Fuel Hedging is a contractual tool some large fuel consuming companies, such as airlines, use to reduce their exposure to volatile and potentially rising fuel costs. A fuel hedge

Hedge (finance)

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

 contract allows a large fuel consuming company to establish a fixed or capped cost, via a commodity swap or option. Large fuel consuming companies enter into hedging contracts to mitigate their exposure to future fuel prices that may be higher than current prices and/or to establish a known fuel cost for budgeting purposes. If a large fuel consuming company buys a fuel swap and the price of fuel declines, the company will effectively be forced to pay an above-market rate for fuel. If a large fuel consuming company buys a fuel call option

Call option

A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...

 and the price of fuel increases, the company will receive a return on the option that offsets their actual cost of fuel. If a large fuel consuming company buys a fuel call option, which requires an upfront premium cost, much like insurance, and the price of fuel decreases, the company will not receive a return on the option but they will benefit from buying fuel at the then lower cost.

Background

The cost of fuel hedging depends on the predicted future price of fuel. Airlines may place hedges either based on future prices of jet fuel or on future prices of crude oil. Because crude oil is the source of jet fuel, the prices of crude oil and jet fuel are normally correlated. However, other factors, such as difficulties regarding refinery

Oil refinery

An oil refinery or petroleum refinery is an industrial process plant where crude oil is processed and refined into more useful petroleum products, such as gasoline, diesel fuel, asphalt base, heating oil, kerosene, and liquefied petroleum gas...

 capacity, may cause unusual divergence in the trends of crude oil and jet fuel.

A company that does not hedge its fuel costs generally believes one, if not both, of the following:
1. The company has the ability to pass on any and all increases in fuel prices to their customers, without a negative impact on their profit margins.
2. The company is confident that fuel prices are going to fall and is comfortable paying a higher price for fuel if, in fact, their analysis proves to be incorrect.
Typically, airlines will hedge only a certain portion of their fuel requirements for a certain period. Often, contracts for portions of an airline's jet fuel needs will overlap, with different levels of hedging expiring over time.

During the 2009-2010 period, the studies for the airline industry have shown the average hedging ratio to be 64%. Especially during the peak stress periods, the ratio tends to increase.

Southwest Airlines

Southwest Airlines

Southwest Airlines Co. is an American low-cost airline based in Dallas, Texas. Southwest is the largest airline in the United States, based upon domestic passengers carried,...

 has tended to hedge a greater portion of its fuel needs than other major U.S. domestic carriers. Southwest's aggressive fuel hedging has helped the airline avoid some of the pain of the recent airline industry downturn resulting from high fuel costs. Between 1999 and 2008, Southwest saved approximately $3.5 billion through fuel hedging.