The interesting question is why, in a brutally competitive industry, one player behaves in a way the others don't.

Or put another way, if SWA derives competitive advantage from hedging against a rise in fuel costs (the ability to afford underpricing its seats vis-a-vis the competition), why doesn't every other player do likewise? And if not, why not?

To me, that's a more interesting question than asking in the abstract whether they should or should not hedge.

Yes, they should hedge because fuel is their biggest uncontrollable variable cost.

No, they shouldn't hedge because they are probably less good at it than a trader in London or NY. If SWA's exec in charges of hedging were really that good at it, then he ought to quit Dallas for NYC or London to trade oil futures for himself -- he'd make a hell of a lot more money.

To me, the hedge/don't hedge debate is finally nothing but a preference based on appetite for risk and/or perceived ability to forecast oil prices. Which is not a topic I'd waste a lot of class time debating.

My $.02.

Other airlines do hedge fuel costs or at least used to. American Airlines, for example had various fuel futures contracts that it had to unload to get the cashflow to avoid bankruptcy.

AJL -- Yes - one of the interesting things that my co-author uncovered is that while Southwest was aggressive in its hedging, it remained less hedged than many European airlines.

Auto -- Perhaps its just a preference based on managerial risk averson ... but if so, isn't that a powerful argument that it's a waste of shareholder value, and give rise to a breach of fiduciary duty claim?

This looks like a great case. What fun!

I do think that the discussion, based on a quick review, does not sufficiently consider the affects of hedging on Southwest customers. I recognize that customers can deal with fuel cost shocks – see automobile prices. However, I think a fair number of Southwest’s customers are frequent travelers, and there is something appealing about there being an apparent cap on flight costs. Note that I think there is an asymmetry to this preference. I don’t ever want my ticket to cost more than $60, and I am pleasantly surprised if it is less or much less than this amount. Of course, this raises the issue of whether Southwest’s hedging program needs to be asymmetric. If you had any data about consumer preferences, it might be nice to include it in an exhibit.

Enough ramblings from an all too frequent Southwest customer.

Interesting article today in the Chicago Tribune about how United apparently bet wrong on fuel prices for the third quarter.

http://www.chicagotribune.com/business/chi-0609160052sep16,1,914901.story?coll=chi-business-hed

Mike -- I'll see what I can find ... it would fit nicely into the part where the CFO talks about the Southwest brand and whether consumers would tolerate price changes.

I have worked with a couple of pilot groups on activist initiatives and the union leadership at both were definitely aware of whether the airline was hedging fuel costs--greater predictability for this important expense makes it easier to bargain over wages and other terms of employment. I didn't get any sense, though, that the airlines valued hedging for this reason (and at both airlines there was a substantial amount of regular contact between union leadership and management, including members of the finance department). Indeed, at one, the company stopped hedging shortly before beginning a round of concessionary bargaining, a decision that proved to be a very bad one. The pilots looked on that decision as evidence that the management team was too incompetent to be allowed to continue to run the airline (though hindsight is always 20/20, of course). They frequently compared the airline to Southwest in that regard.

The other major U.S. airlines aren't hedged because no one will enter into these contracts with them due to their financial instability and consequent counterparty default risk.

One other thought:

There is an argument that hedging here does not provide greater diversification and in fact narrows it making the stock more/less risky/attractive. The argument simplified is this. Airlines are not in the oil business. By hedging out this risk they more accurately reflect a pure-play investment opportunity in air travel. While exposure to one idosyncratic risk is now decreased (i.e., oil), to the extent air travel varies the stock performance is more keyed to this rather than also to oil which investors can invest in separately. So, while it is true the stock is more dependent on system-wide risk (with the removal of the oil risk) it is also more dependent on the key business -- air travel. Air travel may be a more or less risky investment. This may make it more desirable to investors who wish to invest in the air travel industry (rather than the unhedged airline industry) for the higher/lower? risk or other reasons. This may also lead SW to use an option rather than forward contract strategy (as feasible)to mitigate the down-side risk of having to resell oil if air travel declines. So, unless I am missing something, there are arguments that this is an unconglomerate story.

Very nice case study -- fyi there is also similar raging debate among gold producers about hedging (i.e., do they want to be bets on the price of gold or on the gold mining industry). Another very hedged industry. With the rise of Newmont (headquartered in Denver) -- it appears those against hedging have won.