Fuel Hedging in the Airline Industry: The Case of Southwest Airlines

By

Dave Carter a, Dan Rogers b, and Betty Simkins c

a
College of Business Administration, Oklahoma State University, Stillwater, OK 74078-4011,
Phone: (405) 744-5104, Email: dcarter@okstate.edu
b
School of Business Administration, Portland State University, Portland, OR 97207-0751,
Phone: (503) 725-3790, Email: danr@sba.pdx.edu
c
CONTACT AUTHOR: College of Business Administration, Oklahoma State University,
Stillwater, OK 74078-4011, Phone: (405) 744-8625, Fax: (405) 744-5180,
Email: simkins@okstate.edu
 Fuel Hedging in the Airline Industry: The Case of Southwest Airlines
By
Dave Carter, Dan Rogers, and Betty Simkins

“If we don’t hedge jet fuel price risk, we are speculating. It is our fiduciary duty to try and
hedge this risk.”

Scott Topping, Director of Corporate Finance for Southwest Airlines

June 12, 2001: Scott Topping, the Director of Corporate Finance for Southwest Airlines
(hereafter referred to as “Southwest”), was concerned about the cost of fuel for Southwest. High
jet fuel prices over the past 18 months had caused havoc in the airline industry. Scott knew that
since the industry was deregulated in 1978, airline profitability and survival depended on
controlling costs.1 After labor, jet fuel is the second largest operating expense for airlines. If
airlines can control the cost of fuel, they can more accurately estimate budgets and forecast
earnings.

It was Scott’s job to hedge fuel costs, however, he knows that jet fuel prices are largely
unpredictable. As shown in Figure 1, jet fuel spot prices (Gulf Coast) have been on an overall
upward trend since reaching a low of 28.50 cents per gallon on December 21, 1998. On
September 11, 2000, the Gulf Coast jet fuel spot price was 101.25 cents/gallon – a whopping
increase of 255 % in the spot price since the low in 1998. The prior day’s (June 11, 2001) spot
price for Gulf Coast jet fuel closed at a price of 79.45 cents/gallon. While this price was lower
than the highest level, Scott knew that future jet fuel prices would be uncertain.

Figure 2 illustrates the high volatility of jet fuel prices. As shown, historical daily volatility over
a recent 25-day period for Gulf Coast has averaged 58.7 percent.2 Clearly, fuel price risk is an
important concern for airlines.
1
One of the most important events in the history of the airline industry was the Deregulation Act passed by U.S.
Congress in 1978. This act removed all government controls over fares and domestic routes for the first time and
gave airlines the opportunity to operate as true businesses.
2
For example, at the price of 79.45 cents/gallon for jet fuel, there is a 68% probability that the price will change by
as much as +/-46.63 cents/gallon (i.e. 79.45 x 0.587). This means that there is a 68 percent probability that the price
will range from 32.8 to 126.0 cents/gallon. Using a recent 10-week average volatility of 30.5% (data not shown),

1
As a result of fuel price increases during the later half of 1999 and throughout 2000, Southwest’s
fuel and oil expense per available seat-mile (ASM) for the year 2000 increased 44.1 percent over
that for 1999.3 As shown in Table 1, Southwest’s average price per gallon of jet fuel in 2000 was
$0.7869 compared to $0.5271 in 1999.4

About Southwest Airlines

Southwest was formed in 1971 by Rollin King and Herb Kelleher and the airline began with
three Boeing 737 aircraft serving the Texas cities -- Dallas, Houston, and San Antonio. The
airline began with one simple strategy: “If you get your passengers to their destinations when
they want to get there, on time, at the lowest possible fares, and make darn sure they have a good
time doing it, people will fly your airline.”5 This strategy has been the key to Southwest’s
success. The airline realized early on that air travel would become a commodity business.

In May 1988, Southwest became the first airline to win the coveted Triple Crown for a month –
Best On-time Record, Best Baggage Handling, and Fewest Customer Complaints. Since then,
the airline has won five annual Triple Crowns: 1992, 1993, 1994, 1995, and 1996. In addition to
being a top quality airline, Southwest was also innovative. They were the first airline with a
frequent flyer program to give credit for the number of trips taken and not the number of miles
flown. Additionally, they pioneered senior discounts, same-day airfreight delivery service,
ticketless travel, and many other unique programs.

By the year 2000, the small Texas airline had evolved to become the 4th largest U.S. carrier
based on domestic passengers boarded and the largest U.S. carrier based on scheduled domestic
departures. At year-end 2000, Southwest operated 344 Boeing 737 aircraft and provided service
to 58 airports in 57 cities in 29 states throughout the U.S. In 2000, Southwest commenced
service to Albany and Buffalo, New York, and in January 2001, to West Palm Beach, Florida.

Tables 2 and 3 provide Southwest Airlines’ consolidated statement of income and consolidated
balance sheet, respectively, for the years 1999 and 2000. Historically, Southwest has
experienced some seasonality in their business. For example, quarterly operating income and, to
a lesser extent, revenues tend to be lower in the first quarter. In 2000, quarterly operating
income represented 22 percent of annual operating income.

Fuel Hedging in the Airline Industry

there is a 68% probability that the price will change by as much as 24.23 cents/gallon. Given that Southwest spent
$484.7 million on jet fuel in the year 2000, there is a 68 % change that jet fuel can fluctuate by as much as $ 147.8
million using the 10 week volatility average (i.e. 0.303 x $484.7 million).
3
See the appendix for a glossary of airline terms.
4
These prices are net of the following gains from hedging -- approximately $113.5 million in 2000 and $14.8
million in 1999.
5
Refer to “We Weren’t Just Airborne Yesterday”, Southwest Airlines – A Brief History,
http://www.southwest.com/.

2
Airlines executives know that it is often impossible to pass higher fuel prices on to passengers by
raising ticket prices due to the highly competitive nature of the industry. Because large airlines
compete with one another on most of the routes they serve, they have little power to raise prices
in response to higher fuel costs. For example, Continental Airlines rescinded a fare hike after
trying a number of times to boost overall fares. The airline said the airfare increases were due to
high fuel costs, but intense airline competition has left the firm unable to pass along fuel costs to
customers.6

Table 4 provides information on competition in the airline industry for both passenger airlines
(Panel A) and airfreight carriers (Panel B). As shown in Panel A, Southwest Airlines holds a
5.51% market share based on total available seat miles flown over the period 1994-2000. Over
the same period, Southwest holds a much smaller share of the freight market (see Panel B). By
2000, Southwest was the fourth largest carrier in the US based on passengers flown and the
largest based on departures (see previous section). Obviously, competition is a top concern for
Southwest. With air travel becoming a commodity business, being competitive on price is the
key to survival and success. As Warren Buffett states: “You cannot be the high-cost producer in
a commodity business. Sometimes it’s not even any good to be the low-cost producer.”
(McCartney, Michaels, and Rogers, 2002).

Airlines that want to prevent huge swings in operating expenses and bottom line profitability
choose to hedge fuel prices. In fact, Raymond Neidl (see Neidl and Chiprich, 2001) points out
that “the carriers that produced an adequate return, especially in the second half of 2000, tended
to be those that had good fuel hedge positions in place.” Airlines without hedges in place had
disappointing earnings or losses. For example, in the fourth quarter 2000, US Airways, which
was unhedged, estimated that its $88 million net loss would have been a profit of $38 million if
their fuel costs had not increased. Airlines are different from most commodity users or
producers in that it usually the airline company’s treasury department (rather than the fuel
purchasers) that handles fuel hedging.

Fuel price risk management techniques were adopted by airlines around 1989 (Clubley, 1999).
Airlines use derivative instruments based on crude oil, heating oil, or jet fuel to hedge their fuel
cost risk. The majority of airlines rely on plain vanilla instruments to hedge their jet fuel costs,
including swaps, futures, call options (including average price options which are a type of call
option), and collars (including zero-cost collars).

There are two main reasons why several fuels other than jet fuel are used in jet fuel hedging by
airlines. The first reason requires a brief explanation of refining. When refiners process crude
oil, the main products are gasoline, middle distillates (heating oil, diesel fuel, and jet kerosene)
and residual fuel oil. Refiners often refer to these products as top, middle, or bottom of the
barrel, respectively. Products from the same part of the barrel share similar characteristics, and
as a result, the prices are highly correlated.7 Hence, heating oil, which shares similar

6
See “Continental Raises Domestic Fares, Cites Fuel Costs” (Reuters, February 27, 2004) and “Continental Airlines
Resends Latest Fare Hike” (Reuters, June 7, 2004).
7
Jet fuel is a essentially pure kerosene with some additives. Two products from the barrel not mentioned above are
the gas liquids like butane at the very top and asphalt at the very bottom.

3
characteristics to jet fuel, is frequently used in hedging by airlines. Also, since jet fuel is refined
from crude oil, crude oil is also used in hedging by airlines due to high price correlation.

The second reason why airlines use several fuels in hedging is because jet fuel is not a
sufficiently liquid market to warrant a futures contract or other type of exchanged-traded
contract. As a result, derivative contracts for jet fuel must be arranged on the over-the-counter
(OTC) markets. However, there are active and liquid markets for exchange-traded contracts on
crude oil and heating oil in New York (the New York Mercantile Exchange, NYMEX) and for
gasoil in London (the International Petroleum Exchange, IPE).8 While exchange-traded products
offer high liquidity and low credit risk, typically these contracts are standardized and inflexible,
meaning that users often face large basis risk.

The term “basis risk” is used to describe the risk that the value of the commodity being hedged
may not change in tandem with the value of the derivative contract used to hedge the price risk.
While crude oil, heating oil, and jet fuel prices are highly correlated, significant basis risk can
emerge if the relationship between the commodities breaks down. In an ideal hedge, the hedge
would match the underlying position in every respect, removing any change of basis risk.
However, in actuality, basis risk is a high concern, even if the derivatives contract is for the exact
same commodity being hedge. More specifically, in the futures markets, basis is defined as the
differential between the cash price of a given commodity and the price of the nearest futures
contract for the same, or a related commodity.9 Hence, basis risk when hedging using futures
contracts refers to the risk of the differential changing over the life of the hedge.

Why does basis risk occur? The following three basis risks occur frequently in hedging: product
basis risk, time basis risk, and locational basis risk. Product basis risk occurs when there is a
mismatch in the quality, consistency, weight, or underlying product. For example, airlines
frequently use crude oil contacts to hedge jet fuel, but obviously crude oil and jet fuel are two
different commodities and hence have large product basis risk. Even within the same
commodity category, such as crude oil, product basis risk occurs because there are many types of
crude oil varying in viscosity (such as heavy versus light crude) and sulfur content (sweet versus
sour crude). Time basis risk occurs when there is a mismatch in the time of the hedge. For
example, if a hedger wishes to hedge long-term but only has short dated contracts available, time
basis risk is very significant.10 Locational basis risk, one of the most common types of basis risk,
8
Gas oil is the European designation for No. 2 heating oil and diesel fuel.
9
Refer to “A Guide to Energy Hedging” published by the New York Mercantile Exchange.
10
For one of the most famous examples of time basis risk, refer to Metallgesellschaft Refining and Marketing
(MGRM), which was an American subsidiary of Metallgesellschaft (MG), an international trading, engineering, and
chemicals conglomerate. In 1992, MGRM implemented what it believed to be a profitable marketing strategy. The
company agreed to sell specified amounts of petroleum products every month, for up to ten years, at fixed prices that
were higher than the current market price. MGRM then purchased short-term energy futures to hedge the long-term
commitments - a "stack" hedging strategy. This timing mismatch caused MGRM to go bankrupt. The MGRM hedge
also illustrates another type of hedging risk: "funding risk" - the risk that positions which may be profitable in the
long run can bankrupt a company in the short run if negative cash flows are mismatched with positive cash flows.
For a short summary of the MGRM hedging disaster, refer to
http://www.erisk.com/Learning/CaseStudies/ref_case_mg.asp.

4
occurs when there is a mismatch in the price of the product from one location to another, a
mismatch in the delivery point for the derivatives contract, among others.

While such extreme breakdowns in correlations are rare, hedgers should be aware of basis risk.
Julian Barrowcliffe, director of global commodity swaps at Merrill Lynch (Schap, 1993) stated:
“Some of the largest hedging losses have resulted from the assumption that heating oil and jet
kerosene were essentially the same product and heating oil futures could hedge jet. At times,
they haven’t tracked each other at all.” For example, in late 1990 when Iraq invaded Kuwait
(which precipitated the first Gulf War), the differential between European jet fuel and heating oil
quickly increased to more than five times the usual margin. As shown in Figure 3, the spread
between jet fuel and heating oil for the Gulf Coast location increased to 28.5 cents per gallon.
This is 8.1 times the average spread of 3.5 cents per gallon and represents a 714% increase
relative to the average spread (i.e. (28.5 – 3.5)/ 3.5). It is important to note that since this period
of time, basis risk fundamentals between jet fuel and heating oil or crude oil have improved.
This is due primarily to the fact that there is significantly more storage of jet fuel in the Middle
East now, which places less price pressure on jet fuel in periods of higher demand due to military
conflict.

Frequently Used Fuel Hedging Instruments by Airlines

This section describes the most commonly used hedging contracts by airlines: swap contracts
(including plain vanilla, differential, and basis swaps), call options (including caps), collars
(including zero-cost and premium collars), futures contracts and forwards contracts.

Plain Vanilla Swap

The plain vanilla energy swap (called this because it is simple and basic when compared to more
exotic swap contracts) is an agreement whereby a floating price is exchanged for a fixed price
over a certain period of time. It is an off-balance-sheet financial arrangement, which involves no
transfer of the physical item. Both parties settle their contractual obligations by means of a
transfer of cash. In a fuel swap, the swap contract specifies the volume of fuel, the duration (i.e.,
the maturity of the swap), and the fixed and floating prices for fuel. The differences between
fixed and floating prices are settled in cash for specific periods (usually monthly, but sometimes
quarterly, semi-annually, or annually).

Figure 4 illustrates fuel hedging using two types of swap contracts. Example 1 in the figure
describes how a plain vanilla jet fuel swap arranged in the OTC market is used. Example 2
illustrates fuel hedging on the organized exchanges using a highly liquid contract -- the NYMEX
New York Heating Oil Calendar Swap contract. In all swap contracts, the airline is usually the
fixed-price payer, thus allowing the airline to hedge fuel price risk. For more information on
these contracts, refer to the NYMEX website at http://www.NYMEX.com.

Differential Swaps and Basis Risk

5
While a plain vanilla swap is based on the difference between the fixed and floating prices for
the same commodity, a differential swap is based on the difference between a fixed differential
for two different commodities and their actual differential over time. Differential swaps can be
used by companies to manage the basis risk from other hedging activities. For instance, assume
an airline prefers to hedge its jet fuel exposure using a heating oil plain vanilla swap. The airline
can used an additional swap contract, the differential swap for jet fuel versus heating oil, to
hedge basis risk assumed from the heating oil swap. The net result is that the airline can
eliminate the risk that jet fuel prices will increase more than heating oil prices. Basis risk can be
an important concern for cross-hedges of this type. For more information on differential swaps,
refer to Chapter 1 of Falloon and Turner (1999).

Call Options (Caps)

A call option is the right to buy a particular asset at a predetermined fixed price (the strike) at a
time up until the maturity date. OTC options in the oil industry are usually cash settled while
exchange-traded oil options on the NYMEX are exercised into futures contracts. OTC option
settlement is normally based on the average price for a period, commonly a calendar month.
Airlines like settlement against average prices because an airline usually refuels its aircraft
several times a day. Since the airline is effectively paying an average price over the month, they
typically prefer to settle hedges against an average price (called average price options).

In the energy industry, options are often used to hedge cross-market risks, especially when
market liquidity is a concern. For example, an airline might buy an option on heating oil as a
cross-market hedge against a rise in the price of jet fuel. Of course, cross-market hedges should
only be used if the prices are highly correlated.

Airlines such as Southwest value the flexibility that energy options provide, but energy options
can be seen as expensive relative to other options. The reason is the high volatility of energy
commodities, which causes the option to have a higher premium. For this reason, zero-cost
collars (discussed next) are often used. Figure 5 provides a conceptual illustration for hedging
gains or losses using swaps, call options, and premium collars when locking into a 60-cent/gallon
price of jet fuel.

Collars, Including Zero-Cost and Premium Collars

A collar is a combination of a put option and a call option. For a hedger planning to purchase a
commodity, a collar is created by selling a put option with a strike price below the current
commodity price and purchasing a call option with a strike price above the current commodity
price. The purchase of a call option provides protection during the life of the option against
upward commodity price movements above the call strike price. The premium received from
selling the put option helps offset the cost of the call option. By establishing a collar strategy, a
minimum and maximum commodity price is created around a hedger’s position until the
expiration of the options. Figure 6 provides an example of the net cost of jet fuel in $/gallon
using a collar where a call option is purchased with a $0.80 strike price and a put option is sold
with $0.60 strike price. As shown, the airline will never pay more than $0.80 for jet fuel no
matter how high prices rise, yet will never pay less than $0.60 regardless of how low jet fuel

6
prices drop. A collar can be structured so that the premium received from the sale of the put
option completely offsets the purchase price of the call option. This type of collar is called a
“zero cost collar.”

If more protection against upward price movements is desired (i.e., having a lower call option
strike price) or more benefit from declining prices is desired (i.e., selling a put with a lower strike
price), a premium collar is used. With a premium collar, the cost of the call option is only
partially offset by the premium received from selling a put option. Refer to Figure 5 for a
conceptual illustration of the premium collar strategy.

Using a zero-cost collar or premium collar may appear to be a reasonable hedging strategy for an
airline since it involves no upfront cost (or low upfront cost) and involves no speculative return.
However, if jet fuel prices fall significantly, as illustrated in Figure 6, the airline may pay more
for jet fuel than its competitors who did not employ the collar strategy. Competitors may lower
their airfares aggressively as a result. Accordingly, the zero-cost collar should be more
accurately called a “zero-upfront cost” collar.

Futures and Forward Contracts

A futures contract is an agreement to buy or sell a specified quantity and quality of a commodity
for a certain price at a designated time in the future. The buyer has a long position, which means
he/she agrees to make delivery of the commodity (i.e., purchase the commodity). The seller has
a short position, which means he/she agrees to make delivery of the commodity (i.e., sell the
commodity). Futures contracts are traded on an exchange, which specifies standard terms for the
contracts (e.g., quantity, quality, delivery, etc.) and guarantees their performance (removing
counterparty risk). Only a small percentage of futures contracts traded result in delivery of the
commodity (less than one percent in the case of energy contract). Instead, buyers and sellers of
futures contracts generally offset their position.

A forward contract is the same as a futures contract except for two important distinctions: (1)
Futures contracts are standardized and traded on organized exchanges, whereas forward contracts
are typically customized and not traded on an exchange; and (2) Futures contracts are marked to
market daily, whereas forward contracts are settled at maturity only. For the futures contract,
this means that each day during the life of the contract, there is a daily cash settlement depending
on the current value of the commodity being hedged. The NYMEX exchange trades futures on
crude oil, heating oil, and gasoline (among other commodities).

Table 5 illustrates how a fuel hedger can use the NYMEX heating oil futures contract to hedge
jet fuel price risk. As shown, the hedger purchases a futures contract at 66.28 cents per gallon
(futures contract size is 42,000 gallons) in January. On the same day, the New York jet fuel spot
price is 80.28 cents per gallon. If the hedger closes out this futures contract for 42,000 gallons
on August 29, 2000 at 98.59 cents per gallon, he/she has made a profit of 32.31 cents per gallon
(98.59 minus 66.28). The spot price of NY jet fuel on August 29th is 103.6 cents per gallon.
(Note: If the hedger had not hedged, he would have paid 23.32 cents/gallon more for the fuel.)
However, by using the futures contract and purchasing jet fuel in the spot market, the gain of
32.31 on the futures more than offsets the 23.32 increase in jet fuel prices. In essence, the

7
hedger’s net cost of jet fuel is 71.29 cents per gallon (i.e., 103.6 spot price in August minus the
futures hedging gain of 32.31 cents/gallon).

Accounting for Derivatives According to SFAS 133

The Financial Accounting Standards Board (FASB) issued Statement 133 to make a company’s
exposure to its derivative positions more transparent. Prior to SFAS 133, most derivatives were
carried off-balance sheet and reported only in footnotes to the financial statements. Under SFAS
133, depending on the reason for holding the derivative position and the derivative’s
effectiveness in hedging, changes in the derivatives’ fair value is recorded either in the income
statement or in a component of equity known as other comprehensive income.

Table 6 summarizes the balance sheet and income statement impacts of cash flow hedges, fair
value hedges, and speculative transactions under SFAS 133. Under SFAS 133, managers such as
Scott Topping that want their hedge to receive hedge accounting treatment, must be certain their
hedge will pass the effectiveness measure. To qualify, the manager must measure the
effectiveness of the hedge at least each reporting period for the entire duration of the hedge. Any
ineffective portion or excluded portion of the change in derivative value must be reported
directly to earnings.

According to the FASB, hedge effectiveness should take into account both historical
performance (retrospective test) and anticipated future performance (prospective test). The
FASB has provided only broad guidelines for testing hedge effectiveness. The FASB has two
suggested approaches to measure historical performance: the “80-125 rule” and the correlation
method. According to the “80-125 rule” (also referred to as the dollar-value-offset method), a
hedge is deemed effective if the ratio of the change in value of the derivative to the change in
value of the hedged item falls between 80 % and 125%. Shown in equation form:

Effectiveness measure = Σni=2(∆PH)i ⁄ Σ ni=2(∆PD)i

Where: (∆PH)i = (PH)i - (PH)i-1

(∆PD)i = (PD)i - (PD)i-1
PH = the daily price of the hedged item
PD = the daily price of the derivative
i = trading day i
n = total number of trading days in the period

According to the correlation measure, a hedge is deemed effective if the correlation between the
changes in the value of the hedged item and the derivative is high. In other words, a hedge
should be considered effective if the R-squared of the regression of this relation is around 80
percent. Furthermore, the slope of the regression line should be close to 1.0 (but this is not
explicitly referred to in SFAS 133).

For more information on measuring hedge effectiveness, refer to Kalotay and Abreo (2001), Risk
Books (1999), and Energy Information Administration (2002), among others.

8
June 12, 2001

Senior management asked Scott to propose Southwest’s hedging strategy for the next one to
three years. Because of the current high price of jet fuel, Scott was unsure of the best hedging
strategy to employ. Table 7 provides Southwest’s hedging practices at year-end 2000 as
discussed in their annual report. Because Southwest adopted SFAS 133 in 2001, Scott needed to
consider this in his hedging strategy.

Southwest’s average fuel cost per gallon in 2000 was $0.7869, which was the highest annual
average fuel cost per gallon experienced by the company since 1984. As discussed previously,
fuel and oil expense per ASM increased 44.1 percent in 2000, primarily due to the 49.3 percent
increase in the average jet fuel cost per gallon. (Refer to Table 1: The average price per gallon of
jet fuel in 2000 was $0.7869 compared to $0.5271 in 1999.)

Although Scott thought the price of jet fuel would decrease over the next year, he cannot be sure
– energy prices are notoriously hard to predict. Scott knew that: “Predicting is very difficult,
especially as it concerns the future” (Chinese Proverb). Any political instability in the Middle
East could cause energy prices to rise dramatically without much warning. If the cost of jet fuel
continued to rise, the cost of fuel for Southwest would rise accordingly without hedging. On the
other hand, if the cost of jet fuel declines, the cost of fuel would drop if Southwest were
unhedged.

To deal with these risks, Scott identified the following 5 alternatives. Scott estimated
Southwest’s jet fuel usage to be approximately 1,100 million gallons for next year.

1. Do nothing.
2. Hedge using a plain vanilla jet fuel or heating oil swap.
3. Hedging using options.
4. Hedge using a zero-cost collar strategy.
5. Hedge using a crude oil or heating oil futures contract.

Appendix 2 contains information on NYMEX futures contracts and futures options contracts,
both for crude oil and heating oil.

For alternative 2 above (i.e. hedging using a plain vanilla crude oil or heating oil swap), there
were two different possibilities: 11

(1) Enron offered Scott an over-the-counter plain vanilla jet fuel swap with a 1-year
maturity. The offer stipulated a fixed rate for Southwest Airlines of 76 cents/gallon. The
variable rate was based on the monthly average price for Gulf Coast jet fuel. Contract
payments would be made monthly during the life of the contract. The size of the swap
contract was one million gallons and for simplicity, assume that Enron was willing to

11
For the swap contract, use 1/12th of the hedge volume since the contracts are settled monthly over the one-year
period. In other words, for the 100% hedging, use swap contracts for a total of 1,100 million gallons divided by 12
= 91.67 swap contracts (or round to 92 contracts).

9
 enter into as many of these swap contracts as Southwest Airlines wanted. This swap was
similar to that explained in Example 1 of Figure 4.

(2) Scott also considered a NYMEX New York Heating Oil Calendar Swap (1-year
duration). The contract size was 42,000 gallons. The contract guaranteed a fixed rate for
Southwest Airlines of 73 cents/gallon for heating oil. The variable rate was based (per
NYMEX regulations) on the arithmetic average of the NYMEX New York Harbor
heating oil futures nearby month settle price for each business day during the month.
Contract payments would be made monthly during the life of the contract. This is similar
to Figure 4 (see Example 2).

Appendix 3 (see the first figure) contains information on the relation between jet fuel costs and
airline stock prices (11 major airlines). Note the negative correlation between the two lines.
Appendix 4 illustrates monthly load factors for U.S. domestic flights. As shown, demand varies
significantly by month and demand is highest in the summer months.

The Excel file (Jet Fuel Hedging Case Excel Data for Students.xls) contains historical prices for
jet fuel (spot), heating oil (spot and futures), and crude oil (spot and futures).

10
Case Questions

1. Why do firms like Southwest hedge? What are the benefits of hedging? (Suggestion:
refer to Carter, Rogers, and Simkins (2004) for assistance in answering this question.)

2. Does heating oil or crude oil more closely follow the price of jet fuel? To answer this
question, use the information in the Excel spreadsheet.

3. (a) Evaluate each of the five proposed hedging strategies. What are the benefits of each
hedge based on two fuel price scenarios in one year? In other words, assume in June
2002 that one of these scenarios occurs. Calculate your net cost of jet fuel under each
scenario incorporating the hedging strategies used. (Note: you can analyze the hedges
under as many price scenarios as you wish, but be certain to include the following two
scenarios.) For both scenarios, consider full hedging and a 50% hedge strategy.

SCENARIO 1: 39.3 cents/gallon spot price for jet fuel; 38.8 cents/gallon spot price for
heating oil, or $14.10 per barrel spot price for crude oil, and
SCENARIO 2: 119.6 cents/gallon spot price for jet fuel; 118.6 cents/gallon spot price for
heating oil, and $40,00 per barrel spot price for crude oil.

(b) Discuss the pros and cons of each hedging strategy.

(c) Describe how a combination of the hedging strategies can be used.

4. What are the risks of being unhedged? Totally hedged? (Note: the February 24, 2004
Wall Street Journal article titled “Outside Audit: Jet-Fuel Bets Are Risky Business” by
Melanie Trottman may be useful.)

5. (a) What is basis risk and how is it different from price risk?
(b) What are the implications of a changing basis?
(c) Does basis risk exist for Southwest Airlines in their fuel hedging program?

6. (a) What is FAS 133 and how does it impact a firm’s hedging strategy?
(b) Using the effectiveness measure on page 6, calculate the effectiveness of hedges
using heating oil futures and crude oil futures for the period 2000-2001 (up until the time
of the case). How does the effectiveness measure impact a firm’s hedging decision.

7. Describe how a market in backwardation or contango (i.e. shape of the forward curve)
might impact hedging strategies. Are current crude oil markets in backwardation or
contango? (Note: Backwardation is the market situation when futures prices are
progressively lower in the distant delivery months when compared to the nearest
(prompt) month. Contango, the opposite of backwardation, is a market situation in which
prices in later delivery months are progressively higher than in the nearest delivery
(prompt) month.)

8. What do you recommend to Scott Topping? Why?

11
 References

Clubley, Sally, 1999, “An Early Take Off”, Risk (May), (see pg. 7 of Commodity Risk Special
Report in the issue).

Carter, David A., Dan Rogers, and Betty J. Simkins, 2004, “Does Fuel Hedging Make Economic
Sense? The Case of the U.S. Airline Industry”, Oklahoma State University working paper.

Energy Information Administration, 2002, Derivatives and Risk Management in the Petroleum,
Natural Gas, and Electricity Industries (October), U.S. Department of Energy.

Falloon, William and David Turner, editors, 1999, Managing Energy Price Risk, Risk
Publications (London).

Kalotay, Andrew and Leslie Abreo, 2001, “Testing Hedge Effectiveness for FAS 133: The
Volatility Reduction Measure”, Journal of Applied Corporate Finance Vol. 13 (No. 4), 93-99.

McCartney, Scott, Daniel Michaels, and David Rogers, 2002, “Airlines Seek More Government
Aid”, The Wall Street Journal, September 23, 2002, (pages A1, A10).

Neidl, Raymond E. and Erik C. Chiprich, 2001, Major U.S. Carriers 2000 Results and 2001
Outlook, Global Research, Ing-Barings.

Reuters, 2004, “Soaring Jet Fuel Prices Threaten Airlines’ Bottom Lines”, March 10.

Schap, Keith, 1993, “Jet Fuel Swaps Ground Risk”, Futures (February), 44-46.

Trottman, Melanie, 2004, “Outside Audit: Jet-Fuel Bets Are Risky Business”, Wall Street
Journal, February 24, page C3.

12
 Table 1
Fuel Usage and Hedging Data for Southwest Airlines

Hedging variables
Exposure variables
Available Longest
Fuel Cost of Seat Total % of Maturity
Fiscal Hedge Used Fuel Miles Total Fuel as a Revenue Fuel Cost Gallons Next of
year Fuel? (Million Fuel Cost ($ per (ASM) Cost/ Expenses % of ($ (% of Hedged Year Hedges
ends Year Gallons) ($million) gallon) (millions) ASM ($ Millions) Expenses Millions) Revenue) (millions) Hedged (yrs)
$
31-Dec 2000 Yes 1022.2 804.4 $ 0.7869 59,910 $ 0.0081 $ 4,628 10.5% $ 5,649 8.6% N/A 80.00% 3.00
$
31-Dec 1999 Yes 939.1 495.0 $ 0.5271 52,855 $ 0.0094 $ 3,954 12.5% $ 4,736 10.5% 126.10 86.00% >1
$
31-Dec 1998 Yes 850.3 388.3 $ 0.4567 47,544 $ 0.0082 $ 3,480 11.2% $ 4,164 9.3% 290.00 33.00% 0.50
$ not not
31-Dec 1997 Yes 792.4 495.0 $ 0.6246 44,487 $ 0.0111 $ 3,293 15.0% $ 3,817 13.0% material material N/A
$ not not
31-Dec 1996 Yes 740.3 484.7 $ 0.6547 40,727 $ 0.0119 $ 3,055 15.9% $ 3,406 14.2% material material N/A
$
31-Dec 1995 Yes 662.2 365.7 $ 0.5522 36,180 $ 0.0101 $ 2,559 14.3% $ 2,873 12.7% 1.05 2.00% <1
$
31-Dec 1994 Yes 592.6 319.6 $ 0.5392 32,124 $ 0.0099 $ 2,275 14.0% $ 2,592 12.3% 2.10 5.00% <1

13
 Table 2
SOUTHWEST AIRLINES CO. CONSOLIDATED STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31,

(In thousands, except per share amounts) 2000 1999 1998
----------- ----------- -----------
OPERATING REVENUES:
Passenger $ 5,467,965 $ 4,562,616 $ 4,010,029
Freight 110,742 102,990 98,500
Other 70,853 69,981 55,451
----------- ----------- -----------
Total operating revenues 5,649,560 4,735,587 4,163,980

OPERATING EXPENSES:
Salaries, wages, and benefits (Note 10) 1,683,689 1,455,237 1,285,942
Fuel and oil 804,426 492,415 388,348
Maintenance materials and repairs 378,470 367,606 302,431
Agency commissions 159,309 156,419 157,766
Aircraft rentals 196,328 199,740 202,160
Landing fees and other rentals 265,106 242,002 214,907
Depreciation (Note 2) 281,276 248,660 225,212
Other operating expenses 859,811 791,932 703,603
----------- ----------- -----------
Total operating expenses 4,628,415 3,954,011 3,480,369
----------- ----------- -----------
OPERATING INCOME 1,021,145 781,576 683,611

OTHER EXPENSES (INCOME):

Interest expense 69,889 54,145 56,276
Capitalized interest (27,551) (31,262) (25,588)
Interest income (40,072) (25,200) (31,083)
Other (gains) losses, net 1,515 10,282 (21,106)
----------- ----------- -----------
Total other expenses (income) 3,781 7,965 (21,501)
----------- ----------- -----------
INCOME BEFORE TAXES AND CUMULATIVE EFFECT
OF CHANGE IN ACCOUNTING PRINCIPLE 1,017,364 773,611 705,112
PROVISION FOR INCOME TAXES (NOTE 11) 392,140 299,233 271,681
----------- ----------- -----------
INCOME BEFORE CUMULATIVE EFFECT OF
CHANGE IN ACCOUNTING PRINCIPLE 625,224 474,378 433,431
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING
PRINCIPLE, NET OF INCOME TAXES (NOTE 2) (22,131) -- --
----------- ----------- -----------
NET INCOME $ 603,093 $ 474,378 $ 433,431
=========== =========== ===========
NET INCOME PER SHARE, BASIC BEFORE CUMULATIVE
EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE $ 1.25 $ .94 $ .87
CUMULATIVE EFFECT OF CHANGE IN
ACCOUNTING PRINCIPLE (.04) -- --
----------- ----------- -----------
NET INCOME PER SHARE, BASIC $ 1.21 $ .94 $ .87
=========== =========== ===========

14
 Table 3
SOUTHWEST AIRLINES CO. CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts) DECEMBER 31,
2000 1999
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents $ 522,995 $ 418,819
Accounts and other receivables (Note 7) 138,070 75,038
Inventories of parts and supplies, at cost 80,564 65,152
Deferred income taxes (Note 11) 28,005 20,929
Prepaid expenses and other current assets 61,902 52,657
----------- -----------
Total current assets 831,536 632,595

Property and equipment, at cost (Notes 3, 5, and 6):

Flight equipment 6,831,913 5,768,506
Ground property and equipment 800,718 742,230
Deposits on flight equipment purchase contracts 335,164 338,229
----------- -----------
7,967,795 6,848,965
Less allowance for depreciation 2,148,070 1,840,799
----------- -----------
5,819,725 5,008,166
Other assets 18,311 12,942
----------- -----------
$ 6,669,572 $ 5,653,703
=========== ===========

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable $ 312,716 $ 266,735
Accrued liabilities (Note 4) 499,874 430,506
Air traffic liability 377,061 256,942
Current maturities of long-term debt (Note 5) 108,752 7,873
----------- -----------
Total current liabilities 1,298,403 962,056

Long-term debt less current maturities (Note 5) 760,992 871,717

Deferred income taxes (Note 11) 852,865 692,342
Deferred gains from sale and leaseback of aircraft 207,522 222,700
Other deferred liabilities 98,470 69,100

Stockholders' equity (Notes 8 and 9):

Common stock, $1.00 par value: 1,300,000 shares authorized;
507,897 and 505,005 shares issued in 2000
and 1999, respectively 507,897 505,005
Capital in excess of par value 103,780 35,436
Retained earnings 2,902,007 2,385,854
Treasury stock, at cost: 3,735 and 5,579 shares in
2000 and 1999, respectively (62,364) (90,507)
----------- -----------
Total stockholders' equity 3,451,320 2,835,788
----------- -----------
$ 6,669,572 $ 5,653,703
=========== ===========

15
 Table 4
Market Share of US Airlines

This table presents the market share of passenger-only or combined passenger and cargo carriers
(designated as passenger airlines) in Panel A and cargo-only carriers (designated as airfreight carriers) in
Panel B. Major airlines are defined as airlines with annual revenues of more than $1 billion, and regional
airlines are those carriers with annual revenues less than $1 billion. ASM stands for available seat miles
and represents one seat flown one mile. Average revenues are calculated as the average over 1994-2000
and market share in Panel A is calculated as the percentage of total ASM for the period 1994-2000.

Panel A: Market Share of Passenger Carriers Based on Available Seat Miles.

Average Total Available
Revenue Seat Miles Market Share
Airline ($ Millions) (1994-2000) Based on ASM
Major Airlines
United Airlines 16,796 1,168,894.0 20.52%
American Airlines 16,913 1,126,177.0 19.77%
Delta Air Lines 13,528 966,188.0 16.96%
Northwest Airlines 9,750 657,477.6 11.54%
Continental Airlines 7,356 498,731.0 8.75%
US Airways Group 8,240 418,607.0 7.35%
Southwest Airlines 3,891 313,827.9 5.51%
America West Holdings 1,879 160,005.0 2.81%
Alaska Air Group 1,746 119,565.0 2.10%

Regional Airlines
Amtran 880 94,232.6 1.65%
Hawaiian Airlines 423 38,455.1 0.67%
Airtran Holdings 360 27,787.1 0.49%
Midwest Express Holdings 347 17,603.5 0.31%
Mesa Air Group 452 16,966.4 0.30%
Comair Holdings 517 15,113.9 0.27%
Frontier Airlines 151 14,992.8 0.26%
SkyWest 291 12,147.6 0.21%
Mesaba Holdings 235 12,054.7 0.21%
Midway Airlines 200 9,775.3 0.17%
Atlantic Coast Airlines 253 8,642.7 0.15%
Total 5,697,244.20 100.00%

16
 Table 4. Continued

Panel B: Market Share of Cargo Carriers based on Freight Ton-miles

(in Millions)

Freight
Airfreight Ton-miles Market Share Based
Carrier (in Millions) on Freight Ton-miles
FedEx 7,401.9 31.71%
United Parcel Service 4,339.1 18.59%
United Airlines 2,529.9 10.84%
Northwest Airlines 2,205.1 9.45%
American Airlines 1,916.7 8.21%
Delta Airlines 1,435.0 6.15%
Atlas Air 1,048.3 4.49%
Continental Airlines 995.1 4.26%
Airborne Express 887.0 3.80%
US Airways 277.7 1.19%
TransWorld Airlines 129.6 0.56%
Southwest Airlines 69.1 0.30%
Alaska Air 57.4 0.25%
Hawaiian Airlines 53.7 0.23%
Total 23,345.60 100.00%
Note: FedEx, United Parcel Service, Atlas Air, and Airborne Express are
cargo-only carriers. The other firms listed are primarily passenger
airlines.

17
 Table 5
Example of a Jet Fuel Cross-hedge Using the NYMEX Heating Oil Futures Contract

On January 6, 2000, a fuel purchasing director wants to hedge his September

jet fuel consumption at current prices. He buys a September New York Harbor
heating oil futures contract on the NYMEX at 66.28 cents per gallon (contract
size is for 42,000 gallons). On the same day, the New York jet fuel spot price
is 80.28 cents per gallon. The director closes out this futures contract on
August 29, 2000 at 98.59 cents per gallon. As shown below, the director has
made a profit of 32.31 cents per gallon (98.59 minus 66.28) on the futures
contract. In essence, the hedger bought a futures contract (a long hedge) in
January and then sold back the futures contract in August. The spot price of
NY jet fuel on August 29th is 103.6 cents per gallon. Without the futures
hedge, the director would have paid 23.32 cents/gallon more for the fuel.
However, by using the futures contract and purchasing jet fuel in the spot
market, the gain of 32.31 on the futures offsets the 23.32 increase in the jet fuel
spot price. As a result, the director’s net cost of jet fuel is 71.29 cents per
gallon (i.e. 103.6 spot price in August minus the futures hedging gain of 32.31
cents/gallon).

Cash Price Futures Price Basis

(i.e. Spot Price) (Cash price minus futures
price)
January 6 cash price 66.28 cents/gallon 14.00 cents/gallon
80.28 cents/gallon

August 29 cash price 98.59 5.01

103.6 cents/gallon

32.31 cents/gallon gain 8.99 cents/gallon basis loss

Result:

Cash purchase price of jet fuel 103.6 cents/gallon

Minus heating oil futures gain - 32.31 cents/gallon
Net purchase price of jet fuel 71.29 cents/gallon

18
 Table 6
Statement of Financial Accounting Standards 133 (SFAS 133) Balance Sheet and
Income Statement Impacts of Cash Flow and Fair Value Hedges

This table summarizes the balance sheet and income statement impacts of hedging
according to SFAS 133.

Type of Derivative Balance Sheet Impact Income Statement Impact

Cash Flow Hedge Derivative (asset or liability) is
reported at fair value. Changes in fair
value of derivative are reported as
components of Other Comprehensive
Income (balance sheet)
No immediate income statement
impact. Changes in fair value of
derivatives are reclassified into the
income statement (from Other
Comprehensive Income in the balance
sheet) when the expected (hedged)
transaction affects the net income.
Derivative must qualify for hedge
accounting treatment.

Fair Value Hedge Derivative (asset or liability) is
reported at fair value. Hedged item is
also reported at fair value.
Changes in fair value are reported as
income/loss in the income statement.
Offsetting changes in fair value of the
hedged item are also reported as an
income/loss in the income statement

Speculative Transaction Derivative (asset or liability) is Changes in the fair value are reported
reported at fair value as income/loss in the income
statement.

19
 Table 7
Disclosures on Hedging From Southwest Airlines’ 2000 Annual Report

FINANCIAL DERIVATIVE INSTRUMENTS The Company utilizes a variety of

derivative instruments, including both crude oil and heating oil based derivatives, to
hedge a portion of its exposure to jet fuel price increases. These instruments consist
primarily of purchased call options, collar structures, and fixed price swap agreements.
The net cost paid for option premiums and gains and losses on fixed price swap
agreements, including those terminated or settled early, are deferred and charged or
credited to fuel expense in the same month that the underlying jet fuel being hedged is
used. Hedging gains and losses are recorded as a reduction of fuel and oil expense.
Beginning January 1, 2001, the Company will adopt Statement of Financial Accounting
Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging
Activities which will change the way it accounts for financial derivative instruments. See
Recent Accounting Developments.

RECENT ACCOUNTING DEVELOPMENTS In 1998, the Financial Accounting

Standards Board (FASB) issued SFAS 133. SFAS 133, as amended, is required to be
adopted in fiscal years beginning after June 15, 2000. The Company will adopt SFAS 133
effective January 1, 2001. SFAS 133 will require the Company to record all derivatives
on its balance sheet at fair value. Derivatives that are not designated as hedges must be
adjusted to fair value through income. If the derivative is designated as a hedge,
depending on the nature of the hedge, changes in the fair value of derivatives that are
considered to be effective, as defined, will either offset the change in fair value of the
hedged assets, liabilities, or firm commitments through earnings or will be recorded in
other comprehensive income until the hedged item is recorded in earnings. Any portion
of a change in a derivative's fair value that is considered to be ineffective, as defined, may
have to be immediately recorded in earnings. Any portion of a change in a derivative's
fair value that the Company has elected to exclude from its measurement of effectiveness,
such as the change in time value of option contracts, will be recorded in earnings.

The Company will account for its fuel hedge derivative instruments as cash flow hedges,
as defined. Although the fair value of the Company's derivative instruments fluctuates
daily, as of January 1, 2001, the fair value of the Company's fuel hedge derivative
instruments was approximately $98.3 million, of which approximately $75.8 million was
not recorded in the Consolidated Balance Sheet. The $75.8 million will be recorded as an
asset on the Company's balance sheet as part of the transition adjustment related to the
Company's adoption of SFAS 133. The offset to this balance sheet adjustment will be an
increase to "Accumulated other comprehensive income", a component of stockholders'
equity. The portion of the transition adjustment in "Accumulated other comprehensive
income" that relates to 2001 hedge positions, based on fair value as of January 1, 2001, is
approximately $73.9 million and will be reclassified into earnings during 2001. The
remainder of the transition amount will be reclassified to earnings in periods subsequent
to 2001. The Company believes the adoption of SFAS 133 will result in more volatility in
its financial statements than in the past.

20
 U.S. Cents/Gallon

25
45
65
85
105
125
1/3/1994

4/3/1994

7/3/1994

10/3/1994

1/3/1995

4/3/1995

7/3/1995

10/3/1995

1/3/1996

4/3/1996

7/3/1996

10/3/1996

1/3/1997
OPIS Chicago Jet 54

4/3/1997
OPIS Gulf Coast Jet 54

OPIS N.Y. Harbor Jet 54

OPIS Los Angeles Jet 54

7/3/1997
OPIS San Francisco Jet 54

21
10/3/1997

Date
Figure 1

1/3/1998

4/3/1998
OPIS Regional Jet Fuel Prices

7/3/1998

10/3/1998

1/3/1999

4/3/1999

7/3/1999

10/3/1999

1/3/2000

4/3/2000

7/3/2000

10/3/2000

1/3/2001

4/3/2001
 Figure 2
Historical Gulf Coast Spot Jet Fuel Price Volatility

COM PUTING VOLATILITY (Standard Deviation)

Results: Periodic Annualized

Variance 0.001378 0.344570998
Standard Deviation (i.e. VOLATILITY) 3.71% 58.70%
Mean -0.06% N/A

Sim ple Continuously

Jet Fuel Rate of Com pounded Squared
Obs. Date Price Return Rate of Return Deviation
1 1/2/2001 86.8 NA NA NA
2 1/3/2001 81.65 -5.93% -6.12% 0.003741
3 1/4/2001 82.8 1.41% 1.40% 0.000196
4 1/5/2001 85.83 3.66% 3.59% 0.001292
5 1/8/2001 82.13 -4.31% -4.41% 0.001942
6 1/9/2001 79.98 -2.62% -2.65% 0.000704
7 1/10/2001 86 7.53% 7.26% 0.005267
8 1/11/2001 84.43 -1.83% -1.84% 0.000339
9 1/12/2001 85.4 1.15% 1.14% 0.000130
10 1/16/2001 87.75 2.75% 2.71% 0.000737
11 1/17/2001 87.25 -0.57% -0.57% 0.000033
12 1/18/2001 90.15 3.32% 3.27% 0.001069
13 1/19/2001 91.47 1.46% 1.45% 0.000211
14 1/22/2001 92.4 1.02% 1.01% 0.000102
15 1/23/2001 91.82 -0.63% -0.63% 0.000040
16 1/24/2001 85.88 -6.47% -6.69% 0.004473
17 1/25/2001 89 3.63% 3.57% 0.001273
18 1/26/2001 93.25 4.78% 4.66% 0.002176
19 1/29/2001 90.13 -3.35% -3.40% 0.001158
20 1/30/2001 85.83 -4.77% -4.89% 0.002390
21 1/31/2001 86.78 1.11% 1.10% 0.000121
22 2/1/2001 82.84 -4.54% -4.65% 0.002159
23 2/2/2001 87.83 6.02% 5.85% 0.003421
24 2/5/2001 87.3 -0.60% -0.61% 0.000037
25 2/6/2001 87.95 0.74% 0.74% 0.000055
26 2/7/2001 87.63 -0.36% -0.36% 0.000013

Totals Count= 25 0.033079

22
 Spread (Jet Fuel - Heating Oil) in Cents/Gallon
M
ar

0
5
10
15
20
25
30
-9
Ju 0
l-
N 90
ov
-
M 90
ar
-9
Ju 1
l-
N 91
ov
-
M 91
ar
-9
Ju 2
l-
N 92
ov
-
M 92
ar
-9
Ju 3
l-
N 93
ov
-
M 93
ar
-9
Ju 4
l-
N 94
ov
-
M 94
ar
-9

23
Ju 5
l-
Figure 3

N 95
ov
-

Date
M 95
ar
-9
Ju 6
l-
N 96
ov
-
M 96
ar
-9
Ju 7
l-
N 97
ov
-
M 97
ar
-9
Ju 8
l-
N 98
ov
Price Spread Between Jet Fuel and Heating Oil for Gulf Coast Prompt

-
M 98
ar
-9
Ju 9
l-
N 99
ov
-
M 99
ar
-0
Ju 0
l-
N 00
Source: Bloomberg

ov
-0
0
 Figure 4
Fuel Hedging Using Swap Contracts

Pay fixed rate of $X per gallon

per the swap contract
Airline is Counterparty is
Fixed-rate payer Floating-rate
payer
Airline receives floating rate based on
monthly average jet fuel price

Example 1 using a Plain Vanilla Jet Fuel Swap Arranged in the OTC Market

Typically, the airline pays a fixed price and receives a floating price, both indexed to expected jet
fuel use during each monthly settlement period. The volume of fuel hedged is negotiated
because this is a customized contract. During the life of the swap contract, the airline buys jet
fuel in the cash market, as usual, but the swap contract makes up the difference when prices rise
and removes the difference when prices decline. The result for the airline is a fixed price for the
period covered. The fixed rate payment is set based on market conditions when the swap contract
is initiated. The floating price of jet fuel is commonly based on Platt’s New York Harbor jet
fuel price and is calculated monthly using daily prices for the month. The net monthly payment
(or cost) to the fixed-rate payer is the floating rate minus the fixed rate. For example, if the
floating rate for a month averages 80 cents per gallon and the fixed rate is 70 cents per gallon,
then the floating rate payer makes a 10 cents per gallon payment that month to the airline. If the
size of the contract is 100,000 gallons, a payment of $10,000 is made to the airline (i.e. $0.10 x
100,000).

Example 2 using the NYMEX New York Harbor Heating Oil Calendar Swap

The NYMEX New York Heating Oil Calendar Swap lets hedgers arrange positions in the heating
oil market as far forward as 36 months. The price settlement of the contract is based on the
arithmetic average of the NYMEX New York Harbor heating oil futures nearby month
settlement price for each business day during the contract month. The swap contract is for
42,000-gallons – the same size as the NYMEX heating oil futures contract. Consider an 18-
month swap currently trading with a fixed-price of 0.6841 cents/gallon. Suppose the futures
average daily price for the month was 0.5900. The hedger who is long the futures contract (such
as the airline) will make a payment to the counterparty of $3952.20 [i.e. (0.6841 – 0.5900) x
42,000]. The airline would purchase jet fuel in the spot market. Assuming the basis has not
changed between jet fuel and heating oil (i.e. the high correlation between heating oil and jet fuel
remains unchanged), the loss on the futures contract will be offset by the lower cash price of jet
fuel. As a result, the airline effectively pays a fixed price for jet fuel.

24
 Figure 5
Swap, Call Option, and Premium Collar Illustration

25
 Figure 6
Net Cost of Jet Fuel Using a Collar Strategy (Buy 80 Cent/Gallon Call and Sell 60 Cent/Gallon Put)

90

80

70
Net Cost of Jet Fuel Using a Collar Strategy

60

50

40

30

20

10

0
30
33
36
39
42
45
48
51
54
57
60
63
66
69
72
75
78
81
84
87
90
93
96
99
102
105
108
111
114
117
120
123
126
129
132
135
138
Price of Jet Fuel in Cents per Gallon

26
 Appendix 1
Glossary of Airline Terms

Aircraft (average during period): The average number of aircraft operated during the period.

Aircraft utilization: The average number of block hours operated in scheduled service per day per aircraft for the
total fleet of aircraft.

Available seat miles (ASMs): The number of seats available for scheduled passengers multiplied by the number of
miles those seats were flown.

Average fare: The average fare paid by a revenue passenger.

Average seats per departure: The average number of available seats per departing aircraft.

Average stage length: The average number of miles flown per flight.

Block hour: The total time an aircraft is in motion from brake release at the origination to brake application at the
destination.

Break-even load factor: The load factor at which scheduled passenger revenues would have been equal to
operating plus non-operating expenses/(income) (holding yield constant).

Cost per available seat mile (CASM): Operating expenses plus non-operating expenses/(income) divided by
ASMs.

Departure: A scheduled aircraft flight.

Fuel price per gallon: The average price per gallon of jet fuel for the fleet (excluding into plane fees)

Load factor: RPMs divided by ASMs.

Onboard passengers: The number of revenue passengers carried.

Revenue passenger miles (RPMs): The number of miles flown by revenue passengers.

Passenger revenue per available seat mile (PRASM): Passenger revenues divided by ASMs.

Yield: The average scheduled passenger fare paid for each mile a scheduled revenue passenger is carried.

27
 Appendix 2

Futures Options Data as per Barrons on 6-11-01 (NYMEX)

CRUDE OIL CALLS CRUDE OIL PUTS
Month Strike Volume Premium Month Strike Volume Premium
Jul-01 $27.50 706 $1.05 Jul-01 $24.00 1,792 $0.01
Jul-01 $28.00 3,610 $0.71 Jul-01 $25.00 1,274 $0.02
Jul-01 $28.50 3,085 $0.47 Jul-01 $25.50 881 $0.03
Jul-01 $29.00 5,122 $0.29 Jul-01 $26.00 2,145 $0.04
Jul-01 $29.50 2,659 $0.18 Jul-01 $26.50 750 $0.07
Jul-01 $30.00 8,575 $0.10 Jul-01 $27.00 4,005 $0.12
Jul-01 $30.50 708 $0.06 Jul-01 $27.50 1,583 $0.22
Jul-01 $31.00 2,463 $0.04 Jul-01 $28.00 5,128 $0.38
Jul-01 $32.00 4,086 $0.02
Jul-01 $36.00 506 $0.01
Aug-01 $28.00 1,966 $1.43 Aug-01 $23.00 535 $0.05
Aug-01 $28.50 4,054 $1.16 Aug-01 $24.00 761 $0.07
Aug-01 $29.00 2,930 $0.91 Aug-01 $25.00 1,022 $0.12
Aug-01 $29.50 4,892 $0.73 Aug-01 $26.00 2,957 $0.24
Aug-01 $30.00 6,127 $0.58 Aug-01 $26.50 1,003 $0.33
Aug-01 $31.00 1,726 $0.34 Aug-01 $27.00 2,026 $0.46
Aug-01 $31.50 1,012 $0.26 Aug-01 $27.50 1,017 $0.62
Aug-01 $32.00 7,880 $0.19 Aug-01 $28.00 5,064 $0.80
Aug-01 $33.00 1,880 $0.13
Aug-01 $35.00 2,309 $0.09
Aug-01 $40.00 1,161 $0.02
Aug-01 $45.00 1,000 $0.01
Sep-01 $28.00 750 $1.75 Sep-01 $24.00 733 $0.16
Sep-01 $28.50 921 $1.48 Sep-01 $25.00 921 $0.28
Sep-01 $29.00 900 $1.22 Sep-01 $26.50 810 $0.59
Sep-01 $30.50 700 $0.71 Sep-01 $27.50 1,200 $0.92
Sep-01 $33.00 1,371 $0.26 Sep-01 $28.00 1,708 $1.12
Sep-01 $34.00 4,305 $0.18 Sep-01 $31.00 500 $2.93

Oct-01 $28.00 675 $1.92 Oct-01 $20.00 815 $0.06

Oct-01 $33.00 945 $0.39 Oct-01 $24.00 520 $0.27
Oct-01 $34.00 2,430 $0.29 Oct-01 $27.00 655 $1.02
Oct-01 $28.00 525 $1.42

Nov-01 $32.00 2,700 $0.63 Nov-01 $20.00 1,250 $0.10

Nov-01 $24.00 3,325 $0.40

Dec-01 $27.50 568 $2.24 Dec-01 $22.00 1,055 $0.22

Dec-01 $28.00 602 $1.89 Dec-01 $23.00 5,850 $0.34
Dec-01 $29.00 500 $1.46 Dec-01 $25.00 2,750 $0.77
Dec-01 $30.00 579 $1.14 Dec-01 $26.00 3,151 $1.08
Dec-01 $34.00 600 $0.42 Dec-01 $27.50 650 $1.67

Apr-02 $26.50 525 $2.50

Jun-02 $22.50 900 $1.80
Jun-02 $26.00 1,287 $2.61 Jun-02 $20.50 950 $0.56
Jun-02 $28.00 600 $1.80
Dec-03 $23.00 700 $2.91 Dec-03 $23.00 700 $2.65

28
 Futures Data as per Barrons on 6-11-01
Heating Oil (NYMEX HO)
42,000 gallons per contract (cents/gallon)
Month Week’s High Week’s Low Week’s Settle Open Interest
Jul 01 78.40 75.00 76.65 29,709
Aug 01 78.35 75.70 77.12 19,087
Sep 01 78.90 76.30 77.77 12,679
Oct 01 79.55 77.50 78.52 7,415
Nov 01 80.35 78.10 79.27 9,606
Dec 01 80.90 78.80 79.82 21,185
Jan 02 80.90 79.00 80.02 8,576
Feb 02 80.40 78.00 78.87 7,055
Mar 02 77.80 75.60 76.17 9,774
Apr 02 74.90 73.18 73.62 1,981
May 02 71.90 70.95 71.27 1,584
Jun 02 70.75 69.75 70.02 1,795
Jul 02 70.02 69.62 69.62 474
Aug 02 … … 69.77 289
Sep 02 … … 70.12 289
Oct 02 … … 70.52 207
Nov 02 71.9 70.38 70.92 382
Dec 02 71.73 71.65 71.42 103

Light Sweet Crude (NYMEX CL)

1,000 barrels per contract (dollars/barrel)
Jul 01 28.74 27.25 28.33 93,423
Aug 01 28.90 27.71 28.63 95,499
Sep 01 28.85 27.90 28.63 46,117
Oct 01 28.61 27.90 28.50 23,347
Nov 01 28.33 27.81 28.32 21,390
Dec 01 28.20 27.55 28.07 35,792
Feb 02 27.65 27.20 27.51 9,215
Mar 02 27.21 26.87 27.23 5,214
May 02 … … 26.67 4,616
Jun 02 26.42 26.10 26.39 19,331
Jul 02 … … 26.13 4,822
Aug 02 25.74 25.60 25.87 2,687
Sep 02 … … 25.62 8,269
Oct 02 … … 25.38 4,494
Nov 02 … … 25.16 3,246
Dec 02 24.99 24.71 24.96 18,953
Jan 03 … … 24.77 3,976
Feb 03 … … 24.59 819
Mar 03 … … 24.43 904

29
Apr 03 … … 24.28 267
May 03 … … 24.14 217
Jun 03 24.10 23.79 24.01 6,504
Jul 03 … … 23.88 169
Aug 03 … … 23.75 230
Sep 03 … … 23.62 415
Oct 03 … … 23.49 …
Nov 03 … … 23.37 …
Dec 03 … … 23.26 9,995
Jun 04 22.88 22.67 22.88 200
Dec 04 22.69 22.65 22.57 5,999
Dec 05 … … 22.17 5,302
Dec 06 … … 21.82 1,996
Dec 07 … … 21.77 375

30
 Appendix 3

Monthly Stock Returns of 11 Major Airlines Versus the Montly Percentage Change in Jet Fuel
Costs Over the Period 1994-1999

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%
Return

0.00%

-5.00%

-10.00%

-15.00%

-20.00%

-25.00%
4

9
4

9
y-9

y-9

y-9

y-9

y-9

y-9
n-9

p-9

n-9

p-9

n-9

p-9

n-9

p-9

n-9

p-9

n-9

p-9
Ma

Ma

Ma

Ma

Ma

Ma
Ja

Se

Ja

Se

Ja

Se

Ja

Se

Ja

Se

Ja

Se
Date

Airline Portfolio Return Change in Jet Fuel Costs

31
 Appendix 4

Monthly Load Factors for U.S. Airline Domestic Flights

80

75
Load Factor (RPM/ASM) %

70

65

60

55

50

00 00 r-0
0
r-0
0 00 00 l-0
0 00 00 00 00 00 01 01 r-0
1
r-0
1 01
n- b- y- n- g- p- ct- v- c- n- b- y-
Ja F e M
a A p
M
a J u Ju A u S e O N o D e J a F e M
a Ap
M
a
Date Source: Bloomberg

32