Oil decline erodes airline fuel hedge value

By Kyle Peterson - Analysis

CHICAGO (Reuters) - Major U.S. airlines are cheering the jaw-dropping decline in fuel prices, but at the same time are wincing that some of the insurance they bought to hedge against fuel spikes seems to have been a waste of money.

To some degree, top carriers all are struggling to blunt the impact of potential fuel price rallies without losing money on hedges if fuel falls more than expected.

Worthless fuel hedges led to huge accounting losses for major airlines in the third quarter. It is likely to happen again in the fourth quarter and could repeat in 2009 because airlines buy their hedges months in advance.

"They were entered into in the second and third quarter when it looked like the sky was the limit (for fuel prices)," said airline consultant Robert Mann. "It certainly did appear that way at the time."

"To the extent that they can't lay (the hedges) off somewhere they're going to have to take some write-downs," Mann said.

He was quick to add, however, that the benefit of cheaper spot market fuel far outweighs the disadvantage of bad hedges.

Southwest Airlines (LUV.N), for example, enjoyed more than $4 billion in hedging proceeds over the last five years and paid far less than rivals because it locked in lower fuel prices while rivals went unhedged.

Hedges are typically derivatives used by companies to lock in a fuel price in advance. The goal is to protect airlines from price volatility.

The amount of hedge-related losses is determined by the type or derivative an airline uses and what obligation is built into the hedge. Airlines also account for the losses in different ways and at different times.

Many airlines use options, which give the holder the right, but not the obligation, to buy a commodity at a predetermined price.

But if the market price falls below the preset price floor, hedges become worthless and may even force carriers to pay more than market price.

In the third quarter, UAL Corp's (UAUA.O) United Airlines and US Airways Group (LCC.N) wrote down almost $2 billion in accounting losses for their hedge portfolios.

Southwest Airlines (LUV.N), long the envy of the industry due to its thorough fuel hedges, took a $247 million write-down.

GUESSING GAME

The airline industry was punished in the first half of 2008 by rising oil prices -- which influence jet fuel prices. Oil peaked in mid-July near $150 a barrel.