For those of you who're wondering how Southwest maintains such low fares, these two articles from The WSJ (several weeks ago) explain a large part of the equation...
 

For Airlines, Fuel Hedging Gets Tricky

By KEITH JOHNSON
Staff Reporter of THE WALL STREET JOURNAL
May 19, 2005; Page C3

For bold investors who can stomach airlines, learning how the companies are dealing with soaring fuel prices can help distinguish between the smoother fliers and those likely to cause aviophobia.

Fuel, the second-biggest cost for most airlines after labor, is now the top expense for some. Even the newer, more-efficient aircraft that most European airlines fly and hefty fuel surcharges added to ticket prices haven't made up for fuel prices that have far surpassed forecasts.

Jet fuel is even more expensive than the crude oil from which it is refined, and that price gap is growing. Historically, jet fuel, which is kerosene, costs only about $5 more per barrel than crude, and prices moved in tandem. But demand also is rising for oil products similar to jet fuel, like diesel. That squeezes refinery capacity, pushing prices even higher. The differential between crude and jet fuel is now hovering near $20 and shows no signs of narrowing.

"Few airlines had $50 oil in their budgets, and nobody planned for $70 jet fuel," says Penny Butcher, a Morgan Stanley analyst in London. Now some airlines are changing how they tackle fuel increases, locking in costs for future fuel needs priced in jet fuel rather crude. That move takes some of the sting out of high prices, and could be a clue for investors.

The fuel hedges that airlines typically have used lock in favorable oil prices for as long as three years. But traditional hedges are tricky with oil prices so high, and some airlines have given up on them. Ryanair Holdings of Dublin, for example, is completely exposed to market prices for fuel this year and says it won't resume hedging until oil prices go below $40. (Crude-oil futures closed at $47.25 on the New York Mercantile Exchange yesterday). The airline is relying on its industry-leading profit margins as a cushion.

Hedges also cost money, like any insurance. Some cash-strapped carriers, like Delta Air Lines, have sold their hedges to raise money. Other U.S. carriers, including Continental Airlines, Northwest Airlines and US Airways Group, are opting to forgo hedges and pay market prices for fuel this year. Profitable, low-cost carrier Southwest Airlines still hedges aggressively, however.

Iberia is one of a few European airlines that hedge directly in jet fuel. The Spanish carrier still posted a loss of €16.1 million ($20.3 million) in the first quarter after fuel expenses increased by €40 million. But it would have been worse without its hedging program, which saved the airline €16.6 million in the quarter.

Elsewhere, British discount carrier easyJet has hedged 20% of its fuel costs through June directly in jet fuel, but will be fully exposed to market prices after that.

Bigger airlines are making the move to jet-fuel hedging more slowly and may not ever be able to fully employ the strategy because jet fuel is an illiquid commodities market where big buyers would distort prices. British Airways, for instance, says it simply can't hedge in jet fuel because of its size. Airlines also need special software and derivatives teams in order to make deals directly in the jet-fuel market.

Germany's Lufthansa has hedged 88% of its fuel needs, almost all in crude oil, through the rest of the year, and saved €50 million in the first quarter by hedging. It plans eventually to cover half of short-term future needs directly in jet kerosene. Currently the airline hedges a fraction of its needs in jet fuel.

"Like most airlines, we underestimated the refinery shortage, so the real cost increase that we suffer" is because of the widening differential between crude oil and jet fuel, says Helmut Friedrich, head of fuel services for Lufthansa. "The big question is what will that spread do from here?" he adds. "It is very tough to hedge in the middle of a paradigm shift."

Even without the distinction in hedging programs, investors seem to be giving the benefit of the doubt to smaller and discount airlines. Lufthansa shares have moved sideways so far this year, even though Lufthansa is better protected against fuel price rises than most of its peers. EasyJet shares, on the other hand, are up about 32%.
 

Hedge Hog Southwest Air
Sharpens Its Teeth

By SUSAN WARREN
Staff Reporter of THE WALL STREET JOURNAL
May 19, 2005; Page C1

Southwest Airlines' aggressive hedging program has shielded it from soaring oil prices, delivered profits while its rivals posted billions of dollars of losses and put a halo over Chief Executive Gary Kelly for his financial savvy.

Still, investors should prepare for less of a good thing. Airline-industry experts say the competitive advantage that Southwest Airlines has enjoyed from its hedging program, which effectively locked in lower fuel costs while prices surged, will be shrinking in coming months and years. And its aggressive hedging could work against it if oil prices tumble -- a possibility that analysts are considering more seriously as they see slower demand growth for crude and swelling supplies.

The ultimate success of Southwest's hedging program will depend on whether the company uses the war chest it has accumulated from hedging gains to climb over rivals weakened by soaring fuel costs. "The benefit on their earnings will diminish over time," says Glenn Engel, an analyst with Goldman Sachs, which does investment-banking work for Southwest. "The question is, 'Will Southwest end up with a sustainable edge because of its hedging?' " Mr. Engel doesn't own any shares of Southwest, which he rates "in line," the equivalent of hold.

(Meanwhile, some airlines deal with soaring fuel prices better than others. See related article¹.)

Since oil prices began climbing in November 2001, when a barrel cost about $17 (compared with $47.25 now), Southwest has been steadily expanding its hedging program. At the end of 2001, Southwest had hedged 60% of its 2002 fuel needs, 47% of its 2003 needs but only "a small portion" of its needs in 2004 and 2005.

At the end of last year, though, Southwest had secured significant hedges as far out as 2009, securing 25% of its fuel at $35 a barrel.

Mr. Kelly said Southwest was better able to cope with high fuel prices because it has long-term hedges in place. "No airline can make money at $50 a barrel. We have five years' protection to make adjustments," he said.

Those hedges represent Southwest's bets that the price of oil will stay above $35 a barrel for the next five years. While many experts do predict that oil prices will stay high -- or go higher -- others believe a decline is just as possible. Oil markets are cyclical, notes John Kilduff, a hedging specialist at brokerage house Fimat USA. "It's just a matter of time before we get back to crude oil in the low $40s," he adds. "Even $25 a barrel isn't out of the question."

Southwest's low-cost model has made it the perennial star of a badly tarnished industry. The Dallas carrier recently posted its 56th straight quarter of profitability in the period ended March 31. Its seven largest rivals posted a collective loss of $1.9 billion in that quarter. Southwest's market value of $11.8 billion is more than the rest of the major U.S. airlines combined. But a good part of Southwest's recent financial success has come from the hedging program.

That program has reaped more than $1 billion in savings since 2000. Without those hedging gains, its profit streak already would be over. In the first quarter, Southwest posted $76 million in net income -- and would have reported a loss but for its $155 million in hedging gains.

Despite the advantage Southwest's hedging has given the company, investors haven't been sure how to value it. Southwest's low operational costs, leading industry position and strong balance sheet all factor into its stronger stock value.

But it isn't the highflying stock it once was, when investors reaped a nearly 1000% gain from $1.05 in 1989 to $10.75 in 1999. In 4 p.m. New York Stock Exchange composite trading yesterday, Southwest shares were down a penny, at $14.99 -- about flat with the price in 2000. Still, that is an accomplishment compared with most other carriers, whose shares have plummeted in the past five years.

Southwest says it hedges through a combination of financial instruments that also protect it if the price of oil falls. Since oil prices have stuck near $50 a barrel, Southwest has had to pay more for hedging its fuel. Because it is harder to get reasonable hedges in a $50 market, it has hedged only 65% of its risk at $32 for next year, compared with 85% at $26 for this year.

Because of higher oil prices, higher hedging costs and greater exposure to the spot-price market, Southwest calculates its fuel costs could surge 50% to $1.5 billion in 2006 from $1 billion in 2004 if oil prices stay at current levels.

Asked if Southwest would be disadvantaged compared with unhedged airlines if fuel prices fell significantly, Mr. Kelly said no. "We have tried to carefully construct the position so we participate if prices drop." He said the airline bought hedges as an insurance policy instead of trying to lock in a price.

If Southwest invests its hedging cash to improve its market position while competitors choke on high fuel prices, the better its stock will do in the long run -- even if its hedging gains eventually evaporate, experts agree.

Mr. Kelly appears to be trying to do just that since taking over as CEO in July. He has been shoring up Southwest's market position in weaker competitors' markets, aggressively expanding Southwest's range with new routes and service in cities such as Chicago, Pittsburgh and Philadelphia.