US Airways Group, Inc. (LCC), AMR Corporation (AAMRQ): Why Do Airlines Hedge Fuel Costs?

Most airlines in the U.S. today hedge fuel costs in a systematic fashion. Each quarter, they open new hedge positions in future quarters, with earlier periods tending to be more heavily hedged than periods further in the future.

If you asked airline executives why they hedge fuel, they would almost all say that since they sell most of their tickets several months in advance, they need to lock in some of their fuel costs in advance, too. However, most airlines hedge fuel one to two years out. Thus, they are hedging far beyond what is necessary to cover previously sold tickets. Most executives would probably claim that they do this in order to mitigate their risk, since it’s difficult to pass fuel prices through to customers immediately.

This fuel-hedging strategy has questionable utility over the long term. Airlines that follow this practice are locking in some of their future fuel consumption each month, and so over time these companies’ fuel costs are tied to the market price just as they would be if they did not hedge at all. The only difference is one of timing; hedging programs tend to smooth out the cost of fuel over time.

US Airways Group Inc (NYSE:LCC)However, systematic hedging programs have very clear costs. Oil prices tend to be quite volatile, leading to high hedging premiums. Moreover, the relationship between oil prices and jet fuel is not constant, creating a risk that fuel hedges will be “ineffective”. As a result, from a long-term investor’s perspective, hedging fuel costs does not make very much sense. Over a typical economic cycle, hedging losses will tend to outweigh hedging gains.

Swimming against the tide
Alone among legacy carriers, US Airways Group, Inc. (NYSE:LCC) abandoned its fuel-hedging program after the Great Recession. The company determined that the cost of hedging premiums was excessive.

Moreover, by locking in fuel prices through collars, swaps, forward price contracts, or similar hedging instruments, airlines lock in a minimum fuel price as well as a maximum price. In the event of a sudden economic shock — something like the Great Recession — the airline would face low demand, but fuel prices would be locked in at an above-market price by the hedges. In other words, hedges provide the least protection in the most dangerous economic environment.

The move away from fuel hedging has worked out well for US Airways Group, Inc. (NYSE:LCC) — despite the fact that oil prices have risen dramatically from 2009 to today. Since 2010, US Airways has paid a lower average fuel price compared to each of the four largest airlines in the country — AMR Corporation (OTCMKTS:AAMRQ), Delta Air Lines, Inc. (NYSE:DAL), Southwest Airlines Co. (NYSE:LUV), and United Continental Holdings Inc (NYSE:UAL) — all of which use fuel hedges extensively.

Airline yearly average fuel prices (2010-present):

Year American Delta Southwest United Continental US Airways
2010 $2.316 $2.32 $2.36 $2.34 $2.25
2011 $3.013 $3.01 $3.18 $3.079 $3.11
2012 $3.201 $3.25 $3.28 $3.272 $3.17
2013 (YTD) $3.140 $3.13 $3.17 $3.145 $3.07
Average $2.89 $2.90 $2.97 $2.93 $2.88

Source: Airline annual 10-K reports

In 2011, when fuel prices skyrocketed due to strong demand and fears about the Arab Spring, US Airways Group, Inc. (NYSE:LCC) paid slightly more for fuel than most of its competitors. However, this has been balanced out by lower fuel bills in every other year, when competitors’ hedge premiums went to waste.

Over the full period, US Airways Group, Inc. (NYSE:LCC) has saved anywhere from $0.01 per gallon (compared to AMR Corporation (OTCMKTS:AAMRQ)), to $0.09 per gallon (compared to Southwest Airlines Co. (NYSE:LUV)). In a declining fuel price environment, US Airways would have shown an even bigger advantage. Since the major airlines use billions of gallons of jet fuel each year, they are potentially losing tens or even hundreds of millions of dollars annually from hedging.