Airlines Hurt By Dropping Oil Prices. Huh?!!

These days it seems like airlines get smacked down even when they do something right. Case in point: this week United Airlines announced that it was taking a $225 million charge thanks to the recent drop in oil prices. Say what?

United has fallen victim to its own efforts to manage fuel costs. The airline has been buying jet fuel using what is know as hedging, which Ben Brockwell of the Oil Price Information Service describes as "an insurance policy against prices rising." 

Here's a very simplified explanation of how fuel hedging works, using a hypothetical scenario:

On November 1 jet fuel is selling for $130 a barrel and United believes the price will rise sharply as winter progresses. It signs a deal with a supplier to buy a three month supply of fuel for $110 a barrel. That's United's fuel hedge. On December 5th the price of fuel jumps to $140 a barrel. Because United is locked in at $110, it sits back and laughs while its unhedged competitors pay a much higher price for their fuel. Good move.

Now turn this on its head. United hedges at $110 a barrel in November, but the price of oil actually drops to $85 a barrel. United's move doesn't look so bright, as it's paying more for fuel than the asking price on the open market. United is now at a competitive disadvantage, and its balance sheet craters according.

It's this second scenario that has become reality at United. The company has 51-percent of its 2008 fuel hedged at $111. Per-barrel prices closed at under $98 yesterday. Looking forward to 2009, the airline's fuel hedges are based on per-barrel prices of $118.

Hedging is a big roll of the dice, and no one has played it better than Southwest Airlines. It has consistently hedged more fuel than its competitors. As of this summer, Southwest has 70-percent of its 2008 fuel hedged at $51 a barrel. Compare that with American Airlines, which has 34-percent hedged hedged at $82 a barrel.

Industry analysts estimate that since 1998 Southwest has paid $3.5 billion less for fuel than its competitors. That's equal to 83-percent of its profits over the last nine years. It's a big part of the reason  the airline continues reporting profits while the rest of the industry bleeds.

So why doesn't every carrier hedge as much as possible? Airlines entering into hedge contracts must pay a deposit or commission, which is set by the seller depending on perceived risk. This can be a significant outlay of cash, money that some execs gamble would be better spent on new airplanes or debt repayment. An airline has to believe that savings from hedging will exceed the costs of the contract.

And, as this last month proves, no one can really predict which way the oil market will go. United Airlines is learning that the hard way.

Photo by Flickr user Soon.