For now, Southwest’s nixing of its fuel hedging program tunes out the risk of a preemptive strike on Iran’s nuclear facilities.
In addition to annoying us all by ending their “bags fly free” policy, Southwest Airlines also announced another move on March 11 which has potentially even greater ramifications for its bottom line – completely ending its fuel hedging program. The move illustrates just how confident market participants have become about the bearish consensus on the oil market in the near-term, and also is arguably complacent given the current situation with Iran’s nuclear program and President Trump’s “maximum pressure” policy.
Fuel hedging is when major consumers of petroleum products – airlines, trucking companies, and ship operators, among others – either buy fuel on futures contracts or hedge their financial risk with other available means like options. On the other side of the trade are forward sellers, often oil producers or countries like Mexico that are dependent on oil revenues. Speculators can take either side of the trade, but usually have more volume on the long side, betting prices will rise.
In this way, the futures market provides a useful service to both producers and consumers, allowing them to buy insurance against the financial impacts of price volatility. Speculators like hedge funds, often viewed as nefarious by the mass public, are useful as providers of financial liquidity to the market. In 2022, when oil prices surged past $100 per barrel, Southwest saved more than $1 billion through hedging. The company saved more than $3.5 billion during the period from 1998 to 2008, when oil prices were generally rising, according to data from Bloomberg.
So why end hedging now? Hedging is not without costs, and in years when prices fall, consumers who hedge end up losing money. The logic of doing it is that there may sometimes be price risks so large that they could completely alter the company’s financial results, maybe even forcing them into bankruptcy. But the structural factor of “spare capacity” in the oil market is making market participants much more confident that large price spikes will not happen. OPEC+ countries now have more than five million bpd in unused capacity, and the cartel just decided to begin bringing a small part of that back on in April, despite the gloomy demand outlook, as its members have become increasingly convinced that sacrificing market share indefinitely is not their best revenue-maximizing strategy.
That spare capacity is the reason that the oil market has been tuning out the Trump administration’s nascent efforts to reduce Iran’s oil exports. There is doubt that China will cave in to American pressure, but even if it does, there is confidence that this would just accelerate moves by Saudi Arabia, the United Arab Emirates (UAE), and a few others to put their own volumes back on the market. The possibility of a relaxation or end of sanctions on Russia also looms in the background.
That is all valid, but one “fat tail” scenario is being discounted in this view: a regional war following an Israeli strike on Iran’s nuclear program. It is understandable. This risk has been present for a long time, and there have been several instances previously when it looked like a real possibility, particularly in 2007 and 2012. The current consensus in the market is one of “Iran fatigue,” regarding the risk of a regional war which could impede shipping or damage oil infrastructure being a “red herring.”
What is different this time, and what is being ignored, is that Iran’s nuclear program is much further along, with a stockpile of highly enriched uranium which is only slightly short of weapons-grade sufficient for a half-dozen warheads. And recent expansions in enrichment centrifuge capacity have given them the ability to rapidly assemble the fissile material for a small nuclear arsenal if they chose to do so. The consensus in the U.S. intelligence community is that Israel is likely to strike Iran’s nuclear facilities this year. If it does, the threat to regional oil infrastructure is very real. The main vulnerabilities are the critical infrastructure in Saudi Arabia and the UAE, which could render “spare capacity” a moot point if the damaged facilities lie between the idle oilfields and the tanker terminals from which they export crude.
For now, Southwest and most market players are tuning this risk out, perhaps foolishly. If they wanted to hedge their financial risk, one alternative right now would be to buy “out of the money” options with strike prices of, say, $100 or higher per barrel. Those are priced very low at the moment but would pay off handsomely if a catastrophe happened. If the market eventually wakes up to this risk, particularly if negotiations between the Trump administration and Iran fail to even begin, that insurance policy will come with a much higher price tag.
Greg Priddy is a Senior Fellow at the Center for the National Interest and does consulting work related to political risk for the energy sector and financial clients. Previously, he was director of global oil at Eurasia Group and worked at the U.S. Department of Energy.
Image: Shutterstock/Markus Mainka