Mark-to-Market Accounting, Southwest Airlines and Steel Futures

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Now I don’t want my airline preferences lead you to the conclusion that I’m a no frills girl. But I’d fly Southwest Airlines over any other airline for a host of reasons. Besides the company culture, friendliness and efficiency in which they do things, I respect Southwest Airlines for their use of hedges. This is the company after all, that everyone talks about when they give examples of best practice hedging techniques. As recently as October 3, I talked about the brilliance of Southwest’s hedging strategies in reference to a discussion on steel futures contracts steel futures contracts.

So when Southwest Airlines posted its first loss in 17 years, I knew I better do a little homework. According to this AP news story, Southwest had to write down the value of “it’s fabled fuel-hedging transactions in the third quarter.” Since oil prices have come down by half since their July highs, Southwest’s fuel-hedging contracts are less valuable. This write-down had to occur in the third quarter due to an accounting rule accounting rule which “ensures that an offsetting gain or loss from a hedging instrument affects earnings in the same period as the gain or less from the hedged item.” In other words, the accounting rule requires Southwest to report the value of some of its hedged contracts. And, according to the AP article, on the last day of September, those contracts were worth much less then they were on June 30.

And what is this accounting rule called ” it’s mark-to-market of the sub-prime mortgage fiasco fame. So how does it work in practice? Essentially, the value of the futures contract (the hedge) is compared to today’s spot market prices. If the hedge price is above the spot price, it’s a gain. If the hedge price is below the spot price, it’s a loss, even though Southwest saved $1.3b in jet fuel this year alone according to this article from the Dallas Morning News.

Does this story represent an argument against hedging in general? No, we don’t think so. Southwest has about 75% of its jet fuel hedged for 2009 at about $75/barrel.The airline can always unwind its hedges by selling them. Southwest, in comparison to every other major airline, has out-peformed everyone and largely due to its use of hedges.

Metals buyers contemplating the new steel Mid-west Hot Rolled Coil contract offered by the CME/Nymex this month can learn more about that here and here here. If you are curious about Mark-to-Market accounting, I highly recommend a friend’s blog, Sam Kinney entitled Up the Economy. Here is his post on mark-to-market accounting.

–Lisa Reisman

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