Fuel hedging lets Southwest post another profit

While most airlines are losing money, Southwest Airlines Co. today reported a $321 million second-quarter profit, beating Wall Street expectations, largely by hedging fuel costs.

Philadelphia's second-largest carrier, which transports 11 percent of passengers and has 71 daily nonstop departures from Philadelphia, posted revenue for the quarter ended June 30 of $2.9 billion, up 11.1 percent.

The Dallas-based airline said it earned $321 million, or 44 cents a share, up 15 percent from a year ago, when it earned $278 million, or 36 cents a share.

Excluding special items, Southwest said it would have earned $121 million, or 16 cents a share. That compares with earnings of $195 million, or 25 cents per share, on revenue of $2.6 billion for the same quarter last year.

Analysts polled by Thomson Reuters expected a second-quarter profit of 12 cents per share.

How has Southwest maintained profitability while other airlines bleed red ink?

Southwest since the 1990s has hedged much of its fuel expense, buying options that let it lock in lower prices. Using complicated financial instruments, known as derivatives, the airline is able to keep fuel costs lower.

For example, in the second quarter Southwest had derivative contracts that brought in $511 million to offset rising fuel. Even so, Southwest said today it paid 35.2 percent more for fuel than in last year's second quarter.

Southwest has hedging contracts for 80 percent of its third-quarter fuel at the crude oil equivalent of $61 per barrel.

The airline has hedged 80 percent of its fourth-quarter fuel at the equivalent of $58 a barrel, and 70 percent of fuel for 2009 is hedged at $66 a barrel.

But by 2012 Southwest's hedges will decline to cover only 20 percent of its fuel.

"We are pleased to report our 69th consecutive quarter of profitability," said chairman and CEO Gary C. Kelly. But with a weak economy and unprecedented jet fuel prices, "we cannot stand still," he said.

"We must continue to make the necessary adjustments to adapt to higher jet fuel prices and restore our profit margins."

Southwest will continue to raise fares, and eliminate unproductive routes. The airline plans to grow no more than 4 percent this year and may not grow at all in 2009, officials said.

The Dallas-based carrier will grow modestly in 2008 primarily to meet customer demand in markets such as Denver, where Southwest plans to add 115 daily flights to 32 cities in November.

"We continue to raise fares to avoid nickel and diming our customers with added fees," Kelly said. Southwest now does not charge, as other airlines do, for a first or second checked bag, soft drinks, curbside check-in, or a change in reservations.

According to Fitch Ratings, Southwest by virtue of its strong balance "has ensured its position as the 'last airline standing' in any far-reaching industry shakeout linked to a prolonged and extreme fuel shock scenario."

Southwest owns its fleet of Boeing 737s, which are "unencumbered" assets and a "solid source of future liquidity" should Southwest need cash, Fitch analyst William Warlick said in a research note.

Southwest is in a strong financial position relative to its major competitors because of its fuel hedge position. While other airlines hedge some fuel, and would like to hedge more, they do not have the cash or credit ratings to do what Southwest does. Most major airlines have emerged from bankruptcy once, or even twice, since 2000.

Southwest is the only U.S. airline with an investment-grade credit rating and access to lines of credit to pay the upfront premiums required to hedge.

Oil producers and financiers, which make hedging deals with Southwest, are confident that the airline can come up with more cash should a change in market conditions trigger a margin call, a demand for additional funds.

Southwest ended the June quarter with $5.8 billion in cash, $2.7 billion more than at the end of March.

Southwest shares fell 44 cents, or 2.7 percent, to $15.44.