Does Hedging Produce Competitive Advantage?
Posted: January 9, 2013 Filed under: books, competitive advantage, economics, finance, Markets, theory of the firm 8 Comments »A review of George Szpiro’s 2011 book on the history of the Black-Scholes option-pricing formula uses Southwest Airlines’famous fuel-price-hedging strategy as a key piece of its explanation for why firms might want to use options. Southwest’s hedging has received a lot of attention; the gains and losses on these financial trades have rivaled operating profits and losses on its income statement. Most commentators have applauded this aggressive trading activity, merely cautioning that sometimes Southwest guesses wrong about future oil prices and loses a lot of money.
What no one seems to ask is why Southwest shareholders would want the firm to be speculating in the fuel market in the first place. Unless these hedges materially reduced the risk of bankruptcy–and Southwest’s balance sheet is typically stronger than its rivals’–the classic argument applies: Shareholders should not want corporate managers to hedge industry-specific risks, such as swings in fuel prices, because they can very easily deal with these risks themselves by holding a diversified portfolio of stocks (including oil firms) or even by buying their own options on oil prices. Southwest’s financial risk reduction via hedging conveys little or no benefit to the owners of the firm.
But wait, many will object–doesn’t hedging give Southwest a cost advantage over its rivals when oil prices go up? And since these hedges are often accomplished by options, isn’t there an asymmetry, since when Southwest guesses wrong, it only loses the price it paid for the option? Doesn’t the airline therefore lower its costs by these trades, gaining a leg up on its rivals?
The answer is No. These hedges have no impact whatsoever on Southwest’s cost of being an airline operator. They constitute an independent, speculative financial side business, a business that is exactly as good for Southwest shareholders as the CFO’s team is at outguessing the fuel market. Even when Southwest guesses right, it is not improving the airline business’s competitiveness.
To see why this is true, think about the incremental fuel cost to Southwest of running a flight with or without the hedge. If the spot price of fuel is $x/gallon at the time of the flight and it consumes y gallons, then the fuel cost is xy. If Southwest has successfully hedged the oil price, then it will make a bunch of money after closing out its position, but it would still independently save $xy by not running the flight. If Southwest has guessed wrong and lost money on the hedge, it would also save $xy by not running the flight. So the cost of operation–the increment in expenditure caused by producing another unit–is unaltered by the hedging strategy.
This situation should be easy to visualize because the hedges are on oil rather than jet fuel and because they are settled for cash rather than physical delivery. But even if the hedges were denominated in physically delivered jet fuel, successful or unsuccessful hedging would have no impact on airline operating costs. If Southwest just bought fuel early for $(x-a)/gallon and stored it until the spot price was $x/gallon, the opportunity cost of the flight would still be $xy, since the airline could cancel the flight and sell y gallons for that amount. The incremental expenditure difference between flying and not flying is exactly the same. (If opportunity cost confuses you, visualize that Southwest has some fuel on hand purchased at the lower hedged price and some at the spot price, and note that it doesn’t matter which barrel of gas goes into which plane–all the fuel is fungible, and it is all worth $x/gallon if that’s what it could be sold for.)
Now, risk-averse behavior by managers may be in their own interest, depending on the form of their compensation, the structure of the labor market, and their perceived ability differential over their peers. But it is of little help to the owners of public firms that are far from bankruptcy. That’s a point that should not be hedged.
[...] OK, maybe it’s not that bad. But their oil-price hedging strategy really isn’t an advantage for them: [...]
What about the idea that SW might be better at guessing future oil prices than the typical shareholders the controlling powers of SW wish to keep and recruit? Meaning that SW is not only trading the profits from its competence as an airline operator to these shareholders (in exchange for past and the potential for future capital injections), but also its competence in financial betting in a narrow market (oil prices).
That’s fine, but it conveys no competitive advantage to the airline business. The cost of flying would be unchanged.
They could always set up a separate unit–Southwest Oil Brokers or whatnot–and even invite separate capital investment into it. If you believe that they are that much better than all the other oil-price speculators out there at guessing prices, then that business might earn profits as a financial speculator.
This analysis is fine but one sided: it only considers the cost side of the business and neglects the fact that cancelling flights means the airline earns no revenue.
As fule prices rise, the airliune that is hedged and doesn’t need to cancel flights will be better off than the one that does have to cancel
Nope. Whether or not a flight should be cancelled is independent of the existence of the hedge, as described in detail in the post. If it pays to operate the flight with the hedge, then it pays to operate without it. If it doesn’t pay to operate the flight without the hedge, then it doesn’t pay to operate with it. Revenue potential and long-term customer goodwill issues are fully covered by the analysis in the post.
Note that no one “has to” cancel a flight unless they are about to go bankrupt for lack of the cash to pay incremental costs. SW has always been very far from this condition, so it is not relevant for them. They simply have to decide whether or not a flight has positive expected NPV, and that number is independent of the existence of the hedges.
What makes this analysis such an interesting instructive example is that it highlights the subtleties of the concept and definition of competitive advantage. Great post!
Let’s consider SW as a portfolio (SW) made up of its airline operations (A) and its hedging operations (H); A weights w, while H weights (1-w); A’s rate of return is r(A), while H rate of return is r(H). The rate of return required to SW is r(SW), which is equal to: w×r(A) + (1-w)×r(H).
If r(SW) is fixed i.e. r(SW) = a, an increase of r(H) allows us to decrease the required r(A), namely for example to reduce flies tickets costs, which gives us a competitive advantage over rivals and can eventually increase our market share, therefore improving our initial r(A) and subsequently r(SW).
My point is: if we consider locally each flight, yes the hedging profit does not provide any competitive advantage, as this profit is independent of our decision to make or cancel the flight (i.e. it does not affect its NPV); however, if we consider SW as a portfolio of operations, the hedging activity could provide the airline with a competitive advantage, it depends on the return on the hedges: if we consider a situation in which SW has only airline operations with return r(A) = r(SW) = a, the difference in the global required rates of return in these two situations is: (1-w)×[r(H)-a]. So providing that the return on the hedges are higher that the required rate of return for SW, the company has a competitive advantage over its rivals.
JJFM: Note that your argument says nothing about hedging per se; the H operation could just as well be stock market speculation, currency speculation, or any other independent financial maneuver. In fact, H could be a non-financial operation, say gold mining or running nail salons. This should be a clue that something has gone awry in the analysis, because if correct you would be proving too much.
This argument amounts to advocating a cross-subsidy from one business to another without either business performing better as part of a portfolio than it would separately. Such cross-subsidies can only help a business unit if it is cash-constrained and the firm to which if belongs has poor access to capital markets. Neither condition holds for Southwest. Lowering the rate of return Southwest earns in the airline business is not what most people would call achieving competitive advantage–competitive advantage is supposed to lead to higher returns.
The sources of the misunderstanding, I think, lie in two areas: First is the assumption of a “required” return. There is no such thing from the standpoint of managing the business–Southwest management’s job is to maximize the expected NPV of the firm, which may well involve exceeding the return an investor could get on equivalent (systematically risky) investments. Using some outside pile of cash, however generated, to finance losses in the airline business does not create competitive advantage in that business. Second is the implicit idea that competitive advantage is per se about gaining market share. Admittedly, the term’s usage is far from nailed down, and my colleagues can attest that this lack of consensus is a hobby-horse of mine, but I have never seen “competitive advantage” used in strategy to mean “conducive to gaining market share as an ultimate goal.”