Fuel costs are the biggest catalyst in the latest flurry of consolidations in the US airlines industry, analysts say, and may bring about more trouble as with the exception of a few, none of the airlines has prepared for today's cost environment.
"Unless fuel prices rapidly retreat, it stands to reason that additional carrier bankruptcies cannot be ruled out," - JP Morgan Securities report.

"Frankly, we do not believe that the US airline industry can withstand $100+/barrel oil prices (see chart: NYMEX sweet crude oil) without major structural change," analysts at Merrill Lynch Airline Research said.

"Fuel is the highest single expense for Delta and Northwest, significantly eroding the financial benefits of restructuring and placing the airlines' new-found strength and stability at long-term risk," Delta Airlines said in a press release on the announcement of its intended merger with Northwest Airlines.

While fuel costs used to represent the second largest category in airlines' operating expenses, coming right after personnel costs, they have now outpaced labor to constitute nearly 40% of ticket prices, John Heimlich, Vice President of Air Transport Association (ATA), a US-based industry trade organization says.

Average US jet fuel price growth rate in the past five years through April 2008 was approximately 30% per year, the Energy Information Administration (EIA) data show. And Platts assessments show that May 2008 marked a record-setting period in price surges. US Gulf Coast spot jet fuel prices have surged to a record $3.74/gallon mid-May, representing a jump of more than 81% over the same period last year, Platts data indicate (podcast: Nymex crude and heating oil contracts send jet fuel price soaring).

History depicts a gloomy picture of the US airlines industry, which has been in financial distress for almost a decade, and raises the imperative question of why airlines have overlooked the value of hedging fuel costs, which has proven to single-handedly determine the fate of the sector.

"Unless fuel prices rapidly retreat, it stands to reason that additional carrier bankruptcies cannot be ruled out," JP Morgan Securities said in a recent research report (see chart: Chicago Jet Rack Price).

Paradoxically, when crude oil was still trading in double digits, which would effectively reduce the cost of jet fuel hedges, the industry seemed less concerned in reducing its exposure to energy commodities.

A prize-winning research paper from Northwestern University's Kellogg Graduate Business School had said in 2004, "The airline industry is relatively un-hedged at the present. Using derivatives to hedge jet fuel costs creates a competitive advantage and has been shown to increase firm value."

In fact, empirical research shows that there is a premium associated with the stocks of companies that use derivatives to hedge their price exposure.

Many airlines have long held the contention that risk management was not one of their core competencies, and as long as their competitors did not hedge, everyone in the industry would be exposed to the same risks.

Furthermore, the little amount of fuel hedges that the airlines had executed in the past were prematurely sold on the back of low passenger demand post-September 11.

Today, some airlines continue to hedge a very low proportion of their fuel consumption because "hedging high and volatile fuel prices is expensive and may require posting cash collateral," Standard and Poor's said in reviewing the credit ratings effects of high fuel prices.

However, the no-hedge strategy has failed spectacularly as multiple airlines declared, and continue to declare, bankruptcies, citing fuel costs among the chief reasons for doing so (see presentation: Hedging mistakes to avoid).

"Passenger airlines reported first quarter results and the industry reported a $1.74 billion loss for the quarter [Q1-2008] compared to profits for the first quarter of 2007, with the swing almost exclusively the result of increased fuel costs," Richard Anderson, Chief Executive of Delta Airlines said in testimony to the US House of Transportation and Infrastructure Committee.

"Because jet fuel is not traded on an organized futures exchange, there are limited opportunities to hedge directly in jet fuel," Southwest Airlines said in its latest quarterly filing to the US Securities and Exchange Commission (SEC).

"However, we have found that financial derivative instruments in other commodities, such as crude oil, and refined products such as heating oil and unleaded gasoline, can be useful in decreasing exposure to jet fuel price volatility," the company added.

Southwest Airlines, dubbed by many the most successful hedger among its peers, has a mixture of extensive call options, collar structures, and fixed price swaps to decrease its exposure to jet fuel prices for over 70% of its remaining 2008 jet fuel needs at average crude oil equivalent price of approximately $51/b.

Based on current growth plans, the company also has derivative positions for over 55% of its anticipated jet fuel needs for 2009, nearly 30% for 2010, over 15% for 2011, and over 15% for 2012 at approximately $63/b.