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Oil is getting pricier by the minute. A barrel of the benchmark West Texas Intermediate crude hit a record of $123.80 in intraday trading May 7, before settling at $123.53. And look out: on May 6, investment bank Goldman Sachs (GS) said oil prices could hit $200 within the next two years as limited supply growth and rising demand causes a "super spike".



That's not welcome news for airlines. Rising jet fuel prices -- one of the industry's biggest costs -- have helped send seven airlines into bankruptcy this year, and more could follow. One exception to the sea of red ink so far is Southwest Airlines (LUV), which has saved billions since 2000 by successfully hedging against increases in oil prices. But with each rise in oil prices, that strategy gets more and more expensive.



Rich Payoff

"We would like to see more coverage, and we're reviewing our options," says Scott Topping, treasurer of Southwest and manager of its hedging program. "The fundamentals still point to the risk of higher prices; we feel we need to [hedge]."



A hedge is a financial instrument that allows investors to lock in certain prices to act as insurance against the possibility that the open-market, or spot, price of that commodity will rise. If the price then rises, the company gets a financial payoff that cushions the blow of higher prices. In this way, investors can actually make money using hedging as insurance, giving them an advantage over competitors in the marketplace.



Southwest is currently the only major airline with most of its fuel costs hedged at lower prices, largely because it is the only large carrier with the cash flow to do so. For 2008, 70% of its fuel needs are hedged at $51 a barrel. That means that while competitors have to contend with spot prices hovering around $120 a barrel, Southwest can buy oil at less than half that. Access to this discounted price means Southwest feels less pressure to pass on higher costs to customers, which could afford it more market share as competitors hike ticket prices.



Southwest's bets have paid off richly. For the first quarter of 2008, $302 million in hedges allowed Southwest to report a profit of $34 million as competitors like United (UAUA) and US Airways (LCC) posted losses. Overall in 2007, hedging saved the company $727 million, when Southwest was 90% protected at oil prices around $51 a barrel. To see the link between oil and airline share prices, just look at what happened to airline share prices on May 6, as oil prices soared. American Airlines' parent AMR (AMR), was down 17%, or 2%, to 8.85; Delta Air Lines (DAL) was down 24%, or 3%, to 7.87; and United was down 85%, or 5.7%, to 14.15. Southwest's shares, meanwhile, fell 3%, or 0.2%, to 13.37.



Hefty Cash Outlay

Even with prices hovering at $122 per barrel and higher, Southwest should be well positioned for the next few years. For 2009, the company is covered about 55% at $51 a barrel; for 2010, 30% at $53 per barrel; and for 2011 and 2012, at more than 15% at $64 and $63 per barrel, respectively. Because the oil market is so volatile and hedging requires so much cash up front, the percentage of coverage gets smaller in later years.



Even an expert like Topping, who spends his days consulting with oil experts and poring over analyst reports, says he doesn't know for certain where oil prices are headed. But for now, indications point upward, which justifies more hedging. "There doesn't seem to be hope for a big price drop unless an unexpected dramatic event took a big chunk out of demand," says Topping. While high prices are beginning to slow demand for oil in Western countries, developing nations like China and India have an ever-growing thirst for oil. Consider that the U.S. currently has 800 vehicles per 1,000 people, vs. fewer than 30 in China and India. As those countries' economies ramp up -- and as hundreds of millions of people seek their first cars -- energy demand will also rise.



But protecting against fuel increases is itself cash-intensive. To purchase options, investors need to pay a commodities clearing house a margin of about 10%. For example, a contract for 1,000 barrels of crude oil at $123 per barrel would be worth $123,000. To hedge at that price, the investor would need to pay about $12,300 and ultimately be prepared to pay the balance. Generally speaking, an option written one year ago, in a $65-per-barrel environment, was roughly half the cost of an equivalent option placed today.



Besides the margin costs, investors must also pay a transaction cost for each hedge, called a "bid-ask spread." And companies like Southwest choose to pay premiums for options that offer downside protection in case oil prices fall. In other words, if the price drops below the strike price, Southwest can allow the option to expire [as opposed to being locked in to buying oil at a given price, as in "swap" contracts]. In this scenario, the company loses the premium in exchange for the insurance the option offers.



An Inability and Reluctance to Hedge

The large initial cash outlay is one of the main reasons other airlines haven't followed in Southwest's footsteps. "It's a question of credit risk," says Peter Fusaro, founder of the Energy Hedge Fund Center, an energy-trading information firm. "Facing higher energy prices and billions of dollars in debt, most airlines can't afford to hedge." Instead, says Fusaro, airlines either have to pass increased costs on to customers or absorb them.



Alaska Airlines maintains what Treasurer Jay Schaefer calls a moderate program that keeps the company hedged up to 50% in three-year intervals. "We think of it as an insurance policy," says Schaefer. "We pay a premium for call options, but it has been absolutely worth it. The runup in oil prices has been traumatic to our industry, and our hedging program has helped ensure our survival." But fuel-price hedging can only go so far. Alaska Airlines' parent company, Alaska Air Group (ALK), which also owns Portland [Ore.]-based Horizon Air, reported a $35.9 million loss in the first quarter of 2008, and rising fuel prices were a big factor.



The price runup has led some other airlines to shrink from hedging. Allegiant Travel's (ALGT) Allegiant Airlines, a low-cost, all-jet airline based in Las Vegas, got out of the options game last autumn as energy prices soared. Allegiant now buys its fuel on the spot market. The advantages offered by the short-term contracts the company was signing were elusive given the market's volatility, says Allegiant Chairman and CEO Maurice Gallagher Jr.: "It got to be very expensive. If you were on the other side of a [fuel] trade and have to give us money you're going to charge a pretty good premium for that."



Indeed, many airline executives shy away from the risks involved. "I think airlines have been reluctant to hedge because corporate culture views futures as a gambling tool," says Stephen Schork, an energy consultant in Villanova, Pa., and editor of The Schork Report, a daily energy newsletter. "But they've been reluctant to their own detriment. If you're an airline without a significant hedge, you're in a difficult spot."