Does Hedging Produce Competitive Advantage?

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.

Are You in The New-Wave Utility Business?

A long time ago, in a blog far, far away, I outlined the idea of a “new-wave utility.” The idea was that some innovative high-growth service businesses were transitioning into utility-like systems whose large and diverse customer bases implicitly depended on them for ubiquity, reliability, and stability of offering. One example I mentioned in passing was Starbucks. Apparently, in Manhattan, Hurricane Sandy has revealed the truth of this classification. From the story in the link, access to bathrooms has been a key issue in the Big Apple. That’s less of a factor in L.A., but power outlets, WiFi, and table space in a congenial environment have certainly put Starbucks (and its smaller rivals such as the Coffee Bean and Tea Leaf Co.) in the category of utilities for the city’s horde of writers, students, and deal-makers.

Alex Tabarrok’s Patent Policy napkin

Alex Tabarrok's Patent Policy napkin

Alex Tabarrok’s pictorial commentary on patent policy, drawn on a napkin, posits that the current patent system is somewhat too strong and thereby decreases innovation (the link to his original post is below). I have to say, however, that I don’t think patent strength is the problem. The problem is that the growth in patent applications over the last two decades has vastly exceeded the growth in resources available to the patent office, resulting in 1) long delays between patent application and granting (which can render patents completely pointless in fast moving industries), and 2) inadequate ability to examine the patent applications for novelty, usefulness and non-obviousness. This lowers the value of good patents (because they aren’t granted quick enough or may be fallaciously challenged) and increases the likelihood of bad patents being granted. As a result, for many individuals and firms, the expected net gains from manipulating the patent system for the purposes of extortion (hostage taking, patent trolling) now exceeds the expected net gains from using the patent system to actually innovate.

It’s difficult to assess how patent strength affects innovation without first making sure that patents are being granted and used the way the system had originally intended.

Alex Tabarrok’s original post can be found here:

Fallacious Reasoning on Clean Coal

Over at the Atlantic, Jordan Weissmann argues that the Obama administration’s claim to be pursuing an “all of the above” energy strategy is unrealistic because the EPA’s new CO2 emission rules will make traditional coal plants untenable while “clean coal” technology is uneconomical relative to natural gas. Fine.

But Weissmann goes on to argue that the reason why clean coal R&D is a big waste of money is because of the lack of a cap-and-trade policy that would put a price on CO2 emissions. That’s dead wrong. With a price for carbon dioxide, just as with the EPA’s technology or emissions standards, power producers would look for the cheapest alternative to coal. That would be natural gas (given the same forecasts Weissmann relies on). So the clean-coal subsidies are unlikely to pay off regardless of what kind of policy we pursue, be it a CO2 tax, cap and trade, or emissions or technology standards for power plants. Cheaper is cheaper. It’s amazing how often people fail to grasp principles of competitive advantage.

(We could, of course, come up with a convoluted policy to keep coal miners employed, similar to how the 1977 amendments to the Clean Air Act were set up to penalize low-sulphur Western coal so as to keep Eastern mines open, but I’m hopeful that we can avoid that kind of perversity this time. If you see laws or regulations that punish natural gas use in electric power, though, you’ll know my hopes have gone unfulfilled.)

Motivation Trumps IQ. What now?

An article recently posted in Slate reviews research showing that a significant portion of the variation in IQ tests is attributable to motivation rather than ability. In one striking study researchers measured the children’s IQ and split them into High, Average, and Low groups. They reran the test offering the low group an M&M for every correct answer. As a result of this simple incentive, the low group’s score went from 79 to 97 – on par with the average group.

Ok, so incentives work. Perhaps not a big surprise on many levels.

On the other hand, there is a large OB/HRM literature invested in the conclusion that performance increases are associated with hiring employees with a higher IQ. The assumption there is that IQ measures ability as opposed to motivation.

This raises a critical question for strategy scholars. Is motivation an immutable attribute of human capital Read the rest of this entry »

Strategic Human Capital Paradoxes…

For a PDW, I was asked to develop a short list of paradoxes linked to the strategic human capital (spoiler alert for those of you planning to be at the session at 8am on Friday). I’m sure some of them would not surprise you in the least. Others might spur some discussion though. Here is the short list:

  • Rent from human capital may not show up in profitability
  • “Who” is a firm?
  • Firm-specificity isn’t as important as we might think
  • HR Departments may not matter much
  • High performance work systems don’t tell us much about such advantages

Rent. The first point is what you would expect from me so let me dismiss it quickly. Obviously, if rent is linked to human capital, some portion of it is likely to be captured by people. Nuff said.

Who is a firm? A sharp distinction is made between hiring on the spot market and an internal labor market. Rightly so. However, one might think that once labor is “internal” such people are part of the firm. Read the rest of this entry »

New Resource: Carpenter’s Strategy Toolbox

Some of you may remember Mason Carpenter’s old teaching web page with experiential exercises, videos, and other tips for teaching strategy. I’ve repackaged his content, added some of my own materials, and it can now be found at:

A quick tip is that you can now sort the resources by topic (click the category list on the right). I included the most common broad topics in a core strategy course so this should get you to something useful quickly. Probably most importantly, there is a mechanism so people can submit new tools and comment on exiting tools to keep the site fresh.

To give you a feel for it, here are links to a few exercises and resources that you might find particularly useful:


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