Hedging Can Cause Volatility in Earnings and Stock Price By Bull Trader Just last summer as crude oil moved towards $150 a barrel, some companies were being applauded for having had the foresight to hedge their energy and fuel cost by locking into lower prices for future delivery. Unfortunately, as crude oil fell sharply from its summer highs to below $40 a barrel, some of these same companies were now finding themselves on the other side of the profit/loss equation. Just recently, Delta Airlines reported a $507 million loss on its fuel hedges in Q4, while UAL reported a $370 million hedging-related loss. Southwest Airlines, known in the past for its smart use of hedging, is finding that its needs to post $300 million in collateral with its various counterparties as the price of crude oil and fuels continue to decrease. Not surprising, or maybe surprising to some, it how investors are punishing the stocks of those companies that were considered to be "prudent" in their use of hedging. What is often forgotten by both investors and management is that hedging is not speculation, or at least should not be treated as such when done correctly. A properly managed hedge should theoretically provide a predictable cost, but changes in the price structure of an industry could cause earnings to be volatile, not to mention the company stock price.
For instance, if an airline company has hedged its fuel cost based on crude oil being around $70 a barrel, the company should see some benefit compared to its un-hedged competitors as crude moves above $100 a barrel. Yet if companies in the industry have pricing power, they can pass some or all of this cost on to their consumers. Therefore, higher costs are followed by higher product prices (obviously, never exactly one-to-one, even with pricing power). For the un-hedged company, their profit margin will theoretically be the same, while the hedged company will experience increased profits due to their lower cost structure compared to their competitors. On the other hand, as crude oil prices fall into the range of $30 per barrel, the un-hedged companies could once again adjust prices, but now to reflect their lower cost (and attempt to take business from those paying higher costs who may not be able to adjust prices as quickly). Those companies that are hedged and are forced to pay the higher $70 per barrel price will experience a lower profit margin, lower earnings, and potentially a lower stock price. So while hedging can help a company "lock-in" to a specific cost structure, if others within the same industry are not hedged, and those companies have pricing power, the hedged company can expect to see higher swings in profit margins and earnings, and subsequently a more volatile stock price. Not only does this surprise investors who were expecting a less volatile stock given that the company was hedged and should experience consistent costs, but it also generates inquiries from management as to why the risk management department suddenly turned into speculators, and more importantly why they made such a bad bet. In reality, the hedging allowed the company to control what it could (the cost), but still left it at the mercy of what it had less control over - industry pricing and investor reaction. Something to keep in mind as you invest in companies and industries that actively engage in hedging, especially in commodity markets that are volatile. --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups ""GLOBAL SPECULATORS"" group. To post to this group, send email to [email protected] To unsubscribe from this group, send email to [email protected] For more options, visit this group at http://groups.google.com/group/globalspeculators?hl=en -~----------~----~----~----~------~----~------~--~---
