HOW SOUTHWEST AIRLINES
ADDRESS THE PRICE UNCERTAINTY
ON JET FUEL
Irving Rivera
802-03-6561
Wilfredo Robles
802-02-6129
IN...
Agenda






Introduction
Glossary
Key Concepts
Methodology
Strategies
Conclusions and Recommendations
Introduction


The main objective of this paper is to introduce and
ponder a few techniques that airlines like southwe...
Glossary



Price Uncertainty
 the chance or speculation that
the price of an asset will
change.
Hedging
 is any s...
Southwest



Southwest Airlines is the largest domestic carrier.
The marketing strategy of the company is to have the...
Price Uncertainty on Oil
Explain as the changes between the Spot prices and the Futures
prices paid for contracts promisin...
Hedging
Hedging is any strategy designed to offset or reduce the risk of
price fluctuations for an asset or investment. He...
Methodology
1) Chose the topic
 Price Uncertainty
2) Search the data base of the university looking for
papers on price u...
Methodology cont.
3) Analyze the selected papers; we will mainly use
papers as reference of our study
 David A. Carter et...
Strategies
I. Do nothing.
 Here they take what the market gives them; if oil
goes up the hike prices and cut cost and if ...
Strategies cont.
II. Hedge using a plain vanilla jet fuel or heating oil
swap.
 An example of this is when the a refiner ...
Strategies cont.
III. Hedging using options
 What they do is they buy the jet fuel and married with
a put. They also buy ...
Strategies cont.
IV. Hedge using a zero-cost collar strategy.

Zero-cost collar is
established by buying
a protective pu...
Strategies cont.
Pros
High flexibility
Upside price protection and firm still benefits from
declining prices until the pu...
Strategies cont.
V. Hedge using a crude oil or heating oil futures
contract.
 Airline use this deal to create a positive ...
Conclusions and Recommendations




The price paid for jet fuel can significantly impact
earnings and the ability ...
Conclusions and Recommendations

Volatility future research may consider
 How long the contract agreement should be val...
References






Carter, David A., Simkins, Betty J., Rogers, Daniel A., Treanord, Stephen D., 2007.
Southwest...
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Price Uncertainty on Jet Fuel

HOW SOUTHWEST AIRLINES ADDRESS THE PRICE UNCERTAINTY ON JET FUEL This paper we will explain the uncertainty on oil prices and what causes its volatility and how Southwest address this risk utilizing different hedging strategies like buy and sell future contracts and or options.
Published on: Mar 4, 2016
Published in: Business      Economy & Finance      
Source: www.slideshare.net


Transcripts - Price Uncertainty on Jet Fuel

  • 1. HOW SOUTHWEST AIRLINES ADDRESS THE PRICE UNCERTAINTY ON JET FUEL Irving Rivera 802-03-6561 Wilfredo Robles 802-02-6129 ININ 6030 Advanced Engineering Economics Mayra Mendez PhD
  • 2. Agenda       Introduction Glossary Key Concepts Methodology Strategies Conclusions and Recommendations
  • 3. Introduction   The main objective of this paper is to introduce and ponder a few techniques that airlines like southwest use to deal with the price uncertainty of jet fuel. In this paper we will explain the uncertainty on oil prices and what causes its volatility and how Southwest address this risk utilizing different hedging strategies like buy and sell future contracts and or options.
  • 4. Glossary    Price Uncertainty  the chance or speculation that the price of an asset will change. Hedging  is any strategy designed to offset or reduce the risk of price fluctuations for an asset or investment. An option  is a financial derivative that represents a contract sold by one party (option writer) to another party (option holder).    Futures contract  consist out of an agreement that upon expiration you will get delivery of the hard asset. Spot prices  the prices paid for oil here and now. Futures prices  prices paid for contracts promising the delivery of oil at a future date.
  • 5. Southwest    Southwest Airlines is the largest domestic carrier. The marketing strategy of the company is to have the lowest possible fare price. Jet fuel is the second largest operating expense for airlines, after labor cost.  Southwest maintained low operating expenses, primarily through it’s extensive fuel hedging strategy.
  • 6. Price Uncertainty on Oil Explain as the changes between the Spot prices and the Futures prices paid for contracts promising the delivery of oil at a future date. These prices are benchmark by West Texas Intermediate, Dubai or OPEC.  Causes  Demand  Weather  Speculation  Dollar Value  Production Cuts  Geopolitical Events  Transportation Bottlenecks  Effects  Economic Activity  Investment  Consumption  Unemployment  Raise the Good and Service Prices  Transportation Cost  Profit Margins
  • 7. Hedging Hedging is any strategy designed to offset or reduce the risk of price fluctuations for an asset or investment. Hedge requires the purchase of a second asset with a negative correlation to the first.  Key aspects  Hedging is used to reduce risk.  Hedging is not about making a profit, but about removing uncertainty by minimizing loses.  Hedging can be profitable when is used sparingly and effectively.  Benefits  Minimizes price risk.  Improves firm value.  Reduce risk of financial distress.  Reduce the firm’s cost of capital.  Manages the volatility of earnings.  Increase ability to make profitable investment opportunities.
  • 8. Methodology 1) Chose the topic  Price Uncertainty 2) Search the data base of the university looking for papers on price uncertainty in the oil market.  Proquest  Science Direct  The format use for this work is the same use as the International Journal of Production Economics.
  • 9. Methodology cont. 3) Analyze the selected papers; we will mainly use papers as reference of our study  David A. Carter et.al, (2007), Southwest Airlines Jet Fuel Hedging-Case Study.  Hui Guo et.al, (2005), Oil Price Volatility and U.S. Macroeconomic Activity, Federal Reserve Bank of St. Louis Review, 87(6) pp. 669-83. 4) At the end we will made conclusions, recommendations and future research consideration.
  • 10. Strategies I. Do nothing.  Here they take what the market gives them; if oil goes up the hike prices and cut cost and if the price goes down the lower the fares. Pros No upfront cash costs. Cons Unlimited market risk.
  • 11. Strategies cont. II. Hedge using a plain vanilla jet fuel or heating oil swap.  An example of this is when the a refiner of jet fuel and the airline make a contract that state; I (the airline) will buy you (the refiner) X amount of fuel, at Y price during, for a Z period of time. Pros Cons Cash flows occur monthly which more Liquidity closely Southwest wants to unwind the position matches of the actual fuel may be a concern if expenditures. early. No upfront cash costs. Limited ability to benefit financially if jet fuel prices decline.
  • 12. Strategies cont. III. Hedging using options  What they do is they buy the jet fuel and married with a put. They also buy a call that give the right to buy the fuel on agree upon price. Pros Cons Greatest flexibility for all alternatives. Basic risk. Upside price protection and firm benefits High upfront cash costs in the from declining prices. form of option premiums.
  • 13. Strategies cont. IV. Hedge using a zero-cost collar strategy.  Zero-cost collar is established by buying a protective put while writing an out-of-themoney covered call with a strike price at which the premium received is equal to the premium of the protective put purchased.
  • 14. Strategies cont. Pros High flexibility Upside price protection and firm still benefits from declining prices until the put strike price is reached. Low or zero upfront cash costs. Cons Basis risk.
  • 15. Strategies cont. V. Hedge using a crude oil or heating oil futures contract.  Airline use this deal to create a positive investment income capital to pay for actual jet fuel this way softening the blow of higher prices. Pros Low upfront Cons cash Basis risk. costs. The firm does not benefit from lower prices. Contracts are marked-to-market daily. Backwardation & Contango.
  • 16. Conclusions and Recommendations     The price paid for jet fuel can significantly impact earnings and the ability of the Southwest to remain competitive with other airlines. Southwest’s policy of providing air travel at the lowest possible fares demands strict cost management, making hedging a must. Hedging reduces the risk associated with price fluctuations. Hedging allows a firm to set a fixed price now for any flying ticket in the future. The zero-cost collar option strategy is the most favorable for the company because it lower cost and well know volatility capping the upside and downside of their risk.
  • 17. Conclusions and Recommendations  Volatility future research may consider  How long the contract agreement should be valid.  Jet fuel oil consumption must be reduce to contribute with the company’s efficiency and environment.  Stochastic Models to determine if the price will decrease or increase.
  • 18. References       Carter, David A., Simkins, Betty J., Rogers, Daniel A., Treanord, Stephen D., 2007. Southwest Airlines Jet Fuel Hedging-Case Study. Guo, Hui, Kliesen, Kevin L., 2005. Oil Price Volatility and U.S. Macroeconomic Activity, Federal Reserve Bank of St. Louis Review, 87(6) pp. 669-83. Hamilton James D. “Historical Causes of Postwar Oil Shocks and Recessions”, The energy Journal, January 1985,6(1).pp.97-116 Shrestha, G.B., Pokharel, B.K., Lie, T.T., Fleten, S.-E., 2007. Management of price uncertainty in short-term generation planning, IET Generation-Transmission & Distribution, doi: 10.1049/iet-gtd:20070177. Stock, James H. and Watson, Mark W. “Forecasting Output and Inflation: The Role of Asset Prices.”Journal of Economic Literature, September 2003,41(3), pp. 788829. Wikinvest, (2009, ) OIL, http://www.wikinvest.com/concept/Oil_Prices. Access November 15, 2009.

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