An airline executive colleague of ours submitted his resignation the day before his airline reported that its financial results had swung severely down, reversing a previous record of profits and recording a loss described by the trade press as "staggering." The reason for the loss? Fuel hedging. Twelve months ago, when oil was climbing beyond $145 a barrel, and many observers predicted $200 oil by the end of 2008, this airline and others began to hedge their fuel costs against further price increases. Naturally, these contracts were expensive at the time, because no one knew how high oil prices would go, so the financial players selling the options didn't want to lose money any more than the airlines did. But airlines that had successfully hedged in the past were seen as responsibly managing their exposure to commodity price risk.
Fortunately for the world economy, but unfortunately for those airlines cautious enough to have bought the most hedges, oil prices fell dramatically by the end of the year, to around $40 a barrel. This meant that all those option contracts became completely worthless and had to be "marked to market" -- written off as losses directly against net income. And because fuel typically comprises 30%-40% of every airline's operating costs, some of these hedging losses were huge. Southwest Airlines, for instance, recorded its first quarterly loss in 17 years, even though operating earnings improved significantly with higher air fares, and a whole host of other airlines, including United, Singapore, and others, compiled similarly dismal results. (Side note: I've commented at length on the "mark to market" rule previously on this blog, and while I think it has an economically destructive effect when combined with banking regulations, contributing significantly to the massive financial industry "meltdown" that we're still experiencing, mark-to-market makes perfect sense when applied to other industries, responsible only to shareholders for their capital structures.)
Before you leap to the conclusion that these airlines just got caught taking an unwise financial gamble, consider their alternatives, last summer when already sky-high oil prices were widely expected to go higher still. If prices had continued climbing, and an airline had been required to buy it at the market rate, its operating profits would have been significantly hurt -- probably wiped out. But there was no way to know, really, which way prices would go. In other words, not hedging against the rising price of oil was just as much a gamble as hedging.
As I've said before, the economy is random, folks. Deal with it. Anyone tells you different, sell them a bridge. Or, if they're your boss, start updating your resume. Turns out it's not just easy to be fooled by randomness. You can be fired by it, too.
(Thanks to Bruce Sweigert, the airline practice leader at Peppers & Rogers Group, for many of these insights.)