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.

59 Comments on “Does Hedging Produce Competitive Advantage?”

  1. […] OK, maybe it’s not that bad.  But their oil-price hedging strategy really isn’t an advantage for them: […]

  2. 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).

    • stevepostrel says:

      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.

  3. Rovert says:

    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

    • stevepostrel says:

      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.

  4. Corey says:

    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!

  5. JJFM says:

    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.

    • stevepostrel says:

      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.”

  6. Tim says:

    Airlines’ business models do not operate on the notion that they cancel flights if they “guessed wrong and lost money on the hedge”, so your analysis is fundamentally flawed.

    As for your statement that “hedges have no impact whatsoever on Southwest’s cost of being an airline operator”….well, that’s simply divorced from reality. Hedges can greatly benefit an airline through reduced operating costs, if done right. They can also be a net drag on earnings if done wrong. There is a very real impact to hedging.

    • stevepostrel says:

      The post does not say that they should cancel flights because they lost money on the hedge, as you imply in your comment. It says that regardless of whether the hedge comes out ahead or behind, the economic cost of running the flight is unaffected, and it explains why in several different ways.

      Your assertions to the contrary (e.g. “business models do not operate,” “fundamentally flawed,” and “divorced from reality”) do not respond to the argument at hand. Do you have an explanation of how the hedge could possibly affect real, economic operating costs given the arguments above?

      • Tim says:

        The whole point of hedging is to have an impact (hopefully positive!) on the effective cost of fuel. The trick is to get your price call right – which is difficult, but not impossible – there is a prize to be had, i.e. a beneficial impact to the “real, economic operating costs”, and that’s why airlines chose to hedge in the first place.

        Question to you – does hedging have an impact on an airline’s cash flows?

      • stevepostrel says:

        Hedging has zero impact on the “effective” cost of burning the fuel, which is the relevant cost for determining the competitive advantage or disadvantage of the operating business.

        Another way of looking at it is that running an airline doesn’t make the hedge any more profitable than it would be for a financial speculator. In every state of the world, the value of the hedge and the value of the business of running the airline are separable and are simply added together to get the value of the composite portfolio.

        As for liquidity impacts, those only matter if the firm is cash constrained or near bankruptcy, neither of which has been true for Southwest for a long time. (Furthermore, if maintaining liquidity were the primary objective, it is not apparent that a hedge on fuel prices would be the optimal way to do it, although it could be depending on the specifics of the situation. Hedges also consume cash upfront and sometimes in different states of the world.)

  7. Corey says:

    Tim: if SWA had a way to procure Kit Kat chocolate candy at 50% of the acquisition cost of other airlines and sold it on their flights at the same price as their competition, would they have a competitive advantage in flying airplanes?

  8. Tim says:

    They sure would – those airlines with the leamest cost structure are strongest and most likely to prevail in the long term in this very competitive industry. For starters, a lower cost structure lends to support a company in building its cash on hand and thus puts it in a better place to fund capital investment. Do you agree with that view?

    Question back to you – if you were running a company and had an opportunity to achieve a lower cost structure for the benefit of your long-term viability would you not have a go at it?

    • stevepostrel says:

      You keep assuming what you are trying to prove (i.e. begging the question in the classic sense). It is FALSE that hedging produces a leaner cost structure, as explained exhaustively above. But you seem not to be interested in responding to the specifics of that explanation, so there is little point in continuing.

      • Tim says:

        Your focus on the cost structure alone and ignoring the potential positive impacts of hedging is myopic. A proper analysis requires one to look at “both sides of the coin.” When hedging is done properly (airlines pay experts to make the proper market calls to get this right) it produces a net benefit to a firm’s cash flows and thus adds value to the firm. There’s a body of evidence out there that supports that view.

        Perhaps you can let us all know what you disagree with here?

    • Corey says:

      Yes it is better for a company to have a lower cost structure, which will then have a positive net impact on the firm. However, SWA’s hedging strategy does not yield them a competitive advantage in flying airplanes. This is because, no matter how well they do at hedging fuel prices, they will still have to pay the same price for jet fuel at the pump as all of their competitors.

      Now, unless then build their own refineries and infrastructure to transport jet fuel to all of their hubs and do this in a more efficient and cost effective way than oil companies do, they are no more better off (from a CA viewpoint) than their competitors.

      Your second question is trivial.

      • Tim says:

        Your statement “no matter how well they do at hedging fuel prices, they will still have to pay the same price for jet fuel at the pump as all of their competitors” is simply not true.

        You do understand that a successful hedge has the effect of an airline paying a lower price for fuel than they would have otherwise paid if they were unhedged, right? That leads to a lower cost structure, all other things being equal. A lower cost structure equates to competitive advantage. These points are unassailable.

        ….and my second question wasn’t trivial, in fact it was quite appropriate to address your implication that having lower cost Kit Kats (or, more importantly, fuel) doesn’t give an airline a competitive advantage. Quick reminder that fuel now represents the single biggest operating cost for an airline.

      • stevepostrel says:

        Last try: The price paid for the fuel after the hedge is NOT the actual cost of the fuel. The cost of the fuel is the spot price at the time of the flight. The reasons for this are explained voluminously in the original post.

      • Corey says:

        So you are implying that a hedge fund guy/gal who hedges oil futures all day for living gets cheaper gas at the pump than I do?

  9. Tim says:

    Understood Steve, but it’s the effective cost of the fuel after one factors in the impact of the hedge that matters. Looking at the “actual cost” of the fuel, as you say, doesn’t account for the whole picture. For example, Airline A paid on average an “actual cost” $3.00 per gallon for fuel over the last year, as did Airline B. Airline B was unhedged. Airline A was hedged, and the hedge had the impact of the airline getting a $1.00 per gallon net benefit, after taking into account hedging costs. The net result is that Airline A’s effective cost of fuel was $2.00 per gallon. That benefit shows up directly in the airline’s operating cash flow. In other words, the money that the airline makes with a successful hedge can’t simply be ignored – it very much impacts the airlines competitive disposition.

    All other things being equal, which airline would you have rather held stock in at the beginning of the year?

  10. Tim says:

    Corey – have a look at my Airline A/Airline B example above and please get back to me….

    • Corey says:

      Tim – the subtlety in your example lies in the fact that the the income from hedging doesn’t necessarily apply to just the cost of fuel. Let’s say that Airline A made $100 MM in the year from its hedging strategy. That $100 MM goes straight to their bottom line and not to offsetting their spot fuel prices (unless they have some kind of weird setup that I am unaware of). It is just another source of income for them. As such, they gain no competitive advantage in flying airplanes. What they get is another source of revenue (that, yes, they can use that money to price tickets lower; but they were not able to create more value or reduce the cost of flying the airplane). If that is the case, they should just create another business solely dedicated to hedging or selling Kit Kats, or whatever else they want to do.

      The only way the SWA would have a CA over its rivals is if they literally pay less at the pump than others due to some contractual agreement with a fuel provider (giving them a cost advantage), which is not what they are doing with their hedging operations.

      • Tim says:

        Money is fungible, so having another income stream of $100MM relative to the competition is no different than paying less at the pump by the same amount. Both impact the bottom line and result in competitive advantage.

        I’m curious – what do you do for a living? Me – I’m a senior manager for a major international oil company, selling jet fuel to commercial airlines and the military.

        And you never answered my question from above – in the example, would you have rather been a shareholder of Airline A or B?

      • stevepostrel says:

        It is indeed always better to own a company that successfully speculates in addition to its operating business–you own two separate profit centers. But it would be equally good to own two separate businesses, one that successfully speculates and one that runs an airline business.

        The point is that putting them together does nothing to improve either one for a company in the condition of Southwest Airlines. The hedging, if successful speculation, makes money but does not make SWA more competitive because it doesn’t lower their operating costs. If SWA successfully speculated in licorice futures it would have the same implications as fuel speculation–it just creates another pool of profit unrelated to the efficiency of the operating business.

      • Corey says:

        Tim – I would rather be a shareholder of a company that makes the most profit, and that does not necessarily mean the firm that is hedging. I’m an entrepreneur in the tech space and I don’t think our profession has any bearing on the context of this conversation.

        I believe that your definition of CA is differnent than normal conventions used, thus the back and forth banter. There really is no more to say on this topic than we already have here. Good luck!

  11. Tim says:

    If the hedging makes money for SWA, then that lends support to their ability to offer the same value of service to their customers (relative to their competitors) at a lower ticket price…..and/or the cumulative proceeds from hedging may enable them to finance capital investment cheaper than their competitors. Both of these things fall in the realm of competitive advantage.

    Then again, I suppose we have to back up to what the definition of “competitive advantage” is. Yours seems to be different than mine, whereby you hold that competitive advantage is simply driven by the revenues and costs associated with flying planes and excludes any “ancillary” benefits of fuel hedging, licorice speculation or nail salon operations. Please correct me if I’m wrong on my interpretation of your definition of competitive advantage.

    I hold the view that money is fungible, and any proceeds realized from the ancillary items above can be applied to the airline’s overall cost structure, and to the extent that the cost structure is lower than its competitors then the airline has a very real competitive advantage. The key is sustainability and scale of income generated from the ancillary items.

    A question for you: I believe that in your article you had made an allowance for the fact that hedging may reduce the risk of bankruptcy. I can therefore conclude that you recognize that there is a potential cash flow benefit associated with hedging (said cash flow can stave off bankruptcy, right?). Cash flow drives stock price, whether or not a firm is teetering on bankruptcy, so how do you conclude that hedging conveys little or no benefit to the owners of a firm?

  12. Tim says:

    Note that my previous post was in response to Steve….but feel free to reply Corey, and best of luck to you too! I enjoy the discussion!

    • stevepostrel says:

      Corey below in the thread cited the definition of CA that I employ–what normal people call superior value creation and I call superior surplus creation (in the transaction under study). There’s no point in even having a CA concept if it is just a redefinition of “more profit.” Then CA just become a slightly pompous way of saying “firms that make more profits make more profits.”

      So a company that does many profitable things in different markets is more profitable than a company that only does one profitable thing in one market. But CA must be a) defined one market at a time (actually even more narrowly, but let’s let that slide here) and b) in terms of something other than profit itself.

      Even ignoring my definition of CA, though, just using the common economic concept of cost it still is true that SW”s fuel hedges don’t lower its costs.

      As for bankruptcy, yes, cash flow in bad states of the world adds value to the equity holders if they are near bankruptcy. If those bad states are especially likely to be correlated with high fuel prices then a long position in fuel might be a good idea.(During the 1982 recession, airlines needed cash but fuel prices were low, so it’s not a no-brainer.) You’d have to look at all the other cash management options available, though.

  13. Tim says:

    One more thing Corey – in my Airline A/B example, all other things are equal, so Airline A made the most profit due to their lower effective fuel cost, which was driven by successful hedging. That should help inform your answer….c’mon, is it too hard to say “Airline A”?

  14. Corey says:

    Competitive advantage is the ability of a firm to profitably create more surplus than its rivals. By surplus I mean the difference between value created and the cost associated with creating such value (can be thought of as a given consumer’s maximum willingness to pay). Pricing has nothing to do with a firm’s CA position (which can be demonstrated mathematically). Cheers!

  15. Rovert says:

    Steve you keep making the point that the results of fuel hedging are equivalent to an independent line of business such as making kitkats or speculating in liquorice futures.
    The thing is, fuel hedging is NOT an independent business – the success or failure of that hedging activity is *directly* related to an operating cost of the business (the cost of fuel).

    Trading liquorice futures is indeed an independent activity which I’m sure shareholders would question.

    • Corey says:

      Rovert – whether SWA successfully (or unsuccessfully, for that matter) hedges oil futures, has no impact on the price they pay for jet fuel before a flight. That price is the same price that all of SWA’s competitors pay, hence no cost advantage.

      Their oil hedging business is completely independent. Just because fuel (really oil) hedging and fuel cost share a common word, does not mean that the hedging activity is related to the cost of jet fuel under OpEx. This whole thread and post is not about accounting practices; it’s about the concept of CA.

    • stevepostrel says:

      I’m not sure if the following will clarify given that the post and all the upthread comments didn’t, but:

      There is sometimes a semantic confusion about “costs.” Costs are only defined relative to a decision. “The cost of x” means “what I give up if I do x instead of some implicit alternative to x.”

      For SWA, “the fuel cost of operating its flights instead of not operating them” is the spot price of fuel, regardless of whether it has fuel in inventory, regardless of whether it made a bet on fuel prices that paid off before the flight, and regardless of whether it had any other outside infusion of cash from any source.

      Giving the airline business a “sugar daddy” that could pay its fuel costs of flying doesn’t lower those costs. It wouldn’t matter if the sugar daddy were a fuel hedge, a gold-mining strike, or a donation from George Soros–SWA would still be giving up the spot price of fuel when it launched its jets. And the existence of the sugar daddy shouldn’t change decisions about how many flights to schedule–it wouldn’t make an unprofitable-at-the-spot-price flight turn profitable.

      The only time the sugar daddy might matter to the decisions of the equity holders is if the firm would otherwise lack liquidity to make debt payments. In that case the sugar daddy might enable them to run profitable flights that would otherwise be stopped by the debt holders’ asset seizures.

  16. Tim says:

    Steve – your position is inconsistent in that you acknowledge the fungibility of money in recognizing the benefit provided by a successful hedge for a near-bankrupt airline, but you don’t give the same recognition in the case of Southwest. You can’t have it both ways, as they say.

    Airlines recognize that hedging can strengthen their overall financial disposition, given the very basic concept of the fungibility of money. Hedging provides a competitive advantage to those who are consistently best at it.

    • stevepostrel says:

      The fungibility of cash–not value–is relevant only when cash is a constraint.

      For firms that are not liquidity constrained, external sources of cash add nothing to the value of their equity. They do not change anything about the profitability of the operating business.Thus there is no inconsistency. Iron supplements may be valuable to someone with anemia, but just giving random people iron doesn’t make them healthier.

      • Tim says:

        “external sources of cash add nothing to the value of their equity”…..really? That’s news to me and anyone else who understands stock price valuation. I suppose there’s no inconsistency, as long as you believe what you wrote. I suspect we’ll agree to disagree.

      • stevepostrel says:

        Now you’re just trolling. Obviously, I mean the value of the equity in the operating business. The value of the combined business is just the sum of the values of the equity in the two separate businesses.

        I suggest you look up the Modigliani-Miller theorem.

  17. Rovert says:

    What if SWA entered into an arrangement whereby the counterparty with whom they hedged actually delivered the physical fuel at the price agreed to at the inception of the hedge?

    Or even… what if SWA took out a futures contract on pork bellies but their counterparty actually delivered the physical fuel at a price adjusted for SWA’s profit or loss on the pork bellies futures?

    • stevepostrel says:

      Already answered. The penultimate paragraph of the original post answers your first hypothetical and the “sugar daddy” comment above answers your second one.

  18. Tim says:

    Steve – can you kindly point out which of SWA’s outstanding shares are allocated to the “operating business” as opposed to the hedging activity?

  19. Tim says:

    I still hold the view that incremental positive cash flow that is rightly deemed beneficial to a company on the verge of bankruptcy (as you also state) is also beneficial to the likes of SWA. That is a consistent position and is analogous not to your iron supplement example but to a human’s need to breathe air – which applies equally to both the sick and the healthy.

  20. I agree that hedging does not produce competitive advantage; others can replicate the hedging strategy. However, if one applies Barney’s VRIO test, it appears to result in competitive parity (Valuable, but nor Rare).

    More important, it seems to me, is that a firm known for prudent hedging, as Southwest is, reduces the company-specific component of its risk profile. Reducing risk increases value.

    With respect, Steve, the argument about diversified portfolios holds little water where investors such as corporations or owners of SMEs are concerned. As you know, the assumption of full diversification is one of the cornerstone assumptions of modern portfolio theory. MPT did no one any favors with that assumption. Among other negative fallout, it largely eliminated research streams related to unsystematic risk, which, according to MPT, can be eliminated through diversification.

    However, an investor that does not–and cannot–hold a diversified portfolio gets clobbered by the diversification assumption. In my line of work, analyzing and valuing non-public companies, unsystematic risk is the beginning, the middle, and the end of the story. In our typical engagement, I spend over 2/3 of my time researching, analyzing, quantifying, and explaining unsystematic risk. In fact, to paraphrase the late legendary coach, Vince Lombardi, to the typical owner of an SME, “Unsystematic risk isn’t everything. It’s the only thing.”

    To be sure, a stream of research beginning with Rumelt’s 1991 SMJ paper shows clearly that, on average, variation in rates of return from sources inside a company are about three times as strong as variation from external sources. That is useful to know. However, having specifics on the precise sources of variation inside a company would be far more helpful to practicing managers, but MPT’s nonsensical assumption threw up a roadblock to pursuing that.

    Datasets from Morningstar and from the Center for Research in Securities Prices do enable the computation of risk premiums arising from a company’s size. Morningstar measures size in terms of market cap of equity only, while CRSP measures size eight different ways: (1) market cap of equity, (2) market value of invested capital, (3) sales, (4) five-year average net income, (5) five-year average EBITDA, (6) total assets, (7) book value of equity, and (8) headcount. Morningstar also computes industry risk premiums (appropriate-sounding acronym: IRPs) at the two-, three-. and four-digit SIC code levels (no NAICS codes yet). However, its method for calculating industry risk of divisions within diversified companies is revenue-driven; that introduces a pronounced bias that underestimates such risk. Because risk and valuation are negatively correlated, understating risk will overstate the market value of equity. That is why we don’t use Morningstar’s IRPs data.

    Still and all, yours is a great post that has created a great thread. Thank you for posting this.

    • stevepostrel says:

      Thanks, Warren. The main point of the post is really about understanding cost and cost advantage. So I’m glad the thread may have contributed there.

      On your other point:
      Unsystematic risk of course is a big deal for private companies or for firms operating in countries where equity markets are hard to access. I’m sure the Mars brothers worry about the variance (and even the seasonality) of their earnings and cash flows. Perhaps they do a lot of hedging on cocoa prices and no one could not object to that a priori.

      In writing about a publicly traded company widely held in the United States, the MPT assumption about diversification seems like the natural one. That’s why SWA makes such a nice, clean example.

      Discussion question for some other thread:
      Inasmuch as trading off expected real output to achieve a lower variance in payments necessarily reduces the overall standard of living, is the separation of financial from operating decisions the primary economic advantage of well-functioning public equity markets?

  21. CJ says:

    Am a bit late to the party on this but am quite intrigued by the discussion. Was wondering if we can concede that hedging provides no competitive advantage, then we must also concede that the management team at SWA must have been the most inept management team of any airline? Who would price tickets far below the cost of operating the flight…seems crazy to me. Nonsense to be sure.

    Whilst I grasp the notion that hedging does not impact the actual cost of the flight, it does have a very real impact on the corporate strategy of the company, and hence it’s competitive advantage over rivals (again, unless we concede that management is crazy…who let’s bags fly for free?!?!?). Without their hedging strategy in place, SWA doesn’t acquire AirTran and isn’t able to start switching strategy after the financial collapse to gain business travelers by capturing VRIN resources (gates at East coast terminals and in Atlanta–major business hub).

    Further, would it not be safe to say that SWAs Treasury Department is a source of competitive advantage? These folks obviously have systems for hedging fuel which put professional speculators to shame. Does this not give SWA a competitive advantage when it comes to resource procurement? Remember that indeed the hedges are placed well in advance of the actual use date for the fuel. Further, this also gives SWA an advantage in that it has certainty of its operating costs, which other operators do not have–allowing it to change flight routes and offerings that other companies may not (which also alters cost structure).

    Last comment–MPT also suggests that transactions for individual investors are frictionless (i.e. no transaction costs). Given that SWA conducts massive transactions, they also reap the benefits of scale economies in transaction costs (of which regular folk like us don’t get). How does this change the notion that the individual investor is better off trading in complex derivative products like oil, gas, and (from above) yummy Kit Kat chocolate?

    Thanks, love the blog and would like to get your all’s thoughts.

    • stevepostrel says:

      You have a bunch of different claims sprinkled in here, a number of which were addressed earlier in the thread.

      As for SWA’s competence–there isn’t evidence that they actually underpriced their flights relative to spot fuel prices or that their fares were lower than rivals’ in years where their fuel hedges paid off. All we know is that they had years where they made a lot of money on fuel hedges and years where they lost money. So they may have been simply smoothing earnings without changing any operating decisions–perhaps a venial sin for a publicly traded U.S. corporation.

      In terms of corporate strategy versus business strategy, I see little evidence of synergies between the fuel-speculation and airline businesses. Assuming the AirTrans acquisition was a good idea, I also don’t see what the fuel hedges have to do with it–they could have made the acquisition absent the hedges or even if they happened to have guessed wrong on the hedges that year. It’s not like the company was locked out of the capital markets.

      The SWA Treasury department might be a profit center, but it wouldn’t add to the competitive advantage of the airline business as defined and explained above. It neither raises the value of the product to the user nor does it lower the cost of providing the product (again, exhaustively explained above). And if they were good at speculating in things other than fuel they would equally be a profit center and valuable for that reason, but not a source of competitive advantage in the airline business.

      The hedges do not provide cost certainty, if costs are defined as the difference between what you pay if you do versus if you do not do something. The hedges may promote earnings certainty.s

      SWA can certainly do fuel speculation at lower transaction costs than individual investors. But those investors can simply own stock in oil companies to get most of the same effect. And of course individuals can invest in mutual funds of all kinds and participate in a vast range of speculative and hedging activities on a shared, collective basis just as SWA’s public shareholders do through SWA’s treasury department.

      • CJ says:

        Hi Steve, thanks for the reply. Would disagree with a few of your comments and would love to get your thoughts. Seems pretty well documented that SWA came to be known as the low cost carrier because they were able to keep costs down while other airlines had to raise prices due to higher fuel costs. Sure there were some additional cost savings as a result of operating a single type of plane, no frill beverages/snacks, etc. However, you will notice that in years where SWA ‘guessed’ wrong on fuel prices, ticket prices did increase–a simple survey of the financials show this. Another small disagreement with something you had said–fuel hedges absolutely provide certainty. Would love to know a bit more on why you think they don’t give you certainty on the hedged portion of the fuel. Seems to me if I have a call with a strike price of $100 on 30% of my expected fuel usage I know for that 30% the highest price I will pay for my fuel. Seems like pretty valuable information. Last point, again Modigliani and Miller assume that risk management using hedges is inefficient because of frictionless market transactions and perfect information for individual investors. We know with certainty that these assumptions do not hold. Thus your last point is still invalid. To assume that just owning oil company stocks to get the same effect is a horrible idea–not only are you getting the effect of the underlying price fluctuations in oil but now you are also getting company specific effects (which now requires you to expand your portfolio even further to diversify these risks…which increases your transaction costs). Further, these transactions (even mutual funds) carry all kinds of costs for individual investors. Finally, investors do not have access to the kind of information needed to make informed decisions about complex ‘speculative and hedging activities’ whether on a shared basis or not. So would still stand by my original statement. Hedging does provide value to shareholders.

        Oh, and would concede that hedging does not impact the competitive advantage of the ‘airline business.’ However, in the real world companies do not operate a series of single businesses with the intent on not sharing synergies across businesses. Would definitely argue that having competencies in fuel hedging (or a fuel hedging business) would be considered related diversification across most business circles. Thanks and certainly enjoy the blog.

      • CJ says:

        One last comment–there is a great paper by Fatemi and Luft (2002) in the Global Finance Journal. Check out section 7 of the paper–seems to have implications for providing value to consumers (increasing debt capacity can allow firm to make strategic investments that provide customer value).

  22. stevepostrel says:

    I should be happy that we agree that the fuel hedges don’t provide competitive advantage in the airline business and just let it go, but earlier you said that SWA’s famous low-cost position came from the fuel hedges, so apparently we don’t agree. Actually, my impression is that SWA didn’t get involved with the hedges until well after the heyday of its cost advantage. By 2005 or so, SWA was no longer the clear cost leader as a victim of its own continuous success (I.e. non-bankruptcy) leading to the highest pilot salaries in the industry, for example. I’m nearly certain that the “famous” era of SWA low-cost advantage from 1978-2000 had nothing to do with financial speculation but rather came from a combination of integrated practices and route structure that enabled them to get the highest load factors, highest time-in-the-air proportion for planes, highest on-time performance, highest labor productivity, etc.

    As for any correlation between SWA’s ticket prices and fuel hedge failures, it would be entirely compatible with the hypothesis that the same illusion that motivated the hedges distorted pricing decisions, but I am skeptical about your claim in any case without a full study of rivals’ prices over time, assessment of how many data points we’re even talking about, etc.

    The hedges don’t provide cost certainty for the same reason that they don’t provide advantage, as I have stated repeatedly: They don’t affect real costs at all, since the opportunity cost of the fuel for a flight is the spot price rather than the hedge price. The hedges smooth airline cash flow between the states of the world with high and low fuel prices, but cash flow is not cost reduction and, while useful in scenarios where liquidity is at issue, it’s hard to see why SWA would have had extraordinary liquidity issues over this period.

    M-M is an idealization, of course. The question is whether in this case the more realistic assumption changes anything. I find it hard to believe that as a general rule non-financial companies should open up speculation subsidiaries in order to provide investors with lower transaction costs in speculation. The argument would prove too much. If anything it seems like activist investors are in the mood to split up diversified companies into focused parts, although this too could just be a fad. The long-time wisdom in the empirical corporate finance literature has been that unrelated diversification is bad on average (“the diversification discount”) although more recent findings have put out important caveats.

    Even related diversification, though, is not going to automatically generate real synergies. Otherwise all firms would be vertically integrated from end user to raw materials. Real synergies involve coordination of activities and specialized idiosyncratic investments across business units, and even when these are possible joint ownership may not be necessary to achieve them as contracts, JVs, alliances, etc. may suffice.

  23. CJ says:

    Thanks again for the reply Steve. Would disagree with what you said in your very first paragraph. SWA up until very recently, has been considered the low cost air carrier. Traces of a fuel hedging strategy can be found all the way back to the early 90s so I am not entirely convinced that fuel hedging was not at least a component of any cost advantages. Also would disagree that a hedge doesn’t provide certainty to the company. Hedges by definition give companies a worst-case scenario price. To me, this represents a significantly valuable piece of information. As for your argument about opportunity cost and spot prices, this doesn’t seem to make much practical sense–some airlines enter into swaps and other hedging contracts directly with refiners. When two parties make a contractual agreement, the spot price is of absolutely no relevance since I have already purchased the fuel being used, regardless of what the spot price might be. For example, if you and I agree today that in one month I will give you $20 for 100 widgets, it makes no difference what the price of widgets is in one month. My strategic plans are already based upon my known cost for the widgets and my costs reflect this. In some cases where there is a settling up (an intermediary brokering the hedge), perhaps this whole notion of opportunity cost plays a role?

    Of course M-M is an idealization, that does not change the fact that my argument is indeed true. Regardless of what you might find ‘hard to believe,’ this can’t really be debated. There are very real tax consequences, transaction costs, and capitalization ramifications.

    Your point about companies opening up speculation subsidiaries is a bit interesting because it is not pure speculation…it is purchasing insurance–there is a difference here. Further, again, SWA has competencies and advantages in purchasing insurance/hedging. Thus, investors should want the firm to do these things when the firm can do them better/cheaper (as is the case with SWA since we have established that there are real market frictions that make it expensive for individual investors).

    Totally agree that diversification does not automatically generate synergies. Although, if we acknowledge that ‘real synergies’ involve coordination and specialized idiosyncratic investments across units, isn’t that what SWA is doing? From everything I have read about their hedging operation, the hedging folks are actively involved in providing input to management and have been given the resources to carry out their hedging strategies.

    Interesting to note, if there are no synergies and no company specific relationships/competencies/knowledge etc., why hasn’t a big investment bank/hedge fund poached this group of hedgers? They apparently are better at predicting markets than these firms. All of the investment companies should be falling over these folks and throwing hundreds of millions of dollars at them…interesting that by and large this group is still intact. Does not mean that there is something company related here but would seem to suggest so.

  24. stevepostrel says:

    You’ve misread my first paragraph, which said that SWA WAS the low-cost airline from 1970-2000 but that this status had nothing to do with fuel hedges. And since even you find only “traces” of the hedge behavior back in the 1990s (after their advantage existed) I’m happy to stand with that causal assessment, which agrees with every one of the many analyses of SWA’s cost advantage that I’ve ever read.

    This discussion on opportunity cost is regressing. You are re-litigating points already nailed down earlier in the thread; the responses to what you suggest about cost certainty have already been made to other commenters who tried to argue the same thing. At this point, responding would just be making the rubble bounce. The fact that you can always transact on the spot market means that any “cheap” fuel you own (as a result of clever hedges or just having forgotten about some drums in the back of the warehouse) still costs the spot price when it is burnt.

    The issue with departures from M-M is purely a quantitative matter–how big are these transaction cost differences, and is owning SWA stock a good way to engage in fuel speculation? (Note that you are contradicting your other argument about getting cost advantage or cost certainty, since if SWA were really providing itself cost certainty with its hedges then owning its stock would be a poor way to speculate on fuel, since any gains would be neutralized by their airline business.) If SWA wants to set up a profit-center trading subsidiary run out of its treasury department and let people buy stock in that, it might make sense if they showed some consistent advantage in that market. It just would have no synergy with the airline business, which was my point.

    As to why the SWA folks haven’t been poached, there could be many reasons. My best guess is that their performance on these hedges over time isn’t impressive enough to be distinguishable from luck. Or that scaling up their trades to hedge-fund scale would move prices and destroy their ability to profit. You should ask somebody from finance-world about that question.

  25. CJ says:

    Hi Steve, great reply as always! While we won’t see eye to eye on some of these things (I think there are academic vs. practical gulfs that divide us), for the most part I think your viewpoint is interesting. Best of luck with your academic research!

  26. Deepak says:

    Interesting thread. I think Steve’s original post presents a correct analysis but rests on the the assumption (widely adopted, originating in finance) that the goal of the firm is to maximize shareholder returns. Additionally, the analysis does rest on the ability of shareholders to diversify (or take) risk on their own. Under these assumptions, Southwest’s hedging is possibly irrational, and at best represents some kind of related diversification.

    If instead we take the view that managers may seek to (should?) maximize the long run value of the firm while “satisficing” various stakeholders, including shareholders, an alternative more rational narrative may be devised. Two factors are important here – (1) oil prices tend to move sharply because short run demand tends to be inelastic, and (2) fuel is a large cost of operating an airline. Thus, sharp changes in oil prices are both a very real risk and have a significant impact on the bottom-line of an airline. Southwest management may believe that there is value to “income smoothing” by hedging – it reduces the likelihood of pressure from shareholders and preserves freedom of action in operations, which in turn allows the firm to persist with its unique constellation of business practices that are critical for its long run competitive advantage.

  27. stevepostrel says:

    Deepak, you’ve smuggled in a contestable assumption yourself–that there is a consistent difference between the stock price and the long-term value of the firm and that the managers know and care about the difference. But I doubt that American, which doesn’t hedge, has a wildly different shareholder/manager relationship than Southwest, which does hedge.

    BTW I recently saw some interesting empirical research presented that indicates that the fuel hedges actually affect airlines’ price and volume behavior, suggesting that any optical illusions that might exist actually carry over to operational decisions.

  28. You’re entitled to your opinion, of course, Shan. But what you wrote reflects a fundamental misunderstanding of what Southwest Airlines did: It reduced the risk of a major component of its cost structure by using opions to lock in a fixed jet-fuel price for the duration of its hedge.

    That is completely different from what you, as an individual trader, are doing with your options broker. You are speculating. Southwest was not. You’re comparing apples and oranges.

  29. Tracy says:

    I take issue with this section….

    This discussion on opportunity cost is regressing. You are re-litigating points already nailed down earlier in the thread; the responses to what you suggest about cost certainty have already been made to other commenters who tried to argue the same thing. At this point, responding would just be making the rubble bounce. The fact that you can always transact on the spot market means that any “cheap” fuel you own (as a result of clever hedges or just having forgotten about some drums in the back of the warehouse) still costs the spot price when it is burnt.

    … if I have bought the right to buy oil/jet fuel at say, $45, and the spot price is $100, I GET TO BUY the oil/jet fuel at $45. This it costs be $45 and not $100. Physical vs financial settlement of options……

    When did insurance policies become solely vehicles for speculation?

  30. abd says:

    why the inventory cost not taken into consideration, by the way, the oil storage is costly as safety is so important and risk of damage is so high, I think that should be part of your equation the cost of managing a hedge portfolio shall be cheaper than to keep a stock of a whole year in addition to if prices fall the airline company can not go for the hedge price so it make sense.

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