Southwest Airlines suffers its first loss in 17 years as fuel-hedging strategy backfires

Southwest Airlines Company, the low-cost airline based in Dallas, Texas, the United States, has posted its first quarterly loss in 17 years.

The airline said it became a victim of its own strategy of fuel-hedging as prices of crude oil declined.

For many years, hedging had made Southwest Airlines Company the most consistently profitable airline in the United States. However, the company’s earnings for the third quarter of 2008 reflected a decline in the value of its hedges as the price of oil fell during the quarter.

Southwest Airlines, with its largest focus city at McCarran International Airport, Las Vegas, the United States, took $247 million in charges to adjust the value of fuel hedges, resulting in a loss of $120 million.

Gary Kelly, the chief executive of Southwest Airlines, said in a statement: “Southwest Airlines incurred a loss of $120 million in the third quarter of 2008 as it had to take an accounting charge to write down the declining value of a fuel-hedging programme. However, the dramatic drop in energy prices since July 2008 is a significant overall benefit for Southwest Airlines. Even with the drop in prices, fuel-hedging still saved the airline $1.3 billion so far in 2008.”

Till July 2008, when the oil prices reached their peak, Southwest Airlines was one of the few airlines to earn a profit, which it did by paying less than the prevailing rate because it had locked in lower prices months earlier.

However, in recent weeks, prices of oil fell by more than half, to $69.85 a barrel on October 16, 2008, from their high of $147 a barrel in July 2008. In the process, oil prices fell below what Southwest Airlines had locked in previously, reducing the value of its so-called fuel hedges in the third quarter of 2008.

According to Gary Kelly, for the first quarter of 2009, the airline plans to cut 190 daily departures and reduce capacity, or the number of available seats, by about 5%-6%.

The website latimes.com quoted a spokesman of Southwest Airlines as saying: “Southwest will back off its hedging strategy, though that could change if oil prices rebound. In the current environment of falling prices, it is probably better to be ‘less’ versus ‘more’ hedged, thus we are lightening our hedge positions.”

The website also quoted an aviation analyst as remarking that, “for the first time in many years, Southwest Airlines will essentially have no hedging benefit for fuel in 2009 if oil prices stay at their current level. And, that would eliminate a key financial advantage that Southwest has enjoyed over its rivals.”

In the statement, Gary Kelly reassured investors thus: “Fares are holding up as the economy slows, helping boost the shares after the carrier posted its first quarterly loss in 17 years on costs tied to fuel hedges. Unit revenue, a measure of fares, fees and traffic, rose by 11% in September 2008 and was up by 14% so far in October 2008. The increase shows that the United States-based carriers are succeeding in raising revenue by trimming capacity and eliminating the cheapest fares.”

Meanwhile, Continental Airlines, based in Houston, Texas, and the fifth-largest airline in the United States, reported a loss of $236 million during the third quarter of 2008 thanks to high fuel costs, which peaked in July 2008. At the same time, Continental Airlines’ revenues rose by about 9% to $3.82 billion.