McClatchy Washington Bureau
Posted on Wed, Aug. 17, 2011
Here's a glossary of some oil-finance terms
Kevin G. Hall | McClatchy Newspapers
last updated: March 15, 2013 11:57:51 AM
ATLANTA — Delta is the largest nonmilitary consumer of oil, using about 95 million barrels of jet fuel, or 4 billion gallons, annually. Volatile oil prices wreak havoc on its balance sheet, and it must take numerous financial steps to minimize those ill effects.
Here's a glossary that explains how an airline tries to control its fuel costs:
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- Hedging: The process of offsetting financial risk; in the case of airlines, the risk of changes in jet-fuel prices. An airline can buy a contract for future of delivery of oil, locking in a price a month, a year or years in advance. If Delta hedges that oil will cost $120 a barrel six months from now and fuel prices actually are lower, it loses money. If oil prices are $130 a barrel at that point, Delta's hedge was a winner.
- Futures: Contracts for future delivery of oil, or other commodities traded on an exchange, namely the New York Mercantile Exchange, the Chicago Mercantile Exchange and the Chicago Board of Trade. End-users and investors alike can bet on where the price of oil will go through so-called paper barrels, monthly contracts for future delivery of oil dated anywhere from next-month delivery through December 2019. As recently as April, financial speculators held contracts for the equivalent of 1.5 billion barrels of oil, or about a whopping 267 days of U.S. oil production.
- Basis risk: Unlike crude oil, jet fuel isn't traded on an exchange. When trying to mitigate their risk of price shifts, airlines have to approximate to something close, usually contracts for future delivery of crude oil or heating oil. Airlines thus are exposed to prices that could move differently from the underlying commodity. That's basis risk, and airlines try to minimize it. After Hurricane Katrina in 2005, the price of crude oil fell, but since refiners were knocked offline, jet fuel prices soared. Thus hedging via contracts for crude oil or heating oil provided little protection.
- Swaps: Airlines mitigate their basis risk through swaps, sometimes called OTC derivatives. These are private bets in the unregulated over-the-counter market. The airline "swaps" its risk of rising fuel prices with a counterparty that's willing to take the other side of the bet on where jet fuel prices will go over a given period. These counterparties can be Wall Street banks, oil refiners, petroleum marketers and other middlemen. The lack of transparency and regulation in this market contributed greatly to the turmoil during the 2008 U.S. financial crisis, something regulators now are addressing.
- Position limits: For much of the history in U.S. commodity markets, position limits were in place that limited how much of the market any one participant could hold. Over time, end-users of oil were freed from these limits since they had skin in the game. During the 1990s, Wall Street banks won regulatory exemptions that treated them as end-users since they were hedging the private bets they made in the over-the-counter market. The Commodity Futures Modernization Act of 2000 essentially ended any position limits. The Commodity Futures Trading Commission, as directed under last year's revamp of financial regulation, is creating new rules to restore position limits in an effort to rein in speculation. It's also moving to require that "swaps" transactions be cleared on an authorized exchange as virtually all other financial instruments are.
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