Southwest Airlines’ fuel bet will pay off

South West Airlines (New York Stock Exchange: LUV) managed to save $1.2 billion this year after making savvy deals on its fuel contracts. In a recent SEC filingthe company said its multi-year fuel hedging program provides coverage against spikes in jet fuel prices.

Russia’s loss of the oil supply chain has sent oil and jet fuel prices skyrocketing, forcing airlines to shell out more money to cover trips or cut schedules. Additionally, with the easing of COVID border restrictions, the demand for fuel has only increased, with little additional cost. The Energy Information Administration (EIA), which tracks fuel prices, said a year ago, when the world was still in the throes of the pandemic, jet fuel cost four times less than it does today – on average it was $1.90 per gallon during the same week in June 2021. Last Monday, June 27 of this year, that price was $4.13 per gallon.

Southwest Hedged, Other Majors Didn’t

Southwest CEO Bob Jordan told investors at the end of the first quarter of 2022 that the company expects a “significant gain in fuel hedging in the second quarter and remains well protected with our fuel hedging portfolio in the second.” semester of this year.

Meanwhile, the other three majors, American [NASDAQ: AAL]delta [NYSE: DAL]and United [NASDAQ: UAL], in their respective earnings calls at the time, said they would not hedge and pay the price at the pump. In the end, these bets proved costly because their fuel estimates – while similar to what Southwest covered – were far less than what the fuel ended up costing, as EIA data shows.

Carriers without coverage passed on those expenses to customers, who did not bat an eyelid at the higher ticket prices, due to pent-up travel demand resulting from the pandemic. In the filing, Southwest said it expected its load factor for the second quarter to still be just 87% of the pre-pandemic travel peak from 2019, but revenue during the same period would be 15% more.

With the fuel hedging program, the airline said that as of June 16, “the fair market value of the company’s fuel derivative contracts settled in the remainder of 2022 was an asset of approximately $758 million.” , which would bring savings over the entire year to about $1.2. billion. For 2023 and 2024, the company said the market value of these fuel derivative contracts is worth about $615 million and about $161 million, respectively.

Airlines typically spend a third of their operating expenses on fuel, so even when they can cut the margin down to pennies, it can result in huge savings. For Southwest, the airline said it saved $0.70 per gallon for the second quarter, between $3.30 and $3.40 per gallon, and that was enough for the windfall it could to harvest. Even more, at the start of the second quarter, the company said it would only cover 63% of its fuel for the second quarter, which means the upside could have been much larger.

Fuel derivatives are a type of financial instrument, like stocks and bonds, that companies can trade based on the cost of the expected underlying price of oil. When companies hedge, they lock in specific prices so that if the market price fluctuates due to uncertainty, they only have to pay the agreed price. It serves well when the price goes up but becomes a premium if the price goes down.

Strong earnings ahead

During the company’s first quarter earnings call, Southwest Chief Financial Officer Tammy Romo told investors that the “fuel hedge provides excellent protection against rising energy prices” and would serve of “significant cost reduction” for the year.

For Southwest, with increased travel and fuel savings, the company said in its SEC filings that “barring unforeseen events and based on current trends,” it expects “strong earnings” from the second in the fourth quarter and all of 2022. Benefiting from its financial prowess, the company said it remains the only U.S. airline to maintain an “investment grade rating by all three rating agencies.”

Pilot contract still in question

The company is expected to release its third quarter results in late July. Besides fuel, investors will want to know the company’s progress in negotiating a new contract with its pilots. Last week, more than 1,300 Southwest Airlines pilots, on leave but in uniform, lined the sidewalks of Dallas’ Love Field Airport (KDAL) to demand a new contract.