Airlines, unable to manage risk, scapegoat oil markets
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The e-mail blitz was on this afternoon. Several airlines sent out their bulk-mails, announcing their opposition to “speculators” in the oil market. In an orchestrated letter signed by 12 airline CEOs, the airlines blamed the oil market for their companies’ woes. It’s a maddening piece of propaganda.
The airlines’ efforts to blame the oil market’s participants for causing the price of oil to go up is a red herring. Speculators exist, sure, but unlike the housing market’s speculators, in which investors actually bought physical properties to affect market pricing, oil futures market participants aren’t actually taking delivery of oil. They’re effectively wagering on the direction of prices, but that doesn’t directly affect oil supply or real consumptive demand.
The letter is chock full of misinformation and dumb logic. For example:
A barrel of oil may trade 20-plus times before it is delivered and used; the price goes up with each trade and consumers pick up the final tab.
The price goes up every time? If so, why would anyone sell? No one has ever lost money on a trade? What market is this, and how can I participate?!!
Our country is facing a possible sharp economic downturn because of skyrocketing oil and fuel prices…
It’s a smidge more complicated than that, guys. War in Iraq and Afghanistan, mortgage meltdown and uptick in foreclosures, trade deficits, currency devaluation, bloated consumer debt, runaway derivatives markets… But anyway…
…speculators who trade oil on paper with no intention of ever taking delivery…
Umm, that’s an argument against futures markets in and of themselves, and not against speculators per se.
The Economist has a good breakdown of the “blame the speculators” logic this week. Forgive me for quoting them at length:
[Blaming the speculators] holds obvious appeal for those looking for a scapegoat. But there is little evidence to support it. For one thing, the surge in investment in oil futures is not that large relative to the global trade in oil. Barclays Capital, an investment bank, calculates that “index funds”, which have especially exercised the politicians because they always bet on rising prices, account for only 12% of the outstanding contracts on NYMEX and have a value equivalent to just 2% of the world’s yearly oil consumption.
More importantly, neither index funds nor other speculators ever buy any physical oil. Instead, they buy futures and options which they settle with a cash payment when they fall due. In essence, these are bets on which way the oil price will move. Since the real currency of such contracts is cash, rather than barrels of crude, there is no limit to the number of bets that can be made. And since no oil is ever held back from the market, these bets do not affect the price of oil any more than bets on a football match affect the result.
The market for nickel provides a good illustration of this. Speculative investment in the metal has been growing steadily over the past year, yet its price has fallen by half. By the same token, the prices of several commodities that are not traded on any exchanges, such as iron ore and rice, have been rising almost as fast as that of oil.
Bottom line: The airlines are whining. Suck it up. It’s your business. Manage it.
One surprise: Southwest signed the letter. By the logic of the letter, Southwest is one of the “speculators,” and in fact it’s a major reason Southwest has been eating everyone else’s lunch. Yet they signed the letter decrying their own business practices. Huh.
Less surprising: The signature of United. Despite having a CEO who previously worked at Texaco, these guys couldn’t figure out how to manage fuel prices. When they emerged from bankruptcy, they based their business plan on an unrealistic $50/barrel oil. It was trading around $65/bbl at the time, and it hasn’t gotten any cheaper. ($142/bbl today.)
The airlines who today whine about the oil market moving higher are complaining about their poor past decisions. They’re hatin’ the player and the game.
That said, if you want to check out the airlines’ “campaign” to stop investment, or “speculation,” they’ve got a website which I am loath to link to, but offer up for the sake of fairness and equal time. It’s StopOilSpeculationNow.com. Full text of the airline CEOs’ open letter is here.
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July 10th, 2008 at 10:00 pm |
I completely agree. Southwest had a nice, generic response today: (found this on Today in the Sky)
“We mainly signed the letter as a show of support to the industry and to raise awareness for our customers,” a Southwest spokesman tells CNN/Money.
July 10th, 2008 at 10:32 pm |
Spot on. The airlines are the first to tell the markets about their financial genius when they successfully hedge against fuel increases and save $$$$ in fuel costs. Hedging can only occur because there are speculators in the market that are prepared to bet the other way. If you remove speculators, then hedging disappears and the airlines will have no facility at all for planning ahead of time for fuel purchases. They will have to do what you and I do - turn up to the pump and pay the price on the day. There is not one in the airline industry that seriously wants to remove speculators and therefore hedging. This is a smokescreen to beg for government support/handouts and have someone else to blame when the chapter 11 filings start.
July 11th, 2008 at 12:16 am |
You’re absolutely right, wish more people (specially in Congress) read the Economist.
July 11th, 2008 at 4:15 am |
Nice logic! Seems like all the c-suite types at the airlines must have been sleeping during those expensive MBAs.
The futures market is a zero sum game with the physical commodity delivered if not cashed out by an opposing contract. That means every time someone buys (pushing the price up), they must be prepared to deliver or sell (pushing the price down) come delivery date.
If the airline logic was true, they should be getting into speculation themselves - those supposedly always rising contract prices have fixed delivery dates so all the airline execs would need to do would be to short oil and make a killing come contract expiry. They don’t because their argument is BS.
July 11th, 2008 at 7:55 am |
Of course, if the airlines would just increase their fares, they could pay for the oil. We might not like that, but I think we like trying to squeeze the margin out of the passengers and airline employees even less.
July 11th, 2008 at 8:52 am |
Hey Mark,
One reason Southwest may have signed the letter: although they had 70% of their fuel needs hedged in 2008, that will shrink to only 15% of their needs in 2013.
As another blog pointed out (can’t remember which one), airlines were going bankrupt with $10 oil - scapegoating is as old as the Wright Brothers (Damn you, yields from Kitty Hawk to 400 yards down the road in Kitty Hawk)
July 11th, 2008 at 9:21 am |
So, an MBA will weigh in.
Speculation does have an effect on pricing. Not a huge effect, but an effect. Considering the things an Airline can work on that might affect the price of oil, let’s see. I’ll use your list:
War in Iraq and Afghanistan, mortgage meltdown and uptick in foreclosures, trade deficits, currency devaluation, bloated consumer debt, runaway derivatives markets
Let’s see. I’m sitting at United. I can’t do anything about War in Iraq or Afghanistan. I can’t really do anything about the other things that directly impact oil prices, like uncertainty about Ugo Chavez, US foreign policy towards Iran, Katrina induced shortages in Gulf refinement, and OPEC. Nothing to do on those fronts. Not really. I can lobby, but that an $3.50 might get you a frappuccino.
Mortgages and foreclosures: Nope, nothing I can do to fix people’s moronic purchase of homes they couldn’t afford, or speculation in that market (which clearly had/has an impact). I’m an airline. While it impacts credit markets, it doesn’t do anything but probably make my bonds a more attractive investment (we’re a little more stable than your average REIT right now).
Trade Deficits: A bigger red herring than even oil speculation. Really.
Currency devaluation: Hrm. Central bankers, ForEx wizards, speculation (which can have an impact in that market… ask Thailand, and England), and stupid foreign and monetary policy. Nope, no help there. (FWIW, I think Currency Deval is a big problem and it will get better with domestic regime change, even if it’s Mr. McCain in charge… either one will have a monetary policy more friendly to the dollar than Mr. Bush)
Consumer Debt: “Hey, Customer. Don’t fly. Save some money. So you can fly more later. Assuming we’re still in business.”
Derivatives markets: and this is completely separate from oil speculation how? It isn’t. Not really. The speculation you are describing is derivative trading. Oil futures are derivatives. Yes.
At any rate, it’s always easy to kill management (something I learned in my MBA courses while I was awake). It’s never easy to be management. They don’t have options to talk about any of the things that are really hurting the economy or driving up oil prices, so they talk to the 2% or so they can. Will it work… no. But are there other things for them to do on this specific piece of the business? No, again.
They should fix their business models. This current crunch should force them to. It was bound to happen sooner or later, so it may as well happen now.
Don’t think of it as dead loss. Think of it as creative destruction.
July 11th, 2008 at 9:43 am |
Thanks for the comments, all. Good discussion. A few replies:
Dan and Jared:
Thanks for the clarification on Southwest’s inclusion in the letter. It’s sad that they are willing to stand up for public hypocrisy, just to stick with the team — especially since that team is their competition! Jared’s point that they’re hedgers themselves, but running out of bullets, is probably the real explanation, at the end of the day.
ML Harris:
I appreciate your detailed reply, but I think your point-by-point discussion of factors affecting the state of the economy actually missed a fundamental critique in my post: I wasn’t listing those issues as directly affecting the price of oil, but as affecting the nation’s economy writ large. In doing so, I was responding to the letter. The airline CEOs blamed oil for our economic woes in a simple A –> B fashion (”Our country is facing a possible sharp economic downturn because of skyrocketing oil and fuel prices…”) which is amazingly simplistic.
And by “derivatives,” I should perhaps have been more specific and blamed CDOs, SIVs, credit default swaps, and now, the latest repacking of financial toxic waste, ReREMICs, rather than lumping in any and all derivatives.
You’re right that UA or any of these other airlines can’t affect the state of war, central bankers, or the debt loads of consumers. But this quixotic battle against markets is just as misguided. Better to say nothing.
That said, I agree that the current crunch will (hopefully) create a shakeout of bad business models in the industry. But efforts to blame markets or beg for government bailouts will only delay the inevitable and will prolong the pain.