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Crude Effects: How Crude Oil Affects Airline Stocks Daniel Drew, 12/11/2014 Tweet It's a LUV story that begins with warm feelings and ends in heartache. LUV is the ticker for Southwest Airlines, which spearheaded the movement for extreme hedging in the last decade. Here's the problem in its most basic form: Fuel costs can be a defining expense on any airline's income statement. Fuel prices are volatile. Like crazy girlfriends and boyfriends, people don't like volatile things - especially executives whose compensation is in the form of stock options. They want the profits to come in regularly so the stock price can go up smoothly without giving them indigestion. Volatile fuel prices are like the jalapeno your irritating friend hid in your sandwich at lunchtime. The simplest way to get rid of the problem of volatility is to buy oil futures. If you do that, you can lock in your prices in advance. More complicated possibilities involve buying call options or options spreads on futures. But as with anything in the market, the result is generally a binary outcome: either you're winning or you're flushing your future down the toilet. Many airlines hedged only part of their fuel costs. Southwest decided to hedge nearly all of it. They looked like a genius for a long time as oil went from a low of $20 in 2002 to a high of $140 in 2008. From 1999 to 2008, Southwest saved $3.5 billion from their hedging program. But sometimes being a genius just means being lucky for a long time. Just as oil prices were peaking in 2008, the LA Times ran a story about Southwest being the leader of the industry because its hedging was paying off. Terry Trippler, an industry analyst, said Southwest looks "really good." That would have been the worst moment to buy Southwest stock and the best time to sell. The geniuses at Southwest were piling into oil futures at the very top, locking themselves into the highest possible prices. It had worked for the last decade, so why would it stop now? Just keep rolling the dice. Oil is going to $200, so let's buy at $140. In 1993, an airline consultant named Robert Mann told airline executives they should start hedging their fuel costs. They said it was the dumbest idea they ever heard. Then a few years later, everybody was doing it. This is why consulting is on Stanley Bing's list of 100 Bullshit Jobs. American Airlines had a different view. At the peak of the oil market, instead of loading up on oil futures like Southwest, they decided to suspend their hedging program. They realized that buying insurance blindly for the sake of hedging is a fool's game. The shareholders reaped the benefits of their decision. From the peak of the oil market in the summer of 2008 to the end of the year, American Airlines stock finished up about 100%, as it was effectively short oil because its expenses were dropping. Meanwhile, Southwest stock was demolished, dropping 30%. In early 2009, the bear market caught up to all stocks, including the airlines. But the management at American Airlines was able to avoid the broader turmoil for a long time by cutting their hedges. Now, it appears that Southwest has eased up on their hedges as well. During oil's recent slide, all the major airline stocks have risen together, which signals that the companies are not holding substantial oil futures - if at all. Traditionally, ticket prices were simply adjusted to reflect variable costs. But thanks to a meddling consultant, the airlines decided to transform themselves into mini hedge funds as they waded further into the gambling business and away from the business of actually operating airplanes. Hedging your bets is supposed to be a way to reduce risk, but some of the worst losses in market history have come from people hedging their bets: Long Term Capital Management, AQR Capital, and the most recent J.P.Morgan disaster in 2012. The most effective way to reduce risk isn't hedging - it's staying on the sidelines. 
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