‘We will humble them’: four fuel traders took on Wall Street and saved $1.2bn

Southwest Airlines flies alone among the four biggest US carriers in hedging the cost of jet fuel. Its stubborn commitment to the policy is paying off as oil prices hover above $100 a barrel.

Hedging will save the company $1.2bn this year. With the pandemic-battered airline industry returning to profitability, Southwest’s operating margins will surpass its three major peers, according to Raymond James.

The bumper savings are the work of four people based inside Southwest’s Dallas headquarters. Led by Chris Monroe, company treasurer, they transact oil derivatives with nine of Wall Street’s savviest commodity trading desks: Goldman Sachs, Morgan Stanley, JPMorgan Chase and others.

“Send me your most arrogant person on the Street and have them come work for us in the fuel hedge, and we will humble them in about 10 minutes,” Monroe said in an interview.

The value of protecting against the risk of fuel price surges has become clearer as Russia’s invasion of Ukraine jolts oil markets and drives up prices. The price of jet fuel on the US Gulf of Mexico coast has vaulted to more than $4 a gallon compared to $1 in June 2020, according to the Energy Information Administration.

Line chart of US Gulf Coast spot price, $/gallon showing Jet fuel has soared

With passengers returning to the skies, Southwest’s aeroplanes will guzzle 1.9bn gallons of jet fuel this year, accounting for a third of the group’s total operating costs, which Raymond James estimates will be $22.3bn. Just a one-cent increase per gallon can add $19mn to the annual fuel bill.

Thanks to a 70-cent-a-gallon boost from hedging, Southwest expects to spend $3.30 to $3.40 a gallon for jet fuel in the second quarter — far less than American Airlines, Delta Air Lines or United Airlines.

“That’s a huge benefit for them,” said Helane Becker, analyst at Cowen. She noted Southwest offered a 40-per-cent fare sale earlier this month, something other carriers are not doing.

The company’s second-quarter operating profit margin is likely to be 15.5 per cent, according to Raymond James. That compares with 7.5 per cent for American, 10 per cent for United Airlines and 13-14 per cent for Delta, which in 2012 bought a Pennsylvania oil refinery to help manage jet fuel prices.

Monroe said that in the current environment the hedging strategy “obviously is a positive, and it feels pretty good”.

Southwest’s hedging programme dates to the early 1990s, after the surging price of crude around the first Gulf war prompted Gary Kelly, then chief financial officer and later chief executive, to wade into the market. Crude oil futures were less than a decade old.

The company has stuck with the policy in times of high and low oil prices, sometimes at a cost. The company lost more than $1.2bn because of its fuel hedging programme from 2015 through 2017 after oil prices plunged, according to regulatory filings with the Securities and Exchange Commission. “In some years, we did report hedging losses,” Monroe said.

Chris Monroe, company treasurer
Chris Monroe, Southwest’s treasurer, says the airline’s hedging strategy ‘feels pretty good’ © Southwest Airlines

Southwest trades contracts linked to West Texas Intermediate or Brent crude oil as a proxy for jet fuel. While its derivatives book formerly included swaps — contracts between counterparties that based on the price of a commodity — since 2015 the strategy has been exclusively, “all calls and call spreads,” Monroe said. “It’s thought of more as an insurance policy.”

Call options give holders the right to buy a commodity at a set price by a given date, costing hedgers such as Southwest the equivalent of an insurance premium. Call spreads typically involving buying one option and selling another, saving on premium payments but limiting price protection.

While common among European airlines, Alaska Airlines is the only US carrier besides Southwest to hedge fuel exposure. American, United and Delta stopped doing so in 2014, 2015 and 2017, respectively.

A mentality persists among airline executives that fuel hedging is a Wall Street rip-off, said Daniel Rogers, an associate professor finance at Portland State University who studies corporate hedging.

“I found that to be really a dangerous perspective because the market for oil is just so volatile,” he said. The other three rivals have “kind of defaulted to ‘we’re really crossing our fingers that oil prices will go down’”.

At the start of each week, the analyst on Monroe’s team creates a document with a picture of a bear on the left side and a bull on the right, accompanied by bullet points arguing why the oil market should be lower or higher. The team scrutinises oil market data such as drilling rig counts, the latest Opec announcements, geopolitical developments, and economies around the world.

The document is then used as the basis for a weekly oil presentation made to Southwest’s chief executive and chief financial officers. “There’s not a drop of oil that trades at Southwest without senior executive sponsorship or approval,” Monroe said.

The team aims to hedge at least 50 per cent of the carrier’s fuel each year. For the remainder of 2022, Southwest is about two-thirds hedged, while it has hedged about one-third of its projected fuel consumption so far for 2023 and roughly a fifth in 2024.

The team’s strategy is a mix of both plodding and predictive: “There’s a combination of trying to think like your 401(k), where you’re trying to average it over time, but there’s also an opportunistic element,” Monroe said.

Monroe said navigating the volatile jet fuel market was “like flying with a six-month-old baby”.

“You can do everything you can to make them comfortable” such as “feed them and make sure their nap happened right before the plane,” he said.

“But anybody that’s flown with a small baby knows that something can go wrong — and they will let everyone know they are [not feeling right].” Meanwhile, “you don’t know exactly how to fix it”.

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