CHICAGO (Reuters) - A stunning drop in oil prices since last summer has led U.S. airlines to slow or even stop hedging their fuel consumption, a move experts say may save money now, but could be painful if oil rallies again.
The shift in strategy by carriers such as Southwest Airlines (LUV.N) and US Airways Group LCC.N reflects the need of airlines to avoid wasting money on worthless hedges if the fuel prices fall further. It also lets airlines buy fuel at market prices, which are near five-year lows.
“Most of the airlines really aren’t hedging, they’ve all unhedged their hedges,” said Helane Becker, an airline analyst at Jesup & Lamont.
Hedges are like insurance contracts companies use to blunt the risk of sudden price fluctuations in commodities crucial to their operations. For airlines, jet fuel is often the largest expense. So carriers use derivatives markets to lock in fuel costs and smooth out volatility.
By not hedging, airlines are betting that jet fuel prices will decline in line with falling demand. They are showing their willingness by not locking in prices to take a chance on the open market.
Becker said it is a practical strategy for now, but it comes with a slight risk of being caught wrong-footed if the price of jet fuel suddenly shoots up.
“The risk would be missing it on a spike,” she said.
Early last year, airlines bemoaned a rally in oil prices to a record near $150 per barrel in July. The price plummeted 75 percent in the second half of the year as economic recession dampened demand.
The sudden drop, while welcome relief for airlines, also presented new problems for those who hedged at the top of the market and locked in those prices. The drop also lowered the value of airline fuel-hedge programs, resulting in huge accounting losses.
United Airlines parent UAL Corp UAUA.O, for example, reported a $370 million cash loss on fuel hedges in the fourth quarter of 2008. The carrier said last month that it expected an $80 million fuel hedge loss in the first quarter when oil prices inched back up toward $50 per barrel.
Oil rose more than $4 a barrel to above $52 on Thursday from its 2009 low of $32.70 reached on January 20.
As carriers wrote off losses related to hedges, they also scaled back their hedging activity. Southwest, whose thorough hedging program was the envy of the industry as fuel prices skyrocketed in recent years, was forced to unwind its hedges.
The carrier said that based on current market prices and its 10 percent hedge, it expects to pay 15 cents to 20 cents above market prices this year.
US Airways, which wrote down $235 million in the fourth quarter for fuel hedge losses, has not hedged since August. The company has said it would resume hedging when the economy shows signs of improvement that might drive up demand for fuel.
“We believe right now that it’s more risky for us to put in hedges,” US Airways Chief Financial Officer Derek Kerr told Reuters in an interview last week.
“If we had continued to hedge back in August and continued to put that in place, it could have driven us into a situation which we didn’t want to be in,” he said.
US Airways now has 14 percent of its 2009 fuel consumption hedged.
In many cases, airlines are driven by competitive pressures when making decisions about whether to hedge, said airline consultant Robert Mann.
“On the one hand, you’re doing this to remove volatility and to protect margins. On the other hand, you’re doing it as a competitive measure, which is to say if nobody else does it, then I’m no worse off than anybody else,” Mann said.
“It’s not clear that being no worse off than everyone is a sustainable prospect,” he said.
Editing by Maureen Bavdek