Continental finds hedging bumpy

By BILL HENSEL JR.
Copyright 2008 Houston Chronicle

Aug. 12, 2008, 10:54PM

Continental Airlines has struggled with oil prices all year, first on their way up and now on the downside.

The Houston-based carrier, which ramped up its market hedges as it was battered by record fuel costs, appears locked into paying premiums rather than discounts now that energy prices have tumbled.

"Continental was the last mover. Others responded more quickly," said Harlan Platt, a finance professor at Northeastern University who follows the airline industry and who expressed skepticism when Continental announced the hedges as oil prices were rising this spring.

A hedge is basically an insurance policy against price fluctuations. When an airline purchases a type called a collar, it sets both a maximum and minimum price it can pay.

According to a filing with the Securities and Exchange Commission, Continental capped about 33 percent of its expected fuel cost in the third quarter at the average equivalent of $140.81 per barrel of oil.

But that hedge, or collar, also carried an average floor of $121.90 per barrel of oil, and another 29 percent of Continental's third-quarter fuel costs were hedged with a floor equivalent to $3.26 per gallon of heating oil.

Oil futures settled Tuesday at $113.01 and heating oil settled at $3.08, both easily under the floor prices. That means Continental, at least in the short term, could be paying higher prices than the spot market for more than half its fuel.

Some hedges are options

Altogether, Continental has hedged 63 percent of its expected third-quarter fuel costs and 65 percent of those in the fourth quarter. Some of its hedges are options, meaning Continental can decline to exercise them if they exceed the spot price.

"With today's high energy prices, it is as important as ever for us to try to control our fuel costs and reduce risks associated with fuel price volatility," Continental spokesman Dave Messing said in an e-mailed statement. "We adjust our fuel hedges on an ongoing basis depending on market conditions and the forward-looking analytics for jet fuel."

Messing on Tuesday said the quarter is not even half over, so it would be "premature to estimate the net result" of current hedges or compare them to other airlines' setups.

Investors clearly aren't worried. Continental's shares are up nearly 40 percent since the beginning of the month, in line with most rivals. It closed Tuesday at $17.88, up dramatically since bottoming out at $6.65 last month. Standard and Poor's on Friday took Continental off its watch list for a possible credit rating downgrade, and a JPMorgan analyst upgraded shares of Continental and other major carriers Tuesday.

Volatility a given

Pratt, who noted that Continental already might have covered some of its hedges to mitigate any losses, acknowledged that volatile energy markets could reverse course any time and rise back to within the carrier's collar or beyond.

While Southwest Airlines remains the king of hedging — it expects to pay the equivalent of $61 per barrel of crude this quarter to cover 80 percent of its fuel costs — other airlines also appear to be doing OK on their bets so far.

For instance, Northwest Airlines says it wouldn't start having to pay more than spot price on some of its fuel until oil goes under $108 a barrel, and the floor of US Airways' collar on crude is under $93 a barrel.

Continental said last month it is hedged through the middle of next year.

Based on the per-barrel price of crude, it has 29 percent of its fourth-quarter fuel costs hedged with an average $126.25 floor, 24 percent in the first quarter of 2009 with an average $113.72 floor and 24 percent in the second quarter with an average $114.54 floor. It also has future hedges on heating oil, which tends not to be as volatile.

Gaining stability

The stability a hedge offers can be valuable to a company, said Keith Kelly, a managing director for Houston-based Tradition Energy.

Kelly said he applauds Continental and others "for taking the necessary steps to eliminate uncertainty."

And airline consultant Robert Mann said Continental's best hedge of all is not on paper but in the sky: By having such a young fleet of more fuel-efficient jets, the carrier simply burns less fuel than many rivals.

So far, Continental has made money from its hedging — $79 million in the second quarter alone. Oil prices didn't settle under Continental's average floor price for the quarter until Aug. 4, when futures ended the day at $121.41 per barrel.

Tough hedging decisions

If oil prices remain at previously unheard-of triple-digit levels, a recent Government Accountability Office report said, carriers will be faced with even tougher choices about when and how much to hedge.

"Some airlines, particularly Southwest Airlines, reduced the impact of rising fuel prices on their costs through fuel hedges," the GAO report on the industry said. "However, most of those airlines' hedges are limited or, in the case of Southwest, will expire within the next few years and may be replaced with new but more expensive hedges."