LegalStudiesResearchPaperSeries

WorkingPaperNumber06__
September2006

SOUTHWESTAIRLINES:
HEDGINGANDSHAREHOLDERVALUE
(TEACHINGCASE)

PreparedNovember2005
RevisedAugust2006

MichaelIngrassia,GeorgetownUniversityLawCenter
VictorFleischer,UniversityofColoradoLawSchool

This case was prepared by Michael Ingrassia, J.D. 2006, Georgetown University Law
Center,andProfessorVictorFleischer,UniversityofColoradoLawSchool.Certainevents
havebeendramatizedforteachingpurposes.Thecaseisintendedasateachingexercise
andisnotintendedtoevaluatetheconductofanyofthesubjectsofthecasestudy.

DEALS F2006

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INTRODUCTION

DeborahAckermanpacedheroffice,runningtheoptions
throughherhead.AsGeneralCounselofSouthwestAirlines,Ackerman
waspreparingtomeetwithSouthwestsCFO,LauraWright,todiscuss
theimplicationsofSouthwestslongtermfuelhedgingplan.Hedging
hadlongbeenconsideredanessentialpartofSouthwestsoperations,
makinganychangeinstrategyapotentiallightningrodforshareholder
complaints.SouthwestsCEO,GaryKelly,hadaskedWrightandAc
kermantosetasideeverythingelsetheywereworkingontoconcentrate
onit.

Wrightwasfamiliarwiththefinancialbenefitsandpitfallsof
hedging.Butshefeltthat,giventhesensitivityofshareholderstothisis
sue,itwouldbeprudenttohavetheadviceofcounsel.Hedgefundsand
otherinstitutionalinvestorshadaccumulatedsignificantstakesin
Southwest,andWrightandKellywantedtomakesurethattheirdecision
wouldnotbecriticizedasawasteofshareholdervalue.

HedginghadlongbeenasourceofprideforSouthwestAirlines.
Southwesthashadthemostextensivefuelhedgingprogramintheair
lineindustryforyears,helpingittoweathertherapidlyincreasingfuel
pricesof20032005thatdroveseveralofitscompetitorsintobankruptcy.
ButbyNovemberof2005,theprospectofthosehedgingcontractspro
tectingSouthwestappearedslim.BeginninginJanuaryof2006,theper
centofSouthwestsfuelneedsthatwouldbehedgedwasduetodrop
steadilyuntil2009,whenthelastofitshedgingcontractswouldexpire.1
ThisposedadilemmaforSouthwest.

Shoulditenterintoadditional(nowmorecostly)fuelhedging
contracts?

MichelineMaynard,SoSouthwestisMortalAfterAll,N.Y.TIMES,Oct.16,2005atC1.

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Ifso,whatinstrumentsshouldbeused?

o Ifnot,shouldthecompanyseekothermethodsofreduc
ingitsexposuretorisingfuelcosts?

Whatwouldshareholdersthinkofeachofthesealternatives?

BACKGROUND

SouthwestAirlinesisalowcostcarrier(LCC)airlinewithdo
mesticpointtopointservice(ascomparedtothehubandspokesystem
utilizedbylegacycarriers).Thecompanyemploysalowcostmodelthat
hasbecometheenvyoftheU.S.airlineindustry.2

Southwestbeganoperationsin1971asalocalcarrier,basedout
ofLoveFieldinDallas,withroutesonlyinTexas.Duringthe1980s,
Southwestexpandeditspresencethroughoutthesouthwesternandcen
tralUnitedStates,includingservicetoLosAngeles,Phoenix,St.Louis,
andChicago.Duringthe1990s,theairlinecontinuedtoexpandits
routes,includinginitscoverageservicetoNewEngland,thePacific
Northwest,theAtlanticCoast,andtheSoutheast.3

EachtimeSouthwestdecidedtoenteranewmarket,itdidso
withanopportunisticstrategythatwouldlaterbecomethemodelfor
otherLCCs.Thecompanywouldidentifythosemarketsthatwereeither
underserved(oftenduetoretrenchmentsbyotherairlines)orthathad
highpricesduetoalackofcompetition.Southwestwouldthenenter
thatmarket,offeringlowerfaresinordertorapidlybuildmarketshare.
Theywouldthenslowlyraisepricestomaketherouteasprofitableas
possiblewhilestillundercuttingcompetingairlines.4

2SeeAnalystReportonSouthwestAirlinesCo.,BB&TCapitalMarkets,May13,2004at2
[hereinafterBB&T,May2004].
3SeeSouthwestAirlineswebsite,availableatwww.southwest.com.
4SeeBB&T,May2004,at2.

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ThekeystoSouthwestssuccessfulexpansionpolicywerebothits
intelligentidentificationofattractivenewmarketsanditsabilitytocon
sistentlykeepitscostsbelowthoseofitscompetitors.Themetricofcost
competitivenessintheairlineindustryisCASM(CostperAvailableSeat
Mile).CASMisderivedbydividingtotaloperatingcostsbyASMs(the
availablenumberofseatsforpassengersmultipliedbythenumberof
scheduledmilesflown).5 Withinthehighlycompetitiveairlineindustry,
thehighestandthelowestcostcarriersinanygivenyearmaybesepa
ratedbyaslittleas$0.02perASM.6 Southwestslowerlaborcostsand
greateroperatingefficiencyhaveallowedittoachievelowerCASMlev
elsthanitspeers,includingbothlegacycarriersandLCCs(seeExhibit
1).7 ThisCASMadvantagehasincreasedinrecentyearsduetoSouth
westsindustryleadinghedgingprogram.8

SOUTHWESTSHEDGINGPROGRAM

Hedgingreferstoacontractorsetofcontractsthatacompanyen
tersintoinordertolimititsexposuretoabusinessriskthatcouldnega
tivelyimpacttheresultsofitsoperations.Acerealmakermighthedge
againstariseincornpricescausedbydrought;ahotelmighthedge
againstadropinvisitorscausedbybadweather.So,forexample,ace
realmakermighthedgeagainstariseincornpricesbybuyingathree
yearcalloptionthatgivesittheright(butnottheobligation)tobuya
givenamountofcornthreeyearsfromnowattodaysprice.Ifcorn
pricesrise,thenthecerealmakerwillexercisetheoptionandbuythe
cornattodaysprice.Ifcornpricesdecline,thecerealmakerwillallow
theoptiontolapseandbuythecornatthethencheapermarketprice.

Seeid.at23.
Seeid.at11.
7Seeid.at9.
8Seeid.at14.
5
6

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ForseveralyearsSouthwestAirlineshashedgeditsfuelneedsto
protectitselffromfluctuationsinjetfuelpricesoneofthelargestand
mostvolatilecomponentsofanairlinesCASM.Asearlyas2001,South
westwashedgedon80%ofitsfuelneeds.9 BeginninginSeptemberof
2002inanticipationofapossiblewarinthePersianGulfSouthwest
begantohedgeitsfuelneedsevenmoreaggressively,pavingthewayfor
ittoremainthemostprofitableairlineoverthenextthreeyears.10

SouthwestAirlineshedgingprogramconsistsprincipallyofpur
chasedcalloptions,collarstructures,andfixedpriceswapagreements.11
EachoftheseinstrumentsisdescribedinExhibit2.Asjetfuelisnot
tradedonafuturesexchange,itiscommonwithintheairlineindustryto
useoptionscontracts(orswapsorcollars)basedonheatingoilorcrude
oil,asthesecommoditiesmostcloselytrackjetfuelprices.12 Inorderto
convertcrudeoilintojetfuel,thecrudeoilmustberefined,resultingina
refiningmarginknownasthecrackspread.13 Jetfueltradesatapre
miumtocrudeoil(commonlyreferredtoasWestTexasIntermediate
orWTI)becauseofthecostofrefining(cracking)raw(WTI)oilinto
jetfuel.14 Therefore,airlinesseekingtohedgeagainstfluctuationsinjet
fuelpricesmusthedgeagainstbothchangesinWTIpricesandagainst
changesinthecrackspread,thusexplainingSouthwestsuseofheating
oilbasedfinancialderivatives(asheatingoilisalsoarefinedproduct,it
offsetsthejetfuelmarginrisk).15 However,asmostofitslongerterm

See Analyst Report on Southwest Airlines Co., Morgan Stanley Dean Witter, May 1,
2001,at5.
10DanielAltman,TryingtoMakeFuelPricesLessofaWartimeGamble,N.Y.TIMES,May23,
2003,atC4.
11SouthwestAirlines10KReport(2005)at45.
12Seeid.;seealsoDanielAltman,TryingtoMakeFuelPricesLessofaWartimeGamble,N.Y.
TIMES,May23,2003,atC4(indicatingthatthemajorityofSouthwestsshorttermhedging
contractsarebasedonheatingoilpricesastheymorecloselytrackjetfuelpricesthando
crudeoilprices).
13AnalystreportontheEuropeanTransportIndustry,MorganStanley,Sept.15,2005,at
3.
14Id.at4.
15AnalystreportonSouthwestAirlines,Citigroup,Oct.12,2005,at2.
9

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hedgingcontractsarebasedoncrudeoilprices,16 Southwestremains
largelyexposedtothecrackspread.

Goingforward,Southwestishedgedforapproximately65%ofits
2006fuelneeds,45%ofits2007fuelneeds,30%ofits2008fuelneeds,and
25%ofits2009fuelneeds.17 ThismakesSouthwestthemosthedgedof
itsU.S.peerswithrespecttoitsfuelneeds,althoughitisnotashedgedas
manyEuropeanairlines(seeExhibit3).

Southwestsaggressivehedgingprogramhasalloweditto
achievealevelofsuccessoverthepastfewyearsthathasexceededthe
resultsofitspeergroup(seeExhibit4).Jetfuelpricesrose52%fromSep
temberof2004toSeptemberof2005,ontopofariseof60%from2002to
200418 (seeExhibit5).Becausejetfuelandlaborcostsarethetwobiggest
operatingcostsforairlines,largefluctuationscanleadtobankruptcyfor
participantsinanindustrythathasalsoexperienceddecliningtrafficin
thewakeof9/11andfallingpricesduetoincreasedLCCcompetition.

Althoughearningspershare(EPS)forSouthwestscompetitors
havefallenprecipitouslysince2000,forcingmanyofthelegacycarriers
(andsomeoftheLCCs)intobankruptcy,Southwesthasmanagedtosus
tainitsrecordofconsistentprofitability(seeExhibit4).WhileSouthwest
hasalwaysmanagedtoachievealowerCASMthanitscompetitorsdue
tolowerlaborcostsandhigherefficiencyratios,inrecentyearsmuchof
thisCASMadvantagehasbeenduetothecompanyshedgingprogram.
Southwestsfuelhedginghasallowedittoachievea35%CASMadvan
tagevs.itscompetitors(seeExhibit1).19 However,withitshedgeswind
ingdown,analystshavepredictedthatSouthwestsCASMadvantage
willfallto23%by2006anddeclinethereafter(seeExhibit6).20 Southwest
mustnowdecidehowitwilldealwithitsfuelcostsgoingforward.

SouthwestAirlines10KReport(2005)at45.
Id.
18SeeBB&T,May,2004,at15;seealsoAnalystreportontheU.S.AirlineIndustry,Bear
Stearns,Oct.11,2005,at4.
19SeeAnalystreportonSouthwestAirlines,Citigroup,Oct.12,2005,at6.
20SeeAnalystreportonSouthwestAirlines,BearStearns,Oct.17,2005,at3.
16
17

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STRATEGICOPTIONS

WrighthasfocusedonsevenalternativesavailabletoSouthwest:

1. Donothing;
2. Passontopassengersanyincreasedfuelcoststhroughsurcharges
orincreasedfares;
3. Increasetheuseofcostreductiontechniques,suchasadding
blendedwinglets(awingdesignthatreducesfuelconsumption);
4. Hedgeusingaswap(heatingoilorjetfuel);
5. Hedgeusingoptions;
6. Hedgeusingacollar;or
7. Hedgeusingafuturescontract(heatingoilorcrudeoil).

Giventheimpactoffuelcostsonanairlinescoststructure(both
NorthwestandDeltablamedtheirbankruptcypetitions,inlargepart,on
risingfuelprices21 ),GaryKelly(SouthwestsCEO)wouldprefertobe
proactiveindecidinghowtohandlefuelcosts.Whiletheboardofdirec
torsmightbereceptivetoadonothingapproachshouldthecostsof
theotheralternatives(includinghedging)proveexcessive,itwouldcer
tainlyexpectacarefulanalysistobackupanydecision.

ShouldSouthwestdecidetodosomethingproactively,itcould
focusonincreasingitsrevenuesperavailableseatmile(RASM)rather
thanondecreasingitsCASM.Thiscouldbeachievedthroughfuelsur
chargesorfarehikes.However,thismightbedifficultforSouthwest,
whichhasalwaysmarketeditselfasthelowfareairline,asitcouldan
tagonizepassengerswithanysignificantfareincreases.Wrightherself
oncestated:Ourlowfarebrandiswhoandwhatweare.22 Onthe
otherhand,givenSouthwestsstrongbrandequityamongcustomers

21
22

MichelineMaynard,SoSouthwestisMortalAfterAll,N.Y.TIMES,Oct.16,2005atC1.
Id.

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asalowcostcarrieranditsindustrylowCASM,itmightbeabletoraise
faresforshortperiodswithoutlosingmarketshare.

Southwestcould,alternatively,seekothermeansofreducingits
operatingcosts.Forexample,thecompanyrecentlyaddedblended
wingletstoits737700fleet,whichitestimateswillreducejetfuelcostsby
34%amongthoseaircraft.23 Buthowmanyotherwayscouldtherebeto
reducecostsforanairlinethatalreadyhastheindustryslowestCASM?

Finally,Southwestcouldenterintohedgingarrangementsusing
swaps,calls,collars,orfuturescontracts(discussedingreaterdetailin
Exhibit2).Forexample,Southwestcouldprotectitselfagainstariseinjet
fuelpricesbypurchasingaseriesofcalloptionsoncrudeoilat$65per
barrel(apriceabovethecurrentmarketrate)extendingoutbeyond2009.
Shouldcrudeoilpricesremainbelow$65perbarrelinanygivenyear,
Southwestwouldsimplyforgoexercisingitsoptionsinthatyear.Should
marketpricesriseabove$65,Southwestcouldexerciseforthespreadand
therebyatleastpartiallyoffsettheriseinjetfuelprices.But,asmen
tionedinthediscussioninExhibit2,therearecostsassociatedwithmany
hedgingarrangements.Southwest,astheholderofanoption,would
havetopayapremiumforthatprivilegeregardlessofwhetherornotit
decidedtoexercisethatoption.24 Otherhedgingarrangements,suchas
swapsandfuturescontracts,exposethehedgingpartytodownsiderisk
bylockingthemintowhatcouldbeahighprice.FollowingthefirstGulf
Warin1991,forexample,thedropinpricesthataccompaniedtheearly
victoriesofcoalitionforcestookmanycompaniesbysurprise,causing
severaltosuffergreatlossesduetohedgingpositionstheytookinantici
pationofrisingfuelcosts.25

AlloftheseconcernswereracingthroughAckermansmindas
sheponderedSouthwestsdilemma.ShouldshefailtocounselWright

SeeBB&T,May,2004,at15.
SeeDaveCarter,DanRogers,&BettySimkins,FuelHedgingintheAirlineIndustry:The
CaseofSouthwestAirlines(unpublished2004),Fig.5at25.
25DanielAltman,TryingtoMakeFuelPricesLessofaWartimeGamble,N.Y.TIMES,May23,
2003,atC4.
23
24

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appropriately,Southwestsmanagersanddirectorsmightfaceincreasing
pressurefromSouthwestsinstitutionalshareholders.

HEDGINGANDSHAREHOLDERVALUE

DesigninganeffectivehedgewasnotAckermansjob.Asgen
eralcounsel,however,shehadtoanticipatepotentialobjectionsfromthe
boardandfromshareholders.Management,sheknew,wishedtoavoid
bankruptcyatallcosts.Costs,however,wereexactlywhatsomeshare
holderswereconcernedabout.WouldSouthwestfritterawayitscom
petitiveadvantagebyenteringintoexpensivenewhedgingcontracts?

Theproblemwithhedgingisthatitcanbeexpensive.Share
holdersunderstandthatinvestinginequitiesisrisky,buttheydiversify
theirportfoliostomitigatethatrisk.Hedgingthusmaybeanunneces
sarydiversificationoffirmspecificrisk.Itmayjustreflecttheriskaver
sionofmanagers,imposingunnecessarycostsonthefirmandthereby
diminishingreturns.Defendersofhedging,however,notethatthesame
canbesaidofinsurance.26 Andyetfewwouldarguethatcorporations
shouldbecategoricallybannedfrompurchasinginsurance.Deciding
whetherhedgingmakessense,then,requiresamorenuancedandcon
textspecificinquiry.27

A.ArgumentsinFavorofHedging

26SeeKimberlyD.Krawiec,Derivatives,CorporateHedging,andShareholderWealth:Modi
glianiMillerFortyYearsLater,1998U.ILL.L.REV.1039,1046(1998).
27Cf.VictorP.Goldberg,AversiontoRiskAversionintheNewInstitutionalEconomics,146J.
INST.&THEOR.ECON.216(1990).

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Proponentsofhedgingarguethatbyfailingtohedgeagainst
firmspecificrisk,afirmmayreduceitsexpectedcashflowsandthereby
diminishshareholderwealth.28

1.ReductionofTransactionCosts

Oneexplanationforthepositiveimpactofhedgingonshare
holderwealthliesintransactioncosts.Twoobvioustransactioncoststhat
canbereducedthroughhedgingarethecostsassociatedwithbankruptcy
andthecostsofcontractingwiththefirmsriskaversestakeholders(em
ployees,customers,andsuppliers).29

Ifafirmisforcedintobankruptcy,thereareahostofdisruptive
costs,bothdirectandindirect,thatthefirmmustbear.30 Unsecured
creditorsshouldertheweightofreorganizationcosts;thus,thethreatof
insolvencycastsaheavyshadowthatcanreduceshareholderwealth
throughhigherinterestratesortriggeringdefaultonloansbecauseofa
failuretomeetdebtcovenants.Byhedgingagainstkeyrisks,suchasjet
fuelprices,afirmcansmoothoutitscashflows,diminishingtheshadow
ofbankruptcyanditsaccompanyingcosts.

Andthereareothertransactioncosts,outsideoftheinsolvency
context,thatafirmmustbearincontractingwithitsstakeholders;many
ofthesecostscanbereducedthroughhedging.Forexample,apotential
employeewilldemandariskpremiumbeforejoiningafirmifshebe
lievesthecompanymighthavecashflowproblems.31 Similarly,custom
ersandsuppliersmightdemandmorefavorablecontractualtermsifthey
toviewthefirmsoperationalresults(andthereforeabilitytoperformits
contractualobligations)asvolatile.32

SeeKrawiecat1059.
Seeid.at1061.
30Seeid.
31Seeid.at1063.
32Seeid.at106568.
28
29

DEALS F2006

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10

Howshouldtheabilitytoreducetransactioncoststhroughhedg
ingimpactSouthwestsdecision,particularlygiventhetransactioncosts
inherentinmanyhedgingarrangements?Howmightthespateofrecent
bankruptcyfilingsbyotherairlinesfactorintoSouthwestsdecision?Are
transactioncostsstilllikelytoinfluenceSouthwestshedgingdecision
giventherelativebargainingleveragethatSouthwesthaswithitsem
ployeesduetoitssuccessrelativetoitspeers?

2.EnhancementofFlexibilityintheFirmsInvestmentPolicies

Firmsoftenchoosetofinancecapitalintensiveprojectswith
fundsgeneratedbyinternalcashflow.Southwest,forexample,planson
purchasingsomewherebetween57and139Boeing737700sfrom2006
2008.33 Greatervolatilityinafirmscashflowslimitsitsabilitytofund
suchaprojectusinginternalfundsalone.34 Forexample,anairlineseek
ingtopurchasefouradditionalaircraftmayhavetoinvest$800million
peryearoverfouryearsinordertocompletesuchapurchasingprogram.
Assumethattheairlinesuffersfromgreatlyfluctuatingcashflowsdueto
highoperationalvolatility,suchthatinyear3itonlyhas$500millionin
availablefundsforaircraftpurchasesthatyear.Itcaneither(a)holdoff
onpurchasingadditionalaircraftthatyear;(b)seekfinancingfromexter
nalcapitalmarkets,whichmaybemoreexpensivethanitsinternalcost
ofcapital;or(c)shiftfundsfortheaircraftfromotherareas,either
throughunplannedcostreductionsorassetdivestitures.

Inanyoftheabovesituations,afirmwithhighoperationalvola
tilitymayexperienceasignificantadverseimpactonshareholderwealth
byexposingitselftotheinformationcostsoftheexternalcapitalmarkets
ratherthanhedgingitself.Whatimpactshouldthisunderstandingofthe
effectofhedgingonafirmsinvestmentpolicieshaveonSouthwestsde
cision?

3.ReductionintheFirmsAgencyCosts

33
34

SouthwestAirlines10KReport(2005)at8.
SeeKrawiecat1069.

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11

Theagencycostsfacedbycorporationscanalsobereduced
throughhedging.35 Particularly,thoseagencycostsassociatedwith
noisecanbereduced.36

Hedgingmayreducethenoiseinafirmsperformancebyre
ducingtheimpactofeventsoutsideofthefirmscontrol,therebyallow
ingshareholderstomoreclearlyobservethecompetenceofthefirms
management.37 Forexample,ifNorthwestandDeltahadbeenwell
hedgedagainstfuelcosts,theywouldhavebeenunabletoblametheir
spiralintobankruptcyonrisingfuelcosts.Instead,shareholderswould
havebeenabletomoreclearlyobservewhetherthefirmspoorperform
ancewasduetomanagerialincompetenceorextraneousevents.

WhatimplicationsexistforSouthwestinitsdecisionmaking
processgiventhepotentialimpactofhedgingonagencycosts?Woulda
rationalshareholderconsiderreducedagencycoststobealegitimaterea
sonforSouthwesttoenterintopotentiallycostlyhedgingarrangements?

4.ReplicationofVerticalIntegration

Forsomefirms,hedgingmayservetoassureastableandafford
ablesupplyoroutputsource.38 Therefore,forthesefirms,hedging
wouldsubstituteforverticalintegration.39 Verticalintegrationitself,
whileitmaybeaccretivetoshareholderwealth,maywellbeeitherfinan
ciallyimpossiblebecausethefirmcannotaffordtoacquireasupplieror
legallyprohibitedduetoantitrustconcerns.

Insomeways,hedgingissimilartoaverticalmergerinthatthe
hedgingfirmguaranteesitselfaccesstoagiveninput,protectedfrom
fluctuationsinthatinputsmarketprice.Thus,byhedgingagainstfluc

Seeid.at1072.
Seeid.at107375.
37Seeid.at1075.
38Id.
39Seeid.
35
36

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12

tuationsinthepriceofagivensupply,afirmcouldrealizemanyofthe
sameshareholderwealthbenefitsofverticalintegrationwithouthaving
toactuallyacquireadownstreampartnerthroughaverticalbusiness
combination.40

IsSouthwestshedgingprogrameffectivelyawaytoreplicatea
verticalmerger?

5.DiversificationforShareholders

Anotherargumentputforwardtodefendhedgingasameansof
enhancingshareholderwealthisthat,despitethecommonassumption
andexpectationthatshareholdersarediversified,infactnotallshare
holdersare,includingemployeeswhoownstock.41 Therefore,byhedg
ingagainstcertainkeyrisks,afirmcanreduceitsexposuretosignificant
unsystematicrisks,therebyreplicatingthebenefitsofdiversificationfor
itsinvestors.Thisargumenthas,however,beenlargelydiscountedeven
byproponentsofhedging.

Whatarethekeyweaknessesofthisargument?ShouldSouth
westutilizehedgingarrangementsinordertoprovidegreaterdiversifica
tiontoitsshareholders,assumingthattheyhavenotalreadydiversified
theirinvestmentportfolios?Isthiseffectivelyareformulationofthe
muchmalignedconglomeratetheoryofcorporatemanagementthaten
joyedpopularityinthe1960sand1970s?

B.ArgumentsAgainstHedging

Othercommentatorshavequestionedtheroleofhedgingin
managementsfiduciaryduties.Thequestionsfrequentlyturnon:(i)
whetherthetruebeneficiaryofmanagementsfiduciarydutiesshouldbe

40
41

Seeid.
Seeid.at1078.

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13

shareholdersorthecorporateentity(ineffect,stakeholders)and(ii)
whetherhedgingisconsistentwithmanagementsdutiesineithercase.

Theargumentthathedgingisinconsistentwithmanagements
fiduciarydutiesbeginswiththepremisethattheproperbeneficiariesof
thosedutiesarethefirmsshareholders.42 Therefore,anymanagement
actionsthatarechieflyforthebenefitofothersratherthanforthebene
fitofthefirmsshareholdersviolatemanagementsdutyofloyalty.
Thus,hedgingcanbeseenasfurtheringcorporatewealthratherthan
shareholderwealthandtherebyviolatesmanagementsfiduciarydutyof
loyalty.Further,evenifmanagersarelookingtoenhanceshareholder
wealththroughhedging(andarethereforenotviolatingtheirdutyof
loyalty),someclaimthattheyarenotactuallyenhancingshareholder
wealthandarethusviolatingtheirdutyofcarebywastingthecorpora
tionsassets.

Thesetwocontentionsarecontainedinthetwochiefarguments
bythoseopposedtohedging.Thefirstargumentisthathedgingar
rangementsareusuallyenteredintotomanageaccountingearnings(i.e.,
toenhancecorporatewelfare)ratherthantoimprovethefirmsnetpre
sentvalue(i.e.,toenhanceshareholderwelfare).43 Thesecondargument
isthathedgingmerelyreducesunsystematicrisk,whichshareholderscan
(anddo)reduceontheirownthroughdiversification.44

1.HedgingasaMechanismtoManageAccountingEarnings

Thefirstargumentoftenprofferedbythoseopposedtotheuseof
hedgingarrangementshasitsrootsinthedutyofloyalty.Accordingto
thisargument,manycompaniesutilizehedgingarrangementstolimit
theirexposuretoaccountingearnings,ratherthantoreducethecom
panysexposuretoeconomicfluctuations.45

42HenryT.C.Hu,NewFinancialProducts,theModernProcessofFinancialInnovation,andthe
PuzzleofShareholderWelfare,69TEX.L.REV.1273,1278(1991).
43Seeid.at130607.
44Seeid.at130709.
45Seeid.at1306.

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14

Hedgingagainstaccountingfluctuationsdoesnotenhance
shareholderwealth,butinsteadmerelybenefitscorporatemanagersin
theshortrun.46 Particularly,thefirmsmanagersandemployeesbenefit
fromcarefullymanagednumbers(byenhancingtheirprofessionalmar
ketvalueandbyincreasingtheircompensationifitistiedtoperform
ance)attheexpenseofshareholders,whoultimatelybearanytransaction
costsinvolved.Thisargumentemphasizestheprincipalagentdilemma
inherentinthegreaterriskaversionofmanagersascomparedtoshare
holders.

WhataretheimplicationsofthisargumentforSouthwestasit
considerswhethertohedgeagainstrisingfuelcosts?Ifoneconsidersany
effortstomanageaccountingnumberstobewastefulfromashare
holderwealthstandpoint,thenmusthedgingbedeemedaviolationof
managementsfiduciaryduties?Oristherealegitimateargumentthat
hedgingservesadesiredpurposefromashareholderwealthstandpoint
andisnotmerelyamechanismformanagementtomanipulateaccount
ingresults?

2.HedgingasaMechanismtoReduceUnsystematicRisk

Thesecondargumentfrequentlyputforwardinoppositiontothe
useofhedginghasitsrootsinthedutyofcare(andtosomedegreethe
dutyofloyalty).Thisargumentseeshedgingasprimarilyameansofre
ducingunsystematicrisk.47 Giventhatmostshareholdershavealready
reducedtheirexposuretounsystematicriskthroughdiversification,the
useofcostlyhedgingarrangementswouldunderthisviewbewasteful
fromashareholderwealthstandpoint.48

Underthisargument,hedgingmightviolatemanagementsduty
ofcarebywastingcorporateassets.Further,hedgingmightalsoviolate

Seeid.
Seeid.at130708.
48Seeid.
46
47

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15

managementsdutyofloyaltybytransferringwealthfromshareholders
tootherstakeholders(assumingthatmostshareholdersarediversified):
afterall,adiversifiedshareholderhasalreadyreducedherexposureto
manyofthe(unsystematic)risksthathedgingisdesignedtoaddress,
whilemanagersandemployeeslackthatluxuryandsufferfromin
creasedvolatilityinthefirmsperformance.Hedging,therefore,actsasa
mechanismformanagers,employees,andundiversifiedshareholdersto
reducetheirexposuretorisk.Diversifiedshareholders,meanwhile,re
ceivenocorrespondingbenefitwhilebearingmostofthecostofthisrisk
reduction.

WhataretheimplicationsofthisargumentforSouthwestasit
considerswhattodoregardingitshedgingprogram?Wouldacourt
considerextensivehedgingbySouthwesttobewastefulfromashare
holderwealthstandpointandthereforeaviolationofmanagementsduty
ofcare?CouldSouthwestsmanagersordirectorsbedeemedtohave
violatedtheirdutyofloyaltytothefirmsshareholdersbyusinghedging
arrangementstoprotecttheirowninterestsratherthanthoseofthefirms
shareholders?

ConcludingQuestions

Asapracticalmatter,itseemshighlyunlikelythatashareholder
lawsuitwouldsucceed.Undercurrentlaw,managementsdecisions
wouldalmostcertainlybeprotectedbythebusinessjudgmentrule.How
shouldthisfactaffecttheroleofinhousecounsel?Isherdutysimplyto
advisetheboardaboutthelegalconsequencesofitsdecisions?Orshould
shealsovoicethepotentialconcernsofshareholders,eventhoughthe
litigationriskisslight?

Giventhesituation,whatshouldAckermanrecommendto
WrightregardingSouthwestsfuelhedgingprogramgoingforward?
WhatarethekeyconcernsthatsheshouldcommunicatetoWrightre
gardingeachoftheavailableoptions?Fromalegalstandpoint,whichal
ternativesappearmostattractive?

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Appendix
Exhibit 1: CASM Data by Carrier (2000 vs. 2004 vs. 2005-Q2)
16
14
12
10
8
6
4
2
0
Continental

United

American

US Air

Delta

2000-FY

Northwest Alaska

2004-FY

America
West

JetBlue

Airtran

Southwest

Avg.

2005-Q2

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 28-29.

Exhibit 2: Description of Southwest Swaps, Options, and Collars

Frequently Used Fuel Hedging Instruments by Airlines
This section describes the most commonly used hedging contracts by airlines: swap contracts (including plain vanilla, differential, and basis swaps), call options (including caps),
collars (including zero-cost and premium collars), futures contracts and forwards contracts.
Plain Vanilla Swap
The plain vanilla energy swap (called this because it is simple and basic when compared
to more exotic swap contracts) is an agreement whereby a floating price is exchanged for a
fixed price over a certain period of time. It is an off-balance-sheet financial arrangement,
which involves no transfer of the physical item. Both parties settle their contractual obliga-

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tions by means of a transfer of cash. In a fuel swap, the swap contract specifies the volume
of fuel, the duration (i.e., the maturity of the swap), and the fixed and floating prices for
fuel. The differences between fixed and floating prices are settled in cash for specific periods (usually monthly, but sometimes quarterly, semi-annually, or annually).
In all swap contracts, the airline is usually the fixed-price payer, thus allowing the airline
to hedge fuel price risk. For more information on these contracts, refer to the NYMEX
website at http://www.NYMEX.com.
Differential Swaps and Basis Risk
While a plain vanilla swap is based on the difference between the fixed and floating prices
for the same commodity, a differential swap is based on the difference between a fixed differential for two different commodities and their actual differential over time. Differential
swaps can be used by companies to manage the basis risk from other hedging activities.
For instance, assume an airline prefers to hedge its jet fuel exposure using a heating oil
plain vanilla swap. The airline can used an additional swap contract, the differential swap
for jet fuel versus heating oil, to hedge basis risk assumed from the heating oil swap. The
net result is that the airline can eliminate the risk that jet fuel prices will increase more than
heating oil prices. Basis risk can be an important concern for cross-hedges of this type. For
more information on differential swaps, refer to Chapter 1 of Falloon and Turner (1999).
Call Options (Caps)
A call option is the right to buy a particular asset at a predetermined fixed price (the strike)
at a time up until the maturity date. OTC options in the oil industry are usually cash settled
while exchange-traded oil options on the NYMEX are exercised into futures contracts.
OTC option settlement is normally based on the average price for a period, commonly a
calendar month. Airlines like settlement against average prices because an airline usually
refuels its aircraft several times a day. Since the airline is effectively paying an average
price over the month, they typically prefer to settle hedges against an average price (called
average price options).
In the energy industry, options are often used to hedge cross-market risks, especially when
market liquidity is a concern. For example, an airline might buy an option on heating oil as
a cross-market hedge against a rise in the price of jet fuel. Of course, cross-market hedges
should only be used if the prices are highly correlated.
Airlines such as Southwest value the flexibility that energy options provide, but energy options can be seen as expensive relative to other options. The reason is the high volatility of
energy commodities, which causes the option to have a higher premium. For this reason,
zero-cost collars (discussed next) are often used. Figure 5 provides a conceptual illustration for hedging gains or losses using swaps, call options, and premium collars when locking into a 60-cent/gallon price of jet fuel.
Collars, Including Zero-Cost and Premium Collars

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A collar is a combination of a put option and a call option. For a hedger planning to purchase a commodity, a collar is created by selling a put option with a strike price below the
current commodity price and purchasing a call option with a strike price above the current
commodity price. The purchase of a call option provides protection during the life of the
option against upward commodity price movements above the call strike price. The premium received from selling the put option helps offset the cost of the call option. By establishing a collar strategy, a minimum and maximum commodity price is created around a
hedgers position until the expiration of the options. Figure 6 provides an example of the
net cost of jet fuel in $/gallon using a collar where a call option is purchased with a $0.80
strike price and a put option is sold with $0.60 strike price. As shown, the airline will never
pay more than $0.80 for jet fuel no matter how high prices rise, yet will never pay less than
$0.60 regardless of how low jet fuel prices drop. A collar can be structured so that the
premium received from the sale of the put option completely offsets the purchase price of
the call option. This type of collar is called a zero cost collar.
If more protection against upward price movements is desired (i.e., having a lower call option strike price) or more benefit from declining prices is desired (i.e., selling a put with a
lower strike price), a premium collar is used. With a premium collar, the cost of the call
option is only partially offset by the premium received from selling a put option. Refer to
Figure 5 for a conceptual illustration of the premium collar strategy.
Using a zero-cost collar or premium collar may appear to be a reasonable hedging strategy
for an airline since it involves no upfront cost (or low upfront cost) and involves no speculative return. However, if jet fuel prices fall significantly, as illustrated in Figure 6, the airline may pay more for jet fuel than its competitors who did not employ the collar strategy.
Competitors may lower their airfares aggressively as a result. Accordingly, the zero-cost
collar should be more accurately called a zero-upfront cost collar.
Futures and Forward Contracts
A futures contract is an agreement to buy or sell a specified quantity and quality of a
commodity for a certain price at a designated time in the future. The buyer has a long position, which means he/she agrees to make delivery of the commodity (i.e., purchase the
commodity). The seller has a short position, which means he/she agrees to make delivery
of the commodity (i.e., sell the commodity). Futures contracts are traded on an exchange,
which specifies standard terms for the contracts (e.g., quantity, quality, delivery, etc.) and
guarantees their performance (removing counterparty risk). Only a small percentage of futures contracts traded result in delivery of the commodity (less than one percent in the case
of energy contract). Instead, buyers and sellers of futures contracts generally offset their
position.
A forward contract is the same as a futures contract except for two important distinctions:
(1) Futures contracts are standardized and traded on organized exchanges, whereas forward contracts are typically customized and not traded on an exchange; and (2) Futures
contracts are marked to market daily, whereas forward contracts are settled at maturity
only. For the futures contract, this means that each day during the life of the contract, there
is a daily cash settlement depending on the current value of the commodity being hedged.

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The NYMEX exchange trades futures on crude oil, heating oil, and gasoline (among other
commodities).
Source: Dave Carter, Dan Rogers, & Betty Simkins, Fuel Hedging in the Airline Industry:
The Case of Southwest Airlines (2004) at 5-8.

Exhibit 3: Hedging by U.S. and Foreign Airlines

Summary of Fuel Hedging in the U.S. Airline Industry
Airline
AirTran
Alaska
America West
American
Continental
Delta
JetBlue
Northwest
Southwest
U.S. Airways
United
Average
(ex-Southwest)

2H 2005
2006E
% Hedged
Price
% Hedged
Price
34%
$1.71 / gal.
14%
$1.72 / gal.
50%
$30 / bbl
42%
$40 / bbl
53%
$1.40 / gal.
4%
$1.44 / gal.
4%
$48 / bbl
0%
NA
0%
NA
0%
NA
0%
NA
0%
NA
20%
$30 / bbl
0%
NA
0%
NA
0%
NA
85%
$26 / bbl
65%
$32 / bbl
0%
NA
0%
NA
3%
$1.24 / gal.
0%
NA
16%

NA

6%

2007E
% Hedged
Price
8%
$1.69 / gal.
20%
$45 / bbl
0%
NA
0%
NA
0%
NA
0%
NA
0%
NA
0%
NA
45%
$31 / bbl
0%
NA
0%
NA

NA

3%

NA

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 31-32.

Summary of Fuel Hedging in the European Airline Industry

Airline
Air France-KLM
British Airways
easyJet
Iberia
Lufthansa
Ryanair
SAS
Average

2H 2005
% Hedged
Price
83%
$42 / bbl
81%
$45 / bbl
20%
NA
50%
$43 / bbl
90%
$35 / bbl
90%
$57 / bbl
50%
NA
66%
NA

Late 05 - Early 06
% Hedged
Price
83%
$42 / bbl
81%
$45 / bbl
NA
NA
NA
NA
90%
$40 / bbl
90%
$49 / bbl
50%
NA
79%
NA

4/06 - 3/07
% Hedged
Price
54%
$52 / bbl
40%
$50 / bbl
NA
NA
0%
NA
NA
NA
NA
NA
NA
NA
NA
NA

4/07 - 3/08
% Hedged
Price
31%
$58 / bbl
NA
NA
NA
NA
0%
NA
NA
NA
NA
NA
NA
NA
NA
NA

Source: Analyst Report on European Airline Industry, Morgan Stanley, Sept. 15, 2005, at
3-5.

Summary of Effective Fuel Costs per Gallon After Hedging in the U.S. Airline Industry

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Airline
AirTran
Alaska
America West
American
Continental
Delta
JetBlue
Northwest
Southwest
U.S. Airways
United
Average
(ex-Southwest)
Southwest
Advantage

20

2H 2005

2006E

2007E

$1.83
$1.46
$1.63
$1.88
$1.89
$1.89
$1.72
$1.89
$1.00
$1.89
$1.87

$1.86
$1.62
$1.86
$1.88
$1.88
$1.88
$1.88
$1.88
$1.35
$1.88
$1.88

$1.84
$1.76
$1.86
$1.86
$1.86
$1.86
$1.86
$1.86
$1.49
$1.86
$1.86

$1.80

$1.85

$1.85

44%

27%

19%

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 31-32.

Summary of Southwest Fuel Hedging

% Hedged
Hedge Rate / bbl
(WTI)
Current Fwd Rate
/ bbl (WTI)
Crack Spread
WTI + Crack
Cost After Hedge
(per bbl)
Cost After Hedge
(per gal)

2H 2005

2006E

2007E

2008E

85%

65%

45%

30%

25%

$26.00

$32.00

$31.00

$33.00

$35.00

$66.50

$66.00

$65.00

$63.00

$62.00

$10.00
$76.50

$13.00
$79.00

$13.00
$78.00

$13.00
$76.00

$13.00
$75.00

$42.08

$56.90

$62.70

$67.00

$68.25

$1.00

$1.35

$1.49

$1.60

$1.63

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 31-32.

2009E

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Exhibit 4: Diluted Earnings Per Share Results for U.S. Airline Industry
(2003-06E)
Airline
AirTran
Alaska
American
Continental
Delta
JetBlue
Northwest
Southwest
U.S. Airways
Average
(ex-Southwest)

2003
0.74
(1.15)
(9.69)
(3.36)
(8.58)
0.85
(6.57)
0.36
NA

2004
0.13
0.20
(5.57)
(4.32)
(18.10)
0.43
(8.41)
0.41
NA

2005E
(0.15)
1.85
(3.73)
(3.62)
(14.11)
0.20
(18.24)
0.63
(8.04)

2006E
0.40
3.20
(3.20)
(1.00)
(11.25)
0.25
(3.55)
0.63
(4.50)

(3.97)

(5.09)

(5.73)

(2.46)

Source: Analyst report on Airline Industry, Bear Stearns, Oct. 11, 2005, at 10.

Exhibit 5: Jet Fuel and Crude Oil Prices (2004-2005)

NYMEX Futures Price of No. 2 Heating Oil

(Jan. 2002 Nov. 2005)
250

200

Cents
per
Gal.

150

100

50

1/02

5/02

9/02

1/03

5/03

9/03

1/04

5/04

9/04

1/05

5/05

9/05

Source: U.S. Department of Energy, Energy Information Administration (Nov. 23, 2005
update).

11/05

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Exhibit 6: Southwest CASM Advantage v. Airline Industry (2000-2006E)

2000

2001

2002

2003

2004

2005E

0%
-10%
-20%
-30%
-40%
-50%
-60%
Advantage
v. LCCs

Advantage
v. Legacies

Advantage
v. Industry

Source: Analyst report on Southwest Airlines, Bear Stearns, Oct. 17, 2005, at 4.

2006E

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Exhibit 7: Southwest Share Price vs. DJIA and vs. Airline Group (2001-2005)

Source: Wall Street Journal Online, Nov. 15, 2005.

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Exhibit 8: Southwest Income Statement (1999-2007E)

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 40.

Exhibit 9: Southwest Basic Earnings per Share and Analyst Estimates (20022007E)
Actual
Citigroup Estimate
Morgan Stanley Estimate
JP Morgan Estimate

2002
0.26
-

2003
0.38
-

2004
0.43
-

2005E
0.55
0.57
0.55

Source: Analyst Report on Southwest Airlines Co., Citigroup, Sept. 29, 2005, at 40; Analyst Report on Southwest Airlines Co., Morgan Stanley, Apr. 15, 2005, at 5-6; Analyst
Report on U.S. Airline Industry, JP Morgan, Sept. 21, 2005, at 7.

2006E
0.51
0.58
0.50

2007E
0.52
NA
NA