documented, there really wasn't any analysis to be done--there was nothing to unravel.

LUV had one off-balance-sheet entity, a trust for 10 airplanes that they had put into storage but even that was so exhaustively documented it merited only a shrug of the shoulders.

I wish southwest airlines allowed dogs like the other airlines.

Kelly's latest Wright Amendment quote: Gary Kelly, chief executive of the Dallas-based carrier, said in order to “break the log jam” in negotiations, he’d be willing to keep any flights from Dallas Love Field inside the U.S. border and be open to decreasing Love’s 32-gate capacity.

“International (flying) is something that is very important to D/FW Airport and Fort Worth, and it’s not to us,” Kelly told reporters after the company’s annual shareholder meeting in Dallas.

Wait a second...wasn't it Southwest that stated 'flying outside of Texas is not important to us?' in the 70s. And wasn't it Southwest that later stated 'flying outside of our 4 state region is not important to us?'

Dallas.....wake up.... this IS the definition of LOVE without the kiss!!