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Content-Type: text/plain; charset=ANSI_X3.4-1968 Content-Transfer-Encoding: 7bit X-From: Ann M Schmidt X-To: Mark Palmer, Meredith Philipp, Steven J Kean, Elizabeth Linnell, Eric Thode, Laura Schwartz, Jeannie Mandelker, Mary Clark, Damon Harvey, Keith Miceli, Richard Shapiro, James D Steffes, Iona Maclean, Katy Lomax, Vance Meyer, John Ambler, Peggy Mahoney, Johan Zaayman, John Neslage, Gia Maisashvili, Katrin Haux, Sharonda Stephens, Adriana Domingues, Alex Parsons, Andrew Morrison, Aroma Pannu, Dennis Vegas, Eva Hoeffelman, Fiona Grant, Gina Taylor, Habiba Bayi, Henry Means, Jackie Gentle, Janet Johnson, Jennifer Walker, Jimmy Mogal, Julie Green, Kelly Kimberly, Kimberly Nelson, Lauren Goldblatt, Mac McClelland, Margaret Allen, Marge Nadasky, Marie Hejka, Quincy Hicks, Shelly Mansfield, Yvette Parker, Karen Moore, Courtney Votaw, Carrie A Robert, Mika Watanabe, Karen Denne, Alex Parsons, Carla Galvan, Kathie Grabstald, Cindy Derecskey, Joannie Williamson, Peter Berger, Carol Howes X-cc: X-bcc: X-Folder: \Steven_Kean_June2001_4\Notes Folders\Discussion threads X-Origin: KEAN-S X-FileName: skean.nsf Jan. 5, 2001, 12:48AM Houston Chronicle Contracts to ease blow of rise in fuel prices helping airlines Hedging your jets By LAURA GOLDBERG Copyright 2001 Houston Chronicle Faced with higher gasoline prices in the past year, consumers lamented the bite that rising oil prices were taking from their wallets. Other than driving less or buying cars that use less gas, there wasn't much they could do. Airlines, which consume billions of gallons of jet fuel a year, also felt the sting as prices fluctuated. But airlines, unlike drivers, can use financial tools to ease the pain of volatile fuel prices. As airlines begin rolling out their fourth-quarter earnings reports in the next few weeks, those that "hedged" on fuel are likely to show better profits than those that didn't. Not only was that the case last year, but it will continue to be the case if jet-fuel and oil prices remain high. Gary Kelly, chief financial officer at low-fare Southwest Airlines in Dallas, says hedging is "insurance against a catastrophic rise in fuel prices that would put us at unacceptable earnings levels." Hedges aren't agreements to buy fuel. They are financial contracts pegged to the prices of oil and oil products, such as heating oil and jet fuel. If airlines buy the contracts at the right prices, they can collect cash to compensate them when jet fuel goes up. Successful hedging didn't stop airlines from raising ticket prices last year to help cover rising fuel costs. But, airlines say, the increases might have been higher without hedging. When the industry's fuel bill for 2000 is tallied, it is expected to be $13 billion -- 50 percent higher than the previous year's $8.5 billion, according to a recent report from airline stock analysts at Merrill Lynch. At the same time, the airlines used only 4 percent more fuel. If the industry hadn't hedged, fuel expenses would have been $2 billion to $3 billion higher, the analysts wrote. AMR Corp., the parent of Fort Worth-based American Airlines, the No. 2 domestic carrier, is expected to save $550 million alone because of its hedging, they noted. Airlines don't like wild spikes in fuel prices because they make it difficult to plan and they jeopardize profits. A consumer would face the same dilemma if one month's apartment rent was $600, the next it jumped to $1,200 and the next it fell to $800. That's similar to what airlines faced the past year as the benchmark price of jet fuel, which is made from crude oil, fluctuated widely on the spot market. It was above 88 cents a gallon in March, dipped below 66 cents in April, rose to almost $1.10 in September and was just over 78 cents the last week in December. Airlines hedge to help smooth out such ups and downs. Greg Hartford, vice president for fuel at Houston-based Continental Airlines, looks to hedging "to take volatility out of the market, not to second-guess it." There are a variety of hedging tools. Some, just like car or home insurance, require upfront premiums. Hedging can be done through futures exchanges, such as the New York Mercantile Exchange, or through institutions, including banks, investment houses and energy traders such as Houston-based Enron Corp. Hedging is about managing risk, said Bill Berkeland, manager of trading for Enron North America, an Enron Corp. subsidiary. Techniques to cope with fuel price risks have been around probably 20 years, he said, but airlines didn't adopt them until the last decade. Airline hedging has gained more attention recently because of jet-fuel price spikes, he said. Some carriers will be able to take victory laps for being smart enough to hedge, he added, while others will simply blame fuel prices for their earnings problems. Hedges are bought for specific amounts of product and time: 2 million barrels a month for the next three months, for example. They can be pegged to the prices of crude oil, heating oil or jet fuel. Continental generally sticks to three basic types of hedges -- swaps, caps and collars. Hartford outlined the way each works: ? Swap: A swap is one of the simplest types. It essentially locks in the cost of energy at a specific price for a certain time. No upfront payments are required. For example, an airline takes out a swap for 1 million barrels of crude oil at $25 a barrel for February. If the price averages $28 during February, the airline is paid $3 million -- the difference between $28 and $25 a barrel for the million barrels. But if the cost averages $22 a barrel, the airline must pay $3 million. ? Cap: With caps, airlines purchase "call options" that protect them when prices rise but don't penalize them if prices drop. Caps, however, require upfront premium costs, which are based on a variety of factors. For example, an airline buys a crude-oil cap at $25 a barrel for 1 million barrels for February. If at month's end, oil averaged $28 a barrel, the airline collects $3 million. If it averaged $22, the airline gains nothing but loses nothing. Its cost: the upfront price-per-gallon premium. ? Collar: A collar is more complex. It involves buying two different tools that create a price range -- essentially a minimum and maximum. The airline benefits if fuel goes above the range's high end but pays if it goes below the minimum. It can be set up so no premium is paid. Intuitively, it would seem to make sense for airlines to hedge on jet fuel. But the market for trading jet fuel isn't as liquid, or as strong, as the one for crude oil. So airlines look for something that correlates to jet-fuel prices. Heating oil is often best, followed by crude oil. There are trade-offs. Premiums for jet-fuel hedges are more expensive than those for heating oil. In turn, heating-oil hedges are more expensive than crude. But using crude oil as a hedge may not smooth volatility as much because of fluctuations in the relationship between crude and jet fuel. In the first part of 1999, when crude oil traded for around $12 a barrel, Atlanta-based Delta Air Lines started buying hedging contracts pegged to heating oil as far as 36 months out, said Joe Kolshak, director of investor relations at the third-largest U.S. airline. Delta's strategy has served it well. For the quarter that ended Sept. 30, hedging, including premium costs, saved the Atlanta-based carrier from paying an extra $160 million in fuel costs, he said. Even with that gain, Delta still paid 37 percent more for fuel over the same period than the year before. For the Sept. 30 quarter and the four preceding it, Delta had net hedging gains of $600 million. Hedging gains also helped balance sheets at other airlines, including No. 5 Continental and No. 7 Southwest. Southwest's Kelly said the airline's hedging last year met its goal of protecting against catastrophic fuel-price rises. In the third quarter, operating profits rose $43.1 million because of hedging. During the same quarter, Continental gained $27 million from hedging. For 1999, it was $105 million. Hedging isn't without risk. Airlines can predict the wrong way and lose millions. And when prices are already sky-high, certain hedging contracts won't be attractive because they, too, are pegged to higher prices. "Hedging is not a panacea, and it's not the golden elixir that people might consider it to be," Continental's Hartford said.
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