How financial speculation in oil prices ruins airline profits

August 17, 2011
How financial speculation in oil prices ruins airline profits
By Kevin G. Hall | McClatchy Newspapers

ATLANTA — Although planes take off and land round-the-clock at this city's bustling airfield, Paul Jacobson isn't focused on flying, but rather on how much it costs to fly. As the senior vice president of finance for Delta Air Lines Inc., he must navigate volatile fuel costs, which he thinks that oil speculators are driving to punishing levels.

During peacetime Delta is the world's largest consumer of jet fuel, edging out the Department of Defense. So even a small move in oil prices has an impact on the bottom line of a company that flies at least 700 of its own large and regional airplanes and counts more than 1,400 aircraft under its companywide umbrella.

Delta and the Air Transport Association, the lobby for airlines, have been out in front among 98 companies and trade groups that banded together to create the Stop Oil Speculation Now coalition. It's pushing for curbs on financial players in the oil markets, which they believe are pushing fuel prices high to profit from trading rather than from any need to consume fuel.

"Given how much trading there is today in commodities, it warrants as much attention and scrutiny as the stock market gets, and deserves some checks on the power of any individual player so as not to unduly influence" pricing in oil markets, said John Heimlich, the Air Transport Association's chief economist.

Airlines argue that huge investment inflows from pension fund investors and Wall Street firms into the oil markets are driving volatility in world oil prices and distorting the price of crude oil and jet fuel.

"We don't want to be in a scenario where we have to 'right-size' the airline for fuel prices. We want stable fuel prices so we can go and run our business, grow and be a normal business," Jacobson said in an interview at Delta's global headquarters here, next to Hartsfield-Jackson international airport. "When we have to react with capacity reductions, all of this stuff is important."

Capacity reduction is a fancy way of saying that Delta and its competitors have to ground airplanes when oil prices get too high. Because of rising fuel prices, they must cram more passengers onto fewer flights in an attempt to control their costs.

Rising oil prices are out of sync with a weak U.S. economic recovery. Delta and its competitors, all job creators, struggle to remain profitable. The price of the jet fuel they need to fly Americans to and from destinations is as volatile as the prices motorists pay at the local gas pump.

"The way to think about that in our context is about $100 million to the bottom line; more profitability or less profitability, depending on which direction that shifts," said Jacobson, who's also Delta's treasurer.

The airline consumes about 95 million barrels of jet fuel, or 4 billion gallons, annually.

At any point in time, Delta is hedging about 50 percent of its fuel costs. It does so through purchasing contracts for future delivery of oil, called futures contracts. It also does so by entering into private bets with Wall Street banks and other players in the unregulated over-the-counter market, sometimes called the swaps or derivatives market.

For most of the last 30 years, end-users of oil — such as airlines, oil refiners and trucking companies — dominated the futures market. They traditionally composed 70 percent of the market.

Today, that ratio has been flipped on its head: Financial players with no intent of ever using a barrel of oil make up 70 percent to 80 percent of the market in any given week.

That's why Delta and the Air Transport Association are aggressively pushing regulators to rein in financial speculation. They want limits imposed on financial players across several oil-trading platforms, not just in the futures market. And they want to return to a market in which some speculation is encouraged but not to the point that it crowds out users of oil.

Futures markets are designed to bring together buyers and sellers, and through a process called "price discovery" they reach rational, mutually acceptable prices for the underlying commodity, in this case crude oil.

Since 2000, and especially since 2007, big institutional investors such as pension funds and commodity-investment funds have flooded into the commodities markets, taking positions in everything from coffee to crude.

This has led some analysts to argue that these financial players distort the price discovery process in the futures market and raise the price of oil.

However, Sarah Emerson, a Boston-based analyst for Energy Security Analysis Inc., disagrees.

"I think it is price discovery, but in a new and different world than we had 10 or 15 years ago. And it's a world, unfortunately, that the airlines will have to cope with," she said. "They consume a commodity that a lot of people want. It's in every country, in every economy, and it's subject to production problems. ... I would argue that price discovery is better than it ever was."

Emerson thinks that oil was priced too low for too long, and that traditional oil traders looked past real risks to global supply disruptions.

"The world is not perceived as safe as it used to be. Markets are all about perceptions," she said.

However, she agrees with airlines that speculation has raised the price of crude oil and that there needs to be greater transparency about trades to level the playing field.

"There is a premium, and I think that it is huge. There is a gray area for sure that the financial community is in, but I don't think we can say the current pricing is 'wrong.' It is what it is. It's a market where there is asymmetric information, and unfortunately Delta is on the wrong end of that," the veteran energy analyst said.

Delta starts with the assumption that it's always short of the fuel it needs, since it doesn't produce any itself.

"We're short 95 million barrels of jet fuel per year if we want to keep flying. That's a risky position to have, and if you think about it in a Wall Street context, there isn't a trader on Wall Street that would take that big a position ... because of the risk around that position, so we've got to find ways to mitigate that," Jacobson said.

The airline does so by trying to guess the direction of oil prices in the futures market, then making private bets, with supplier contracts and a host of other financial mechanisms designed to hedge against rising oil prices.

American Airlines also is concerned about the role of speculative money in oil markets and how that affects its bottom line. The airline used almost 2.5 billion gallons of jet fuel last year, and it tries to hedge anywhere from 35 percent to 50 percent of its fuel needs, going out as far as 24 months in an effort to smooth out the volatility in oil prices.

"We fully support the Air Transport Association's effort to curb oil speculation driven by those traders who have virtually no intention of ever using or refining the oil they trade," said Sean Collins, a company spokesman in Dallas, adding that hedging efforts have produced cost savings in eight of the last 10 years.

Critics contend that the huge inflow of investment money into oil amounts to a self-fulfilling prophecy, with investors betting that prices in the future will go higher, thus driving them up. Wall Street investment banks touted commodities over the last decade as a way to reduce risk and enhance earnings, since commodity prices often moved in the opposite direction of stock prices.

The rise of emerging economies such as China and Brazil, drivers of growing global demand for oil, has aided this sales pitch. There's no reliable global information about supply, production and consumption of oil. The opaqueness of data encourages speculation.

Speculation is primarily felt in the futures market. When the price of an oil futures contract is higher six months from now than it is for delivery next month, it's a typically short-lived phenomenon called contango. Today, airlines and other end-users lament what's now being called "perpetual contango." Futures prices continue to rise irrespective of weak demand for oil in the sluggish U.S. economy.

"The pension funds, the asset managers, the index investors are essentially saying, 'I just need a piece of the pie. I don't care if the price goes up or the price goes down, because I am doing it as a return-enhancer/risk reducer to my other asset,' " Jacobson said.

These investors care little about supply and demand, said Heimlich of the Air Transport Association.

"I think today a lot of people are playing in the oil market who don't know much about the fundamentals of energy markets, and they may not care much," he said. "It may not be malicious, but they may not be fully informed."

To appreciate what volatile prices mean to airlines, consider that when oil prices tumbled over a period in May, after a price spike, Delta saw the value of its hedges drop by $140 million. That big number is peanuts compared with the $1.2 billion that the top hedge funds invested in oil lost over those same days.

"When you look at the dollars invested and the magnitude of how these markets can move as a result of these non-consuming players that are in it, we think it's obvious that it has a pretty measurable and sizable effect," Delta's Jacobson said.

Oil historian Daniel Yergin has coined the term "financialization" of oil prices. In recent months, as investors fretted over whether Greece would default on its bonds, the United States would raise its debt ceiling and China would lose control of inflation, they flocked to oil futures to diversify their investment base.

"It's almost like oil is now the holy grail financial-vehicle proxy for the future," Heimlich observed. "If you are bullish on oil, buy Exxon Mobil stock. ... You can hedge currencies, play the gold market. But oil has become the choice, the vehicle."

As a consequence, airlines and motorists alike suffer.

"When the price of Apple (stock) goes up, the price of Wal-Mart (stock) goes up, a few people get hurt, but a lot of people benefit. When the price of a physical, widely used commodity like energy or food goes up, a lot of people suffer, and economies suffer," Heimlich said. "I think what we have at stake is far beyond the airlines' interest."

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