From the September 2008 issue of Wealth Manager Web • Subscribe!

Hedging or speculating?

Just a few days ago, I received an "open letter" from the airlines asserting that rampant speculation in the energy markets was destroying their companies. It demanded that I send a letter to Congress urging severe restrictions on oil trading; it failed, however, to condemn speculators who were short oil futures andbetting on a price decrease.

One airline, however, seems to operate above the fray. Southwest Airlines, a discount carrier based in Dallas, uses derivative markets to "lock-in" the price of fuel over multi-year periods. By buying fuel for delivery years in advance, the company secured more than 70 percent of the fuel it expects to consume in 2008 at $51 a barrel--almost two-thirds of the current price. The program has saved the carrier nearly $4 billion since 1999.

These savings did not come without risks. Nine years ago, crude oil was trading under $10 per barrel. The thought of locking in the price of oil, which represents one of the largest single expenses for an airline, probably seemed ludicrous at the time.

Hedging out the price of jet fuel is also pretty complex. At the time, there was no way to directly hedge jet fuel, since derivatives contracts lacked sufficient liquidity. Using other fuels that are closely related--such as kerosene, diesel, or heating oil--eliminates some liquidity issues, but subtle pricing differences between these petroleum products can lead to losses. As a result, Southwest had to commit significant resources to its hedging operations.

There are several ways to view Southwest's activities: On one hand, the company seemed to be speculating that the price of jet fuel would rise. After all, if prices had declined, the hedges would have resulted in big losses for the carrier. Or, as Southwest sees it, they simply wanted to prevent huge swings in operating expenses and bottom-line profitability.

If one accepts the latter premise, it isn't Southwest that was speculating. All of the other airlines were speculating that oil prices would stay lower or go lower. Frank Shea, CFO of World Fuel Services Corporation, posited in a 2004 article in the Greenville, N.C. Daily Reflector that the airline industry has traditionally attracted CEOs who like to take risks, such as betting that the price of jet fuel would drop. Airline "financial statements look like the grin of an old-school hockey goalie--there are big black gaps in it," the article noted. "How many teeth got swallowed by hockey goalies before they started to wear a mask?"

The similarities to the wealth management industry are staggering. How many firms refuse to utilize alternative investments in portfolio construction? For those that insist on using the tried-and-true mix of stocks and bonds, these are troubling times indeed. Even a modest allocation to a hedge fund of funds would have softened the blow considerably. The bottom line: If done prudently, investing in hedge funds offers a ton more upside than downside.

Hedging with alternatives reduces volatility and loss during tough market conditions which, literally, allows advisors to buy when there's blood in the streets.

Ben Warwick is Chief Investment Officer of Quantitative Equity Strategies LLC in Denver, Colo. and Memphis-based Sovereign Wealth Management, Inc.

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