Fuel hedges could waste airlines' money

By Kyle Peterson

CHICAGO (Reuters) - U.S. airlines are cheering a steep decline in the price of jet fuel since mid-July, when crude oil began a nearly $27-per-barrel descent, but that good news may come with a slight sting for carriers that locked in fuel prices when oil was at its peak.

The risk is that oil may drift below the current price airlines guaranteed with hedging contracts, which are usually options. If that happens, the hedges carriers purchased could be a waste of money.

Worse yet, it is possible some airlines could be committed to paying more for their fuel than market prices.

"Given some of the hedging mechanisms they are using, they are going to be subject to significant losses on those portfolios. We've never seen such volatility on oil prices," said Brian Nelson, equity analyst at Morningstar.

"They're going to see significant losses if crude oil continues to fall."

Nymex crude oil CLc1 traded near $120.50 a barrel on Monday, down from the record high of $147.27 set on July 11. The spot price of jet fuel JET-NYH -- directly linked to the price of crude -- was about $3.45 per gallon.

Information provided by the seven largest U.S. airlines last month show their fuel hedges are still effective. That means that, on the portion of their expected fuel consumption, carriers have locked in a price that is currently below the market price.

UAL Corp (UAUA.O: Quote, Profile, Research, Stock Buzz), parent of United Airlines, for example said it would face payment obligations in the third quarter only if the price of jet fuel falls below a price equivalent to $100 per barrel of oil.

AMR Corp (AMR.N: Quote, Profile, Research, Stock Buzz), parent of American Airlines, said it has hedged 35 percent of its third-quarter fuel at an equivalent to $95 per barrel of oil.

Southwest Airlines Co (LUV.N: Quote, Profile, Research, Stock Buzz), whose hedging positions predate those of rivals, said it hedged 80 percent of its expected third-quarter fuel consumption at a price equivalent to $61 per barrel of oil.

Two major carriers -- Continental Airlines Inc (CAL.N: Quote, Profile, Research, Stock Buzz) and Northwest Airlines Corp NWA.N -- each have hedged more than half of their anticipated fuel needs for the second half of 2008. But neither carrier disclosed the prices.

Airlines have been battered severely this year by a run-up in fuel prices to new records. And fuel bills have more than offset a series of fare increases and fees, leading to a collective second-quarter industry-wide loss.

For that reason, airlines do not want to take a chance on operating completely unhedged, a practice that exacerbated their woes a few years ago. But times are still hard for carriers and they do not want to pay for ineffective hedges.

"There's always that possibility. I'm sure there's a lot of sweating," said airline consultant Robert Mann. "(The market) can go against you as easily as it can go for you."

Mann noted, however, that the base objective of hedging is to limit the impact of market volatility, not to capitalize on it. Airlines make it a priority to lock in a fuel price at which the company could be profitable.

If the market moves lower before the hedge expires, that is a risk carriers can accept, he added.