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.
Barry Lynn, apparently some sort of John Kenneth Galbraith wannabe, has an amusingly cockeyed post over at the Harvard Business Review blog. He seems to think that state regulations protecting local beer distributors from vertically integrated competitors are the font of virtue, preserving needed diversity in the beer market by allowing craft and micro-brewers to get their product delivered. But if the big brewers were legally able (and motivated) to foreclose distribution of the small brands, they would be legally able to do it without vertically integrating into distribution (by requiring exclusivity).
A simpler analysis: When there were many competing major brewers, independent multi-brewer distributors made economic sense, since they eliminated needless duplication of sales and delivery of all those brands to retail establishments. With the consolidation of the beer industry into two giant companies that own all the big brands (and a shift from on-premises to at-home consumption), a single-brewer distribution firm can now internalize almost all those economies. Then the beer industry starts to look a bit more like the soft-drink industry, where two major firms own and develop all the major brands and we don’t blink an eye at their bottler/distributors having exclusive relationships with the upstream brand owners or even being vertically integrated with them. If your local Costco or supermarket won’t carry a micro-brew or an off-brand soda, it’s unlikely to be due to market power on the part of the distributors.
UPDATE: It seems that AB InBev, owner of Budweiser and many other beer brands, is indeed shifting to more of a product innovation strategy and running into distribution problems with these new products:
“That’s not to say that AB InBev has perfected the process. Profit this year was hurt by higher distribution and administration costs in the U.S. as the brewer struggled to keep up with demand for Platinum and Lime-A-Rita, which required extensive — and expensive — countrywide distribution.”
So maybe there are strategic reasons why AB InBev would want more control over its distribution pipeline.
Alvin E. Roth is a Professor of Economics and Business Administration, currently at Harvard and soon at Stanford. He is one of the kindest people I know. As of yesterday, he is a Nobel laureate.
Dr. Roth’s interests include “game theory, experimental economics, and market design” says the Harvard website. But Dr. Roth became famous for putting economic theory to work – in the real world. He has designed and redesigned markets and institutions for better performance. Dr. Roth has changed how doctors and hospitals find each other, how students are assigned to high schools, and how kidney patients are matched with a donor.
Putting theory to work is risky. Most of us, me included, describe reality and hypothesize about causes and effects: what makes people cooperative or why some companies are successful, for example. We find it plenty difficult to convince peers, reviewers and editors of our ideas. Implementation is a whole different realm. We can advise, but usually let others practice: executives, government officials, leaders.
But Dr. Roth is different. Acting as both a scholar and an entrepreneur, he embarked on a difficult and perilous journey to reshape institutions. He had to convince laymen that economic theories are useful. He had to bear the risk of failure for organizational and political reasons. He could have failed even if right. Changing the way students are assigned to schools can disturb powerful education official and supervisors; reallocating kidneys to patients can upset hospitals and doctors.
Somehow, Roth triumphed. In his success, he made markets better and society – more prosperous. He also set a challenge for the rest of us. Coming up with a good idea and convincing your colleagues may be just the beginning of a journey. Putting it to action may be the ultimate goal.
For all of his accomplishments, Al remains friendly, humble and approachable. He seems excited by ideas, not glory. A day after the Nobel committee bestowed his prize, he wrote to me “it’s been a busy day…”. Probably nothing out of the ordinary for him.