Summary
Airlines are faced with a dilemma-- to hedge or not to hedge and if so how. Even Southwest Airlines, who runs the most agressive hedging program is at risk to increases in price as they note there is limited opportunity for heddging jet fuel.
Analysis
Any airline considerring hedging their jet fuel with some instrument on the NYMEX also has a basis risk to contend with. Bulk pipeline sales or cargo volumes of jet fuel in the USA trade at a differential to the heating oil contract. Whether it is in NY, Los Angeles, Chicago or Houston, the heating oil contract is the base and a differential to that is negotiated for the physical barrel. The final price can be determined by executing an EFP or a trigger price mechanism or choosing dates for settlement.
If an airline chooses to hedge, they must implement a program to buy the futures contracts and then another program to buy the jet fuel differential to those futures. Although today the NYMEX lists heating oil contracts out until May 2011, for all intents and purposes there is no liquidity for any significant volume after the first twleve months.
An airline looking to hedge volumes out three to five years looks to the NYMEX crude contract for this liquidity. This puts the airline at risk of blowouts in the heating oil contract relative to crude. And that phenomena can be seen this year as the HO crack has risen to over $30. That's the first basis risk.
The second basis risk is the jet fuel to heating oil differential. This is more difficult to hedge since it must be done in the over the counter swaps market where liquidity can be an even bigger issue. For example, today jet fuel in NY Harbor is 18 cents per gallon or $7.50 per barrel over the heating oil contract from prompt delivery while heating oil is in excess of $30 per barrel over crude
So for airlines, and even Southwest to a certain extent, is feeling the effects of higher heating oil cracks and jet fuel differentials.
The government curbing speculation is another issue taking press. One reason speculators love the futures market is the leverage. The current margin per contract for crude or heting oil is roughly $10,000. So for that amoutn of money, one can "control" $134,000 worth of crude or $160,000 worth of heating oil. Significant regulation could move some of the futures trading overseas while raising the initial margin will increase the cost for large and small speculators along with smaller physical traders who would like to hedge their production.
One major problem is defining the difference between a speculator, investor or other. It's pretty easy noting the difference between ExxonMobil and the generic ABC Hedge Fund company. But what if that other person is an investor in the USO ETF fund or say a pension fund like Calpers? The lines are not so clear.
