Jet fuel arbitrage

December 20, 2015 09:00 AM

Airlines have a simple business model, summarized as “planes in the sky, [posteriors] in the seats.”

Theirs is a derived demand, a fancy way of saying passengers tolerate a really dreadful experience as a cost of arriving at their destination. An empty seat is a revenue opportunity permanently foregone, so carriers are willing to sell them below their marginal cost of operations as any revenue is better than none. If you add truculent labor unions, the vagaries of weather and economic factors and the always variable cost of jet fuel (our topic here today) small wonder Warren Buffett once quipped, “Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

Jet fuel is and always has been one of the most difficult refined petroleum products to hedge. It is produced from the same cut of the barrel--called middle distillates--as diesel fuel and heating oil, but unlike those markets where the buyers are small, numerous and scattered widely, the jet fuel market is concentrated in a handful of large airports, some of which have direct dedicated pipelines running from nearby refineries.

A further layer of complexity is added by the actions of the U.S. military. When Uncle Sam decides to launch a few thousand sorties into the wild blue yonder, they pull the price of jet fuel higher relative to that of other middle distillates. What can a self-respecting airline do to manage its fuel price risks and avoid another encounter with Chapter 11? 
Part of the answer lies in hedging the cost of jet fuel with ultra-low sulfur diesel fuel futures (ULSD). This contract succeeded the old heating oil futures contract in May 2013.

Risk management matters

In homage to Samuel Johnson’s maxim, “When a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully,” we might add the prospect of stock market underperformance focuses option-compensated executives’ minds wonderfully as well. The relative performance of the S&P 1500 Airline group vis-à-vis the S&P 1500 Supercomposite has led the price of ULSD in New York Harbor by 96 days on average since the ULSD market began in May 2006 (see “Anticipating change,” below). Investors understand jet fuel price risk management matters and they buy and sell airline stocks in anticipation of price changes for ULSD.

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About the Author

Howard L. Simons is president of Rosewood Trading. @simonsresearch