Stocks and Trading Thread - Channeling your inner Mono

[Barrister]

But a lot of the newer, low-cost airlines have generally been pretty profitable, such as Southwest, Ryan Air, and Westjet.

So in's not some problem inherent to the airline industry.

Isn't a big part of their business model using older, often second hand planes?

Westjet, the Canadian low-cost airline, has the country's newest fleet.  I think they may fhave gotten started using used 737s.  Wiki says average age of the fleet is 6 years.

Wiki says the average age of fleet for Ryanai is 3.9 years.  Wiki doesn't give an age of fleet for Southwest, but it looks like 3/4 of their fleet is the new 737-700, with the remainder being the older 737-200 and 737-300.

All airlines run such a similar business model that they all run identical planes - nothing but 737s.

[Barrister]

Airlines seem to have been going broke for as long as I can recall. I wonder how the average returns on the entire sector since, say, 1950, compare to other industries? At a guess pretty poorly. Rational markets vs.  ooh! it's big and shiny and flies through the air! 

But a lot of the newer, low-cost airlines have generally been pretty profitable, such as Southwest, Ryan Air, and Westjet.

So in's not some problem inherent to the airline industry.

Business isn't supposed to be zero or negative sum. If it was, long term investing would be equivalent to going to vegas--you tend to lose, even if some might win. If the airline industry hasn't been historically profitable even though a few companies have been over the shorter term, I would think there are inherent problems in the industry.

Shorter term?  Southwest goes back to the 70s (but looks like it didn't really get going until deregulation in the late 70s / ealy 80s).  The other two simply wholesale adopted the Southwest business model.

It's like arguing the movie business has inherent problems because all DVD rental stores are going out of business.  It's just one business model within that industry that has problems.

[alfred russel]

So Delta Airlines bought an oil refinery. I know it's near impossible to make an airline profitable in modern times, but this is a different strategy. I guess they are forced to get creative, and figured some vertical integration might help. I doubt it will do much for their operating costs on the airline itself, although it may provide a profitable sideline to offset their flying losses. 

A few years ago, at least one one of the major airlines made a profit almost  based solely on petroleum futures.

That's doesn't seem that funny or strange to me, that just seems like an accounting quirk.  If you're going to hedge the price of fuel, which a competent airline should do, then it's not surprising that a lot of your "profit" is going to come from the futures if the price of fuel goes up.  The futures are supposed to insure your operations against rising fuel prices.  If your house burns down, then most of your "profits" for the year are going to come from the insurance policy.

While I agree, I think there is an inherent problem in using derivatives like this (which I ignored in my defense of derivatives in other threads).

To take a real life example, Southwest hedged against the risk that fuel prices would rise, while Delta did not. Fuel prices did go up, and Southwest had major gains and a significant competitive advantage over Delta. Delta subsequently went bankrupt.

The problem is that there is no such thing as a free lunch: the derivatives Southwest got would have cost the airline dearly had prices declined. Very possibly they would have been bankrupt while Delta grew.

These fate of these two airlines wasn't just about which could best manage normal airline operations, but rather which can best hedge/speculate (depending on your perspective) the costs of fuel.

I think this is too bad, as the focus of management should be on their core business such as figuring out ways to begin charging for carryons or take away drink service, rather than how to play the oil markets.

[Barrister]

So Delta Airlines bought an oil refinery. I know it's near impossible to make an airline profitable in modern times, but this is a different strategy. I guess they are forced to get creative, and figured some vertical integration might help. I doubt it will do much for their operating costs on the airline itself, although it may provide a profitable sideline to offset their flying losses. 

A few years ago, at least one one of the major airlines made a profit almost  based solely on petroleum futures.

That's doesn't seem that funny or strange to me, that just seems like an accounting quirk.  If you're going to hedge the price of fuel, which a competent airline should do, then it's not surprising that a lot of your "profit" is going to come from the futures if the price of fuel goes up.  The futures are supposed to insure your operations against rising fuel prices.  If your house burns down, then most of your "profits" for the year are going to come from the insurance policy.

While I agree, I think there is an inherent problem in using derivatives like this (which I ignored in my defense of derivatives in other threads).

To take a real life example, Southwest hedged against the risk that fuel prices would rise, while Delta did not. Fuel prices did go up, and Southwest had major gains and a significant competitive advantage over Delta. Delta subsequently went bankrupt.

The problem is that there is no such thing as a free lunch: the derivatives Southwest got would have cost the airline dearly had prices declined. Very possibly they would have been bankrupt while Delta grew.

These fate of these two airlines wasn't just about which could best manage normal airline operations, but rather which can best hedge/speculate (depending on your perspective) the costs of fuel.

I think this is too bad, as the focus of management should be on their core business such as figuring out ways to begin charging for carryons or take away drink service, rather than how to play the oil markets.

But a large number of industries have their profit/loss closely tied to the price of a single commodity.  Steel companies, airlines, power companies - all need to be able to best manage their costs, potentially by hedging.

It's nice to say "management should focus on their core business" but that's not how the world works.

[alfred russel]

Shorter term?  Southwest goes back to the 70s (but looks like it didn't really get going until deregulation in the late 70s / ealy 80s).  The other two simply wholesale adopted the Southwest business model.

It's like arguing the movie business has inherent problems because all DVD rental stores are going out of business.  It's just one business model within that industry that has problems.

I would think that rental stores have been historically profitable, and are only now going away as they are becoming obsolete. It isn't an applicable comparison.

I don't know how large Southwest was--I thought they became really big in the past 10-15 years. Could be wrong. I don't see why that matters: Vegas is a terrible overall investment, even if there are millionaires who have made their living at the poker or sports books beating the odds. Southwest may be really good in a really bad industry and make money.

[MadImmortalMan]

Going short EWZ (Brazil ETF). Vertical call spread 55/54.

[alfred russel]

It's nice to say "management should focus on their core business" but that's not how the world works.

No kidding--that doesn't mean I can't whine about it. :p And in this case, sans derivatives, it wouldn't be very practical.

But a large number of industries have their profit/loss closely tied to the price of a single commodity.  Steel companies, airlines, power companies - all need to be able to best manage their costs, potentially by hedging.

A large part of that is because their competitors are hedging. Imagine if no one hedged in the airline industry. If fuel prices went up 50%, that would hit all the airlines. That should end up increasing the cost of a ticket by some value less than that, which would have some effect on passenger travel and hurt the airlines to an extent, but not critically.

If everyone hedges, and hedges in the same way, then the investment banks get healthy fees, and the airlines still likely have some exposure especially longer term, but everyone is in the same boat.

Now imagine that some airlines hedge, and some don't (or at least in significantly different ways)--this is the world we live in. If you have not hedged effectively, you are noncompetitive and bankrupt.

[Barrister]

It's nice to say "management should focus on their core business" but that's not how the world works.

No kidding--that doesn't mean I can't whine about it. :p And in this case, sans derivatives, it wouldn't be very practical.

But a large number of industries have their profit/loss closely tied to the price of a single commodity.  Steel companies, airlines, power companies - all need to be able to best manage their costs, potentially by hedging.

A large part of that is because their competitors are hedging. Imagine if no one hedged in the airline industry. If fuel prices went up 50%, that would hit all the airlines. That should end up increasing the cost of a ticket by some value less than that, which would have some effect on passenger travel and hurt the airlines to an extent, but not critically.

If everyone hedges, and hedges in the same way, then the investment banks get healthy fees, and the airlines still likely have some exposure especially longer term, but everyone is in the same boat.

Now imagine that some airlines hedge, and some don't (or at least in significantly different ways)--this is the world we live in. If you have not hedged effectively, you are noncompetitive and bankrupt.

But an airline hedging on fuel prices, a steel company hedging on iron prices, a power company hedging gas or coal prices - that is what the commodities hedging was designed for in the first place.  These are not derivatives, they're not hyper-complex securities - they're pretty basic financial tools, and no different than producers like a farmer, minor or oil company, using hedging to reduce their risk.

[alfred russel]

But an airline hedging on fuel prices, a steel company hedging on iron prices, a power company hedging gas or coal prices - that is what the commodities hedging was designed for in the first place.  These are not derivatives, they're not hyper-complex securities - they're pretty basic financial tools, and no different than producers like a farmer, minor or oil company, using hedging to reduce their risk.

They are absolutely derivatives. Not to get into another argument about whether derivatives are complex, but I don't think the derivatives being discussed are inherently more simple than say the derivatives that got AIG in so much trouble.

I also think you are mixing categories here. A farmer, a minor, or an oil company all make significant up front investments that are in part based on future product prices. Derivatives help them manage that risk.

An airline or power company is hedging a variable input cost--that in this case can be passed on to some extent to customers. There are dramatically different ways to hedge as well. And I don't know if this is still the case, but at least about 10 years ago you couldn't even hedge jet fuel, these airlines are hedging other products such as oil that are to a greater or lesser extent correlated with jet fuel, but not identically. It is a bit messier.

[Alcibiades]

PBI down to 13.45 today.  Dodged a bullet on that one.   

[alfred russel]

Here is an example that is completely contrary to what I was arguing a few days ago, but I doubt all that many people read what I write anyway.

Take foreign currency hedges. If your Canadian company has a major British sub, you probably are hedging against fluctuations in the pound to keep your earnings consistent.

However, as a diversified investor, I probably own not only shares of your company, but also a British company that has a major Canadian sub that is hedging in the opposite direction.

On a net basis, I was protected before any hedging took place. The only effect of the two companies hedging is that earnings I normally would have had are now going to pay the bonus of some dude on Wall Street. Worse, if one company diversifies and the other doesn't, I'm still paying the bonus of some dude on Wall Street and am now unprotected.

[Barrister]

But an airline hedging on fuel prices, a steel company hedging on iron prices, a power company hedging gas or coal prices - that is what the commodities hedging was designed for in the first place.  These are not derivatives, they're not hyper-complex securities - they're pretty basic financial tools, and no different than producers like a farmer, minor or oil company, using hedging to reduce their risk.

They are absolutely derivatives. Not to get into another argument about whether derivatives are complex, but I don't think the derivatives being discussed are inherently more simple than say the derivatives that got AIG in so much trouble.

I also think you are mixing categories here. A farmer, a minor, or an oil company all make significant up front investments that are in part based on future product prices. Derivatives help them manage that risk.

An airline or power company is hedging a variable input cost--that in this case can be passed on to some extent to customers. There are dramatically different ways to hedge as well. And I don't know if this is still the case, but at least about 10 years ago you couldn't even hedge jet fuel, these airlines are hedging other products such as oil that are to a greater or lesser extent correlated with jet fuel, but not identically. It is a bit messier.

What is the difference between hedging your future product prices and hedging your input cost though?  I will note that both a farmer and an airline have to make significant up front investments that are based both of future product prices and future input costs.

I'll concede that commodity hedging is a derivative - but it's one of the oldest and mature derivatives out there.

[DGuller]

While I agree, I think there is an inherent problem in using derivatives like this (which I ignored in my defense of derivatives in other threads).

To take a real life example, Southwest hedged against the risk that fuel prices would rise, while Delta did not. Fuel prices did go up, and Southwest had major gains and a significant competitive advantage over Delta. Delta subsequently went bankrupt.

The problem is that there is no such thing as a free lunch: the derivatives Southwest got would have cost the airline dearly had prices declined. Very possibly they would have been bankrupt while Delta grew.

These fate of these two airlines wasn't just about which could best manage normal airline operations, but rather which can best hedge/speculate (depending on your perspective) the costs of fuel.

I think this is too bad, as the focus of management should be on their core business such as figuring out ways to begin charging for carryons or take away drink service, rather than how to play the oil markets.

I don't see a problem here at all.  The point of a hedge is to insulate your business against outside influences, because bankruptcy has real costs that amount to waste.  If fuel prices rise, then the value of core business goes down, but you get a payoff from the futures.  If fuel prices fall, then you lose on the futures, but at least you have a profitable core business.  That's why it's a hedge:  it evens out the outcomes if you treat the hedge and hedged item as one unit. 

What probably happened is that Delta gambled and lost.  I also doubt that Southwest would've been bankrupt if fuel prices decreased, as long as their hedge was properly constructed.  If your hedge can bankrupt you, then it's not a hedge anymore, it's speculation.  Obviously airline companies shouldn't speculate as if they're Goldman Sachs, but not hedging their exposure to fuel prices in some way is dumb.

[DGuller]

Here is an example that is completely contrary to what I was arguing a few days ago, but I doubt all that many people read what I write anyway.

Take foreign currency hedges. If your Canadian company has a major British sub, you probably are hedging against fluctuations in the pound to keep your earnings consistent.

However, as a diversified investor, I probably own not only shares of your company, but also a British company that has a major Canadian sub that is hedging in the opposite direction.

On a net basis, I was protected before any hedging took place. The only effect of the two companies hedging is that earnings I normally would have had are now going to pay the bonus of some dude on Wall Street. Worse, if one company diversifies and the other doesn't, I'm still paying the bonus of some dude on Wall Street and am now unprotected.

There are a couple of problems with the "let investors take risk, they're diversified" logic. 

First, financial distress incurs costs that are a waste.  Secondly, if your company can live or die based on some random factor outside of its control, you're either going to be less attractive to potential employees, or you'll have to pay them more.  Lastly, if your company's business is not hedged, its income will fluctuate wildly.  That's not very tax efficient.

[alfred russel]

What is the difference between hedging your future product prices and hedging your input cost though?  I will note that both a farmer and an airline have to make significant up front investments that are based both of future product prices and future input costs.

There is a significant difference for an airline. A generic farmer invests before a crop is planted and then sells when it is harvested. The costs are linked to the revenues--although the revenues are dependent on price and the costs must be determined before those are known.

There would be more similarity if the futures were linked to the purchase of an airplane (or even the purchase of a ticket). But they aren't. Airlines tend to hedge for a number of years: which is less than their useful life of their planes, and they aren't entering the hedges when purchasing/leasing the planes. They are trying to protect against fluctuations in their daily operating costs, which to an extent can be passed on to consumers.