A Life Cycle View of Enterprise Risk Management: The Case of Southwest Airlines Jet

Fuel Hedging
Author(s): Robert Brooks
Source: Journal of Financial Education , FALL/WINTER 2012, Vol. 38, No. 3/4
(FALL/WINTER 2012), pp. 33-45
Published by: Financial Education Association

Stable URL: https://www.jstor.org/stable/41948685

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 A Life Cycle View of Enterprise Risk
Management: The Case of
Southwest Airlines Jet Fuel Hedging

Robert Brooks
University of Alabama

The objective of this paper is to illustrate the life cycle of enterprise risk
management using jet fuel price risk management within Southwest
Airlines, Inc. Enterprise risk management within a corporation appears to
follow distinct life cycle periods as a firm moves from creation through a
fully mature company. We use the history of SWA to suggest the main life
cycle periods.
Volatile fuel costs, coupled with a continued domestic economic
downturn, had a significant impact on Southwest and the airline industry
generally during 2008. The dramatically higher fuel prices during most of
the year led to significant industry-wide capacity reductions. Southwest' s
fuel hedges during this time enabled it to weather fuel price increases,
contributing to cash savings of almost $1.3 billion during 2008; however,
the recent significant decline in fuel prices led to Southwest 's decision to
significantly reduce its net fuel hedge position in place for 2009 and
beyond. [Form 10-K, 2008, Southwest Airlines, Inc., page 1.

INTRODUCTION

The objective of this paper is to illustrate the life cycle of enterpr

management using the case of jet fuel price risk within Southwest Air
(abbreviated SWA). Enterprise Risk Management (ERM) is a business pr
provides a means to manage risk within an enterprise, typically with
mitigate unwanted exposures. A holistic view of an enterprise is taken
various market, credit and other risks are incorporated. The primary ob
ERM is to preserve or create value for the various stakeholders. Our foc
specifically on SWA and jet fuel price risk. It is important to realize th
approach would seek to understand how passenger traffic, ticket prices,
expenses are related to jet fuel prices.
It is conjectured here that ERM follows a distinct life cycle as a fir
from creation through maturity. Obviously, the experiences of different fir
dramatically, but distinct periods can often be identified. We use the history

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to suggest the main life cycle periods. We leave to further research the task of
identifying and refining these distinct periods for a large sample of firms. For
another perspective on SWA, see Carter, Rogers, Simkins and Treanor (2009).
The implications of the ERM life cycle perspective are very important. First,
understanding how management may evolve in their handling of market price risk
would be beneficial for all firm stakeholders. If certain periods involve increased
risk taking, then capital providers should adjust their capital charges. Second, if
management can learn from an improved understanding of the ERM life cycle, then
the painful seasons may be shortened or eliminated. Third, if the various accounting
groups, such as internal and external auditors, can better understand the maturation
process, then certain strategies deemed worthy of hedge accounting may be more
closely scrutinized. Finally, the various regulatory groups have a vital role in
overseeing the ERM strategies pursued by firm executives. For example, bank
regulators may focus more attention on a bank's ERM process during audits of
banks thought to be in specific stages of the ERM life cycle. An improved
understanding of the ERM life cycle may reduce the societal losses generated by
flawed strategies pursued by immature management.
It is suggested here that ERM follows four distinct periods, the formative period,
the exploration period, the enthusiastic period, and the seasoned period. During a
firm's formative period, ERM is not typically a major focus. SWA was founded in
1971 in Texas. Shortly after SWA's formation, the oil crisis of 1973 occurred,
dramatically increasing the volatility of energy prices. Given SWA's Texas origins,
it is not surprising that firm management would be exposed to energy derivative
instruments. Regnier (2007) documents that 1973 was the first major shock to oil
prices since 1955. The first energy futures contract to trade was heating oil (a close
proxy to jet fuel) in 1978, West Texas Intermediate crude oil futures began trading
in 1983 and unleaded gas futures began trading in 1984.
The OPEC price competition during 1986 resulted in a sharp drop in energy
prices and a sharp increase in energy volatility. SWA enjoyed record operating
income in 1986. The subsequent increase in energy prices in 1987 corresponded
with a sharp decline in SWA operating income.
SWA had a similar experience during the first Gulf War and related energy
volatility in the early 1990s. When energy prices rose sharply and volatility
increased, SWA operating income fell. When energy prices fell and volatility
decreased, SWA operating income rose. It appears that little or no jet fuel hedging
occurred at SWA from 1971 through 1993 although reporting requirements make
it difficult to determine.
Based on SWA's experience, it is not surprising that managing its exposure to
energy price changes became a priority in 1 994. During a firm's exploration period,
ERM receives some attention. Pilot studies may be conducted and small trades are
executed for proof of concept and to build the appropriate infrastructure. SWA
began entering into small füel trading strategies in 1994 and positions varied
through 1998.

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 During a firm's enthusiastic period, ERM receives perhaps too much attention.
Dramatic increases in trading positions appear. Eventually it becomes difficult to
justify the magnitude of the positions as hedging. The sheer size of the trading
positions requires a significant amount of senior management attention. Auditors
and regulators should be concerned. SWA dramatically changed their jet fuel
management philosophy in 1999 to one of longer-dated contracts and larger
positions. This was perhaps in response to the energy volatility induced by the Asian
financial crisis and rise in energy prices. Unfortunately, these speculative positions
paid off handsomely stimulating longer maturities and even larger positions. By the
end of 2007, SWA appeared to have a highly successful 'hedging' strategy with
about $2.4 billion in fair value of their derivatives position and several years of
reduced jet fuel expenses.
During a firm's seasoned period, ERM hopefully settles down and proven
modest strategies are pursued. Alternatively, greed and hubris overtakes senior
management and even more highly leveraged bets are taken and eventually the firm
can be destroyed. The financial landscape has recently been littered with
bankruptcies due to bets gone badly. Often, the maturation process occurs in
response to painful losses from risk-taking behavior. In 2008, SWA appears to have
lost about $3 billion in fair value, suffered severe collateral calls, and dramatically
changed their market price risk management approach. It remains an open question,
whether SWA has truly moved away from highly speculative fuel trading activities.
The remainder of this paper is organized as follows. Section I surveys various
corporate hedging strategies with a particular focus on airlines' fuel hedging. In the
next section, we detail the history of Southwest Airlines' jet fuel hedging program.
The last section provides a summary.

HEDGING STRATEGIES

In this section, we briefly review various hedging strategies. Next,

airline hedging strategies pursued by several U. S. carriers. Finally, w
selected fuel-related derivative instruments.

Corporate Hedging Strategies

Recall that ERM is a process that seeks to manage risks within an enterprise. We
now briefly review corporate risk mitigation strategies. From an accounting
perspective, two broad hedging relationships are permitted, fair value hedging and
cash flow hedging. In simple terms, a fair value hedge should reduce the risk of
adverse changes in the fair value of assets, liabilities, or both. A cash flow hedge
should reduce the risk of adverse changes in the cash flows of revenues, expenses,
or both. Obviously, reducing the risk of adverse changes in asset fair value may
actually increase the risk of adverse changes in equity fair value. For example, a
pension fund with long-dated, fixed rate debt assets and long-dated pension

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liabilities, may actually increase the pension fund's overall risk by 'hedging' the
fixed rate debt with an interest rate swap that converts the fixed rate assets to a
synthetic floating rate asset. The synthetic floating rate asset has lower price
volatility, but the pension fund has higher surplus volatility. In this situation, a sharp
drop in interest rates will result in dramatically higher pension liabilities and the
surplus will be diminished.
A similar observation can be made from the cash flow perspective. For example,
a refinery has both crude oil and unleaded gas price risk. Hedging one commodity
and not the other could actually lead to having more risk as these two commodities
are highly correlated. Hence, just because a particular trading strategy can be
classified for hedge accounting does not mean that the trading strategy is risk
reducing from an enterprise perspective. Intuitively, an economic hedge should
result in a reduction of the risk of adverse changes from an enterprise perspective.
Thus, enterprise risk management focuses on the holistic approach and seeks a clear
understanding of the net firm risk once the various interactions are appropriately
identified.
SWA's jet fuel price risk management program appears to fall within the
anticipatory hedging classification. Obviously, SWA knew that they would be
purchasing jet fuel into the foreseeable future, and thus over the years a wide array
of risk management approaches have been pursued. Although future purchases of
a commodity are anticipated, this does not mean that entering into various forward
purchase agreements will result in a reduction of the risk of adverse changes in
either equity or profits. For example, changes in jet fuel prices may be highly
correlated with changes in the overall business activity indicating high fuel prices
occur in tandem with more ticket sales. Hence, in certain scenarios, rising jet fuel
prices result in rising airline company profits, contrary to initial intuition. However,
the combination of rising jet fiiel prices and falling demand for air travel is
extremely harsh on airline companies. Quality risk management must account for
these types of interactions as well as quantity uncertainty, timing uncertainty,
changing correlation over time, and many other issues.

Airline Hedging Strategies

Based on a survey of 1 0-K filings for the fiscal year ending near December 2008
of the airlines identified in Table 1 , there is a wide array of approaches to managing
jet fuel price risk. We will cover Southwest Airlines in more detail later in this
paper. For example, Frontier Airlines had 0 percent of projected fuel requirements
hedged as of their fiscal year end March 3 1 , 2009. However, in April of 2009 they
had hedged 30 percent of their 2010 fiscal year requirements. Alaska Airlines
hedged 50 percent of their 2009 projected fuel requirements, 33 percent of 2010
projected fuel requirements, and 1 1 percent of the 201 1 projected fuel requirements.
The impact on jet fuel price per gallon with and without hedging depends both
on when hedges were put in place and the size of the derivatives position.

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 Table 1. Price Per Gallon (PPG) With and Without
Hedging and Percent Hedged

This table shows price per gallon (PPG) with and without hedging and percent
hedged as reported in the 2008 10-K for selected U. S. carriers.

I I PPG I % Hedged

American

Continental

Delta

Airtran

Alaska

United

Frontier

Hawaiian

Southwest

US Airways

* Estimated price per

For example, Alaska

in higher jet fuel pri

Commonly Used Fuel

Once the risk expo

approach to implemen
types: symmetric and
been pursued by SW
instruments used to i
losses. Symmetric der
and swaps. The goal f
Usually there is no u
Symmetric hedging
synthetically created.
on the underlying ex
be offset by large los

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 Asymmetrie hedging means the payoffs from financial instruments used to
implement the hedge can only experience large moves in one direction. Asymmetric
derivative contracts include option contracts, caps, floors, or swaptions. The goal is
to insure the risk. Usually there is an up-front fee. Collateral is required only if one
is taking a short position. Asymmetric hedging instruments can be exchange traded,
over-the-counter, or synthetically created. Large gains on the hedging instrument
will offset large losses on the underlying exposure. The reverse, however, is not
true. A long position in an asymmetric strategy will not become a future liability.

SOUTHWEST AIRLINES

We now review the history of jet fuel hedging at Southwest Airlin

history is divided into four seasons: the formative period, the exploration p
enthusiastic period, and the seasoned period.

Formative Period (1971-1998)

The first mention of jet fuel derivatives positions at SWA was in the 1 9
The motive for entering these derivatives positions appeared to be to h
against increases in jet fuel prices. Although energy prices rose in the f
1994, West Texas Intermediate (WTI) crude oil stayed within a range o
$20.71, averaging $17.19 per barrel. In 1994, SWA reported entering f
swaps, caps, and collars on jet fuel. SWA reported the quantity as not m
percent of then-current usage, with 5 percent based on fixed price swa
although the quantity of hedging dropped to not more than 2 percent of th
usage, SWA reported using heating oil contracts as well as jet fuel con
average WTI price rose to $18.40 and stayed within a narrow range of
$20.57. The impact on fuel expenses appears insignificant and the o
positions immaterial. Thus, SWA management of jet fuel price ri
experimental with very small quantities.
WTI prices were significantly higher in 1996 averaging $22.12 and
a wide range from $ 1 7.34 to $26.58. The hedging contract reported was
and the underlying instrument reported was crude oil. The motive for
transactions remained protecting against jet fuel price increases. The
hedged grew to 30 percent of the annual fuel requirements. The impa
expenses appear insignificant and the outstanding positions immaterial.
for hedging appeared to shift in 1997, as WTI traded lower but in a simi
1996, from protecting against price increases to acquiring jet fuel at
prevailing prices possible. Interestingly, in the 1 997 1 0-K there was an
derivatives positions existing "... not for trading purposes." It appears
management wanted to assure its constituencies that they were not "
with financial derivative instruments. Although the details are unclear
appeared that the outstanding positions were immaterial.

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 In 1998, Wn traded even lower finishing the year at $12.05, averaging $14.39
with a trading range of $ 1 0.73 to 1 7.9 1 . Near the end of this formative period, SWA
reported using call options and fixed price swap agreements on crude oil for up to
30 percent of their quarterly fuel requirements. The 1998 10-K introduced the
emphasis on providing greater protection during exceedingly low fuel prices and the
goal is to acquire jet fuel at the lowest prevailing prices possible. However, the
impact on jet fuel prices appeared to be immaterial and the carrying value on the
financial statements of existing derivatives positions was insignificant.
During this formative period, SWA neither experienced great gains or losses
from venturing into financial derivatives positions. The derivatives positions appear
more experimental at this point. However, the exploration period would show SWA
to have a dramatically different experience.

Exploration Period (1999-2003)

The year 1999 marked a major philosophical shift in SWA management

thinking concerning jet fuel price risk management sparked perhaps by changing
market conditions. During 1999, WTI more than doubled going from $12.05 on
12/3 1/98 to $25.77 on 12/3 1/99. The trading range was $1 1 .38 to $27.97 and WTI
averaged $19.31. Prior to December 1998, SWA appeared to purchase out-of-the-
money crude oil call options and fixed price swap agreements. Apparently, SWA's
management viewed energy markets to be changing and consequently changed their
hedging strategy. Starting in 1999, SWA pursued hedging both in short-term and
long-term time frames. Also, SWA sought jet fuel derivatives positions where they
could "... take advantage of market conditions." Clearly, derivatives trading driven
by a desire to profit from future price changes is materially different from
derivatives trading driven by a desire to hedge current jet fuel risk exposures.
SWA's strategy appears to be shifting toward market timing and away from
traditional hedging.
The language in the 10-K now appears to be straying from most academic
definitions of hedging activities. SWA enjoyed a $14.8 million gain from hedging
activities in 1999. By February 24, 2000 they had hedged 57, 85, 100, and 100
percent of their quarterly fuel requirements for the four quarters of the year 2000.
They also entered into five-year swaps implying a willingness to pursue longer
duration contracts that lock in jet fuel prices long before any contractual revenues
were locked in. During this period, SWA appeared to shift dramatically in their
hedging positions in light of current jet fuel market conditions. For example, in
December 1998, in order to take advantage of historically low jet fuel prices, they
entered into a fixed price swap agreement and hedged 77 percent of first quarter
1999 and 56 percent of second quarter 1999 jet fuel requirements. Again, the
impression is that SWA has now launched into market timing strategies separate
from hedging current jet fuel exposures.

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 In January 1999, SWA management increased their hedging positions for
quarter 2 of 1999 to 74 percent of jet fuel requirements. The third and fourth
quarters of 1999 showed SWA with nothing hedged because jet fuel prices and
related futures prices were higher. Hence, 1999 saw a dramatic move to selective
hedging, hedging only when management's view of the future dictated potentially
profitable derivatives transactions. The ERM process seeks to manage risk, typically
by lowering unwanted risk exposures. Selective hedging often results in a whipsaw
effect, losing on the risk exposure when not hedged and losing on the derivatives
position when hedged (and hence no gain on the risk exposure when it moves in the
firm's favor).
Interestingly, as the management's philosophy was changing, so was the
industry's management of counterparty credit risk. SWA began implementing
bilateral collateral provisions requiring cash deposits when market values of the
derivatives positions exceeded certain thresholds. By the end of 1 999, SWA had one
counterparty in this bilateral provision and was negotiating with other derivatives
providers.2 The purpose of bilateral provisions is to reduce counterparty credit risk
by requiring the losing party to post adequate collateral in order to eliminate the risk
that the counterparty defaults. The downside of a bilateral provision is that it will
require substantial cash collateral at the very time that the firm is in a potentially
distress situation.
In 2000, SWA enjoyed $1 13.5 million in gains from hedging activities due to
higher average energy prices (WTI averaged $30.32 in 2000 compared with $19.3 1
in 1999). By the end of 2000, SWA had 80 percent of their 2001 anticipated jet fuel
requirements hedged and 32 percent of their 2002 anticipated jet fuel requirements
hedged. They also had a small portion hedged through 2005. Hence, both the
quantity and duration of their hedging positions grew. They were using call options,
collar structures, and fixed price agreements in both heating oil and crude oil
markets. The fair market value of their positions was $98.3 million with $73.9
million classified as current as they were applying SFAS 133 cash flow hedging
accounting. Bilateral collateral provisions were now with two counterparties and
they continued negotiations with other counterparties.
In 2001, WTI dropped from $26.80 on 12/31/00 to $19.77 on 12/31/01. As
would be anticipated with a selective hedger, SWA reduced their derivatives
positions to 60 percent for 2002, 40 percent for 2003 and small portions of 2004 and
2005. Once again, they had positive cash flows on their derivatives positions that
resulted in $79.9 million in gains from hedging activities. However, SWA's fair
value was reported to be a negative $19.4 million as well as a loss of $8.2 million
related to ineffectiveness of its hedges that was reported as an expense. By the end
of 2001, SWA had bilateral collateral provisions with five counterparties.
In 2002, WTI rose sharply from $19.77 on 12/31/01 to $31.22 on 12/31/02.
With the goal of acquiring jet fuel at the lowest possible cost and taking advantage
of energy market conditions, in 2002 SWA dramatically increased their derivatives
positions to 83 percent of 2003, 80 percent of 2004 and "portions" of 2005 through

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2008. They once again collected $44.5 million in gains from hedging activities,
reported $157.2 million in fair value, and $4.5 million in gains related to
ineffectiveness of its hedges. The bilateral collateral provisions were now with seven
counterparties.
WTI traded slightly higher in 2003 compared with 2002 rising to $32.52 by
12/31/03. The results for 2003 were similar with 82 percent of 2004, 60 percent of
2005 and "portions" of 2006 and 2007 hedged. They collected $171 million in gains
from hedging activities, reported $251 million in fair value, had $ 1 6 million in gains
related to the ineffectiveness of its hedges, and seven counterparties with bilateral
collateral provisions.
By the end of 2003, SWA had experienced several years of profitable trading
in jet fuel derivatives contracts. With over $250 million in fair value of the existing
derivatives contracts and several profitable years of trading activities, SWA moved
into the enthusiastic period. It is unclear however, where the $250 million in fair
value loss was located on the economic balance sheet of SWA. The economic
balance sheet here is neither GAAP nor non-GAAP, rather the economic value of
assets, liabilities, and equity. Thus, changes in the fair value of assets must be
reflected in either changes in the fair value of liabilities or equity.
Academically, if SWA had a $250 million gain in fair value of derivatives
contracts and they were hedging something valid, there should exist a $250 million
loss in fair value of something in the SWA economic balance sheet. There did not
appear to be any such loss in value primarily because the profits at SWA are the net
of revenues from ticket sales less operating expenses. Clearly, ticket prices can be
changed as economic conditions change and quantity of tickets sold may depend on
the same factors driving jet fuel prices. The nature of the relationship between the
economic value of SWA and jet fuel prices is not a simple one. The appropriate
hedging strategy required if SWA cannot pass through increases in jet fuel costs to
customers for extended periods of time remains unclear.

Enthusiastic Period (2004-2008)

The year 2004 marked a significant departure for the SWA jet fuel trading
program. In 2004, WTI rose sharply from $32.52 on 12/31/03 to $43.46 on
12/31/04. By 2004, they had long since departed the simple hedging of a small
portion of the next few quarters' anticipated jet fuel purchases. SWA's stated
objective remained: acquire a form of insurance against rising jet fuel prices, acquire
jet fuel at the lowest possible cost, and take advantage of market conditions. They
continued to use call options, collar structures, and fixed price agreements. The
underlying instruments now included heating oil, crude oil, and unleaded gasoline.
The position had grown so large as to require diversifying into other energy
products in order to not have too great of a market impact. The sheer size of SWA
energy positions were phenomenal, 85 percent of 2005, 65 percent of 2006, 45

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percent of 2007, 30 percent of 2008 and 25 percent of 2009 anticipated jet fuel
consumption.
Times were very good in 2004 with $455 million in recorded gains from
derivatives trading, $796 million in fair value, and only a $13 million loss related
to ineffectiveness of its positions. SWA had over 300 different positions on their
books related to jet fuel trading. The dramatic increase in fair value and recorded
gains were attributable to a dramatic increase in energy prices and a significant
increase in the size of the derivatives positions. Seven counterparties had either early
termination rights and/or bilateral collateral provisions requiring cash deposits when
market values exceeded certain thresholds. By the end of 2004, SWA held $330
million cash collateral deposits and $150 million of U. S. Treasury bills under
bilateral collateral provisions.
In 2005, WTI rose again sharply from $43.46 on 12/31/04 to $61.03 on
12/31/05. In 2005, SWA reported strong corporate performance due in part to a
"successful fuel hedge program." They pursued a similar strategy in 2005 but
reduced slightly the magnitude of their positions to 70 percent of 2006, 60 percent
of 2007, 35 percent of 2008, and 30 percent of 2009. They reported $890 million in
gains from hedging activities and $ 1 . 7 billion in fair value due to a dramatic increase
in energy prices. SWA now had over 400 different financial derivative instrument
positions on their books and about $1 10 million gain was related to ineffectiveness
of its hedges. Again, seven counterparties had either early termination rights and/or
bilateral collateral provisions requiring cash deposits when market values exceeded
certain thresholds. By the end of 2005, SWA held $950 million in cash collateral
deposits from other counterparties.
In 2006, WTI started and finished the year at about the same historically high
price. SWA pursued a similar strategy as that of 2005 but increased significantly the
magnitude of their positions to 95 percent of 2007, 65 percent of 2008, 50 percent
of 2009, 25 percent of 2010, 15 percent of 2011, and 15 percent of 2012. They
reported $634 million in gains from hedging activities and $999 million in fair
value. SWA now had over 480 different financial derivative instrument positions on
their books and about a $101 million loss was related to ineffectiveness of its
hedges. Eight counterparties had either early termination rights and/or bilateral
collateral provisions requiring cash deposits when market values exceeded certain
thresholds. By the end of 2006, SWA held $540 million in cash collateral deposits
from other counterparties. The 2006 10-K reported a new statistical regression
approach that resulted in more hedges being classified as effective. From 2005 to
2006, the fair value of derivatives positions fell $700 million from $1,700 million
to about $1,000 million. It is difficult to determine where on the fair value balance
sheet there was a $700 million increase in value if these positions were truly hedges.
In 2007, WTI hit new highs and rose sharply from $6 1 .05 on 1 2/3 1 /06 to $96.00
on 12/31/07. With the enthusiastic times in full force, 2007 was a defining year.
SWA strategy was well defined and management decreased somewhat the
magnitude of their positions to 70 percent of 2008, 55 percent of 2009, 30 percent

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of2010, 15 percent of 201 1, and 15 percent of 2012. They again reported significant
gains from hedging activities ($686 million) and a whopping $2.4 billion in fair
value. SWA no longer reported the number of different financial derivative
instrument positions on their books. They also enjoyed a $360 million gain related
to ineffectiveness of its hedges. Nine counterparties had either early termination
rights and/or bilateral collateral provisions requiring cash deposits when market
values exceeded certain thresholds. By the end of 2007, SWA held $2 billion in cash
collateral deposits from other counterparties. The 2007 10-K document again used
the regression approach as well as other statistical analyses to classify positions as
effective. Again, from 2006 to 2007, the fair value of derivatives positions rose
about $1.4 billion from about $1 billion to $2.4 billion. It is difficult to determine
where on the fair value balance sheet there was a $1 .4 billion decrease in value if
these positions were truly hedges.
It appears that 2008 marked the painful end of the enthusiastic period. In 2008,
WT1 fell very sharply from $96.00 on 12/31/07 to $44.60 on 12/31/08. SWA
enjoyed $1.1 billion in gains from hedging activities during the year before energy
prices fell. However, by the end of the year, the fair value of derivatives positions
fell approximately $3.4 billion in value from $2.4 billion reported in 2007 to -$992
million in 2008. Where was the $3.4 billion increase in fair value on the economic
balance sheet? The change in collateral changed dramatically from holding about
$2 billion to providing $240 million cash collateral. Ratings triggers threatened the
liquidity of SWA. The hedging philosophy dramatically changed to only about 10
percent of SWA's position for years 2009 through 2013. The combined influence
of a sharp drop in energy prices and economic downturn lowering the demand for
air travel was devastating to SWA.
Figure 1 clearly shows the changing philosophy toward jet fuel price
management from 1994 through 2008 as well as the general trend in West Texas
Intermediate crude oil prices. Without any clearly stated benchmark strategy, it is
difficult to appraise whether all of this effort was beneficial.
The oil prices reported in Figure 1 are one year ahead. For example, the oil
prices in the 2008 column correspond to 2009 prices. The goal is to demonstrate
where SWA had derivatives position and then what subsequently happened.
Focusing on average oil prices, we observe a general upward trend from 2001
through 2007 (2000 through 2006 in the figure). Thus, SWA clearly enjoyed being
on the correct side of energy prices during this period. Notice that the volatility
dramatically increased in 2007 through 2009 and the general direction becomes less
transparent. Based on closing prices, it appears that SWA suffered severely being
extremely long at the end of 2007 only to experience a dramatic drop in prices in
2008. When SWA significantly lowered the size of the derivatives positions, the oil
prices rose significantly. However, based on average prices, the story is less
transparent. Clearly, the positions in place at the end of 2008 marked a significant
departure from recent past.

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 Figure 1. Southwest Airlines Derivatives Positions as a Percent of
Expected Fuel Consumption

This figure shows Southwest Airlines derivatives positions expressed as percent

expected fuel consumption as reported in the 10-Ks (+1 year denotes the year
after the 10-K filing year). Bar chart and left axis depict hedged percentage
whereas line chart and right axis depict crude oil prices.

Seasoned Period (2009-...)

As with any company, the future of Southwest Airlines hedging program is unclear.
In 2009, WTI rose again sharply from $44.60 on 12/31/08 to $79.36 on 12/31/09.
SWA' s derivatives positions appear modest (see Figure 1) compared with the
enthusiastic period, yet more than the formative and exploration periods.
Changes in accounting policies and firm experience will likely continue to shape
the financial derivatives strategy pursued by Southwest Airlines. One expected
outcome of the tumultuous recent financial crisis is a move back to fairly simple
derivatives instruments and easily justifiable positions going forward. The CEO
Gary Kelly expressed his sentiments in the following way in the December 2009
Spirit Magazine, "... in many ways, 2009 was an annus horribilis [horrible year] for
the entire airline industry."

44 Journal of Financial Education

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CONCLUSION

In this paper, the life cycle view of enterprise risk management was i
using the case of jet fuel price risk within SWA. Based on the history o
offer four main life cycle periods: the formative period, the exploration
enthusiastic period, and the seasoned period. During a firm's formativ
enterprise risk management is not typically a major focus. SWA appears
little or no jet fuel hedging from 1971 through 1993.
During a firm's exploration period, enterprise risk management rece
attention. SWA began entering into small fuel trading strategies in
positions varied through 1998. Many of these trades appear to be exper
During a firm's enthusiastic period, enterprise risk management receives per
much attention. SWA dramatically changed their jet fuel management p
in 1999 to one of longer-dated contracts and larger positions. By the en
SWA appeared to have a highly successful 'hedging' strategy with
billion in fair value of their derivatives position and several years of reduced
expenses.
During a firm's seasoned period, often brought about by dramatic losses,
enterprise risk management settles down and proven modest strategies are pursued.
In 2008, SWA appeared to have lost about $3 billion in fair value, suffered severe
collateral calls, and dramatically changed their enterprise risk management
approach. It is too early to tell for sure whether SWA has entered the seasoned
period.

ENDNOTES

For a review of jet fuel hedging theory and practice, see Morrell an
(2006).
As will be significant later, bilateral means these collateral provisions go both
ways.

REFERENCES

Carter, D., D. Rogers, B. Simkins, and S. Treanor. Southwest Airlines jet fuel he
and (B). Financial Management Association Meeting, Reno, NV, October 2009.
Morrell, P. and W. Swan, 2006. Airline jet fuel hedging: Theory and practice, T
Reviews 26, 713-30.
Regnier, Eva, 2007. Oil and Energy Price Volatility, Energy Economics 29, 405-4

Fall/Winter 2012 45

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