Falling Crude: A Double-Edged Sword for Southwest Airlines
Southwest Airlines Is Flying High after 1Q16 Results
Fuel hedging
Airlines generally use hedging as a tool to protect against unexpected fuel price fluctuations. The recent fall in fuel prices was very sharp, and many airlines suffered huge hedging losses.
Hedging losses
Most airlines have reduced their hedging for 2016, given the declining oil price environment. Delta Air Lines (DAL) is now only 5% hedged compared to 17% in 2015. American Airlines (AAL) continues its completely unhedged strategy.
Southwest Airlines (LUV) first unhedged its 2015 fuel consumption but later added some new positions in the second half of the year. This resulted in further losses after the recent price slip.
Outlook
Despite these losses, fuel costs are expected to fall from $2 per gallon in 2015 to $1.70–$1.75 per gallon in 2016 due to a continuing decline in crude oil prices. Due to its hedged position, LUV will lose out on taking complete advantage of falling crude oil prices.
This is, however, higher than its peers. Unlike other players, LUV has hedged fuel for 2016 and 2017, incurring an expected $1 billion liability in 2016 alone. For 2017 and 2018, LUV will shell out another $787 million in hedge losses.
Of course, the story will be different if crude oil prices rise. In that case, LUV stands to gain. In fact, it’s probably only a matter of time before fuel prices rebound. LUV stated that it will pull down hedges going forward.
However, if its timing of pulling down hedges is incorrect (that is, it coincides with a fuel price rally), LUV will again end up paying heavily.
LUV forms ~5% of the holdings of the PowerShares Dynamic Leisure & Entertainment ETF (PEJ). PEJ invests 5% each in DAL, AAL, and United Continental (UAL).
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