Southwest Reports that Fuel Hedging Program Creates More Losses

From Southwest's 10Q, released today.

“We benefited from significantly lower year-over-year economic jet fuel costs in first quarter 2009. Even with $65 million in unfavorable cash settlements from derivative contracts, our first quarter 2009 economic jet fuel costs decreased 16.2 percent to $1.76 per gallon. With oil prices rising, we have begun to rebuild our 2009 and 2010 hedge positions, using purchased call options, to provide protection against significant fuel price spikes. These new positions present no additional exposure to cash collateral requirements. Furthermore, we have modified our major fuel hedge counterparty agreements to allow us to use collateral other than cash to limit our cash collateral exposure to comfortable levels. Based on our second quarter derivative position and market energy prices as of April 14, 2009, we currently anticipate our second quarter 2009 economic jet fuel costs, including taxes, to be in line with first quarter 2009 (or the $1.75 per gallon range).”

The Company has derivative contracts in place for approximately 50 percent of its second quarter 2009 estimated fuel consumption, capped at a weighted average crude-equivalent price of approximately $66 per barrel; approximately 40 percent for the remainder of 2009 capped at a weighted average crude-equivalent price of approximately $71 per barrel; and approximately 30 percent in 2010 capped at a weighted average crude-equivalent price of approximately $77 per barrel. The Company has modest fuel hedge positions in 2011 through 2013. The current market value (as of April 14, 2009) of its net fuel derivative contracts for 2009 through 2013 reflects a net liability of approximately $950 million.

I am partial to the SWA business model and corporate culture. It has proven its competitive advantage in the best of times and the worst of times. Its team members are friendly and motivated, and its management is aggressive in attacking opportunity. Plus...they are active fuel price speculators. Their hedging program has earned them kudos from the national media, and has been written about on this site several times. But unless your fuel price speculation program is run by Bernie Madoff (pre-ponzi), even the best traders and economists are going to lose once in a while.

More importantly for propane and heating oil marketers, though, check out that they bought long dated CALLS to protect their position. They weren't afraid to spend the premium for the insurance that the calls provide. Also, they view their fuel risk position as a portfolio - and seem to be willing to enter into a number of strategies to achieve their goal. Finally, they have a model that they use that can help them plan what costs will be due to the hedging tools they hold in their portfolio. These are the things that every propane and heating oil marketer should be doing to manage their risk and fine tune their business.

If SWA management needs a post 10q pick-me-up, I am sure that they could step on board one of their planes with this industrious and talented flight attendant.

Barton Biggs on Charlie Rose

This interview is about a month old - but this morning is the first time I had a chance to watch it. Good stuff.

Natural Gas Basics

This is a 4-page analysis of simple supply and demand in the natural gas sector. It was released by the EIA last week, and is a good basic overview.

Climate Change Doubters Unite

Behind a new website.  

www.climatedepot.com

Causes of the Oil Shock

This article is from Econbrowser, a blog from Dr. James Hamilton - a professor from the University of San Diego.

It discusses a paper he wrote on the causes of the oil price rally of 2007-2008. It is formal and academic, and there are charts and formulas. But here is the bottom line: Dr. Hamilton agrees with my thesis regarding the rally. Dr Hamilton states:

"Growth in world income was the primary cause behind an increase in world petroleum consumption of 5 million barrels per day between 2003 and 2005, a 6% increase over the two years. The next two years (2006 and 2007) saw even faster economic growth (10.1% cumulative two-year growth), with Chinese oil consumption alone increasing 870,000 barrels per day. Yet between 2005 and 2007, global oil production stagnated.

My article (from early January) is here.

The cool thing is that Dr. Hamilton and I agree on the causes. He builds better looking models, though.

New Clear Energy

Is Nuclear Energy the Answer to our power-centric lifestyle?

Here is an opinion article from the Wall Street Journal that details the pro and con. 

Monte Carlo Simulations In Baseball

I remember playing strat-o-matic baseball with my older brothers as a kid. This is just as cool.

In Defense of Derivatives

From the opinion page of the Wall Street Journal, by Rene Stultz:

From the perspective of Main Street companies, derivatives are not just about high finance, quants and politics, but about investing in America's core industries, jobs and economic recovery. Companies find that over-the-counter derivatives are essential to their day-to-day operations. Derivatives help insulate them from risk, which allows them to borrow capital at better prices than they would otherwise. And derivatives are more useful than ever in these days of unusual volatility in financial markets.

For example, not being able to hedge currency risk through the use of a derivative can leave a company exposed to fluctuations in currency markets. Without derivatives companies could see movements in exchange rates turn a profitable export contract into a money-losing agreement.

In its current annual report, Caterpillar Inc. makes the case for why it relies on derivatives: "Our risk management policy . . . allows for the use of derivative financial instruments to prudently manage foreign currency exchange rate, interest rate, commodity price and Caterpillar stock price exposures...."

Our businesses need derivatives. Most of us choose to drive cars even though they sometimes crash. But we also insist that cars are made as safe as it makes economic sense for them to be, and that speed limits and other rules of the road are enforced. The same logic should apply to derivatives.

Declarations about Certainty and Questions about Nuance

Over the past couple of weeks I have posted several pieces that are skeptical in tone, including (especially) my post on Experts. This posting must have touched a nerve, as I received more comments about this posting than any other prior post on the site. It seems folks thought that was ironic for someone who claims himself to be a commodity market expert to dis experts on his site.

(By the way, one of the signs that my blog is gaining traction is that readers contact me now to provide their opinions. FANTASTIC! And THANKS!! I am lucky to have readers who care, and all comments are appreciated. If something in particular strikes you, leave some comments at the end of the posting for others to consider. Heck, most of the readers of this blog are smarter than I am - so you will probably teach me (and everyone else) something significant.)

Allow me to move back to the "Experts" subject, though. Indeed, I do encourage everyone to have a robust skepticism of what they think they "know". I side with Nicholas Taleb in this regard - in The Black Swan he says that the market is far more random than folks want to believe. There are analysts, marketers, and consultants throughout the world of stocks and commodities that make recommendations on how you (Mr. Third Party) should allocate your assets or time the market. Do they know with any reliable certainty? Of course not, otherwise they would keep their mouth shut and do what they are recommending with their own money.

However, just because the markets are more random than we perceive or want them to be does not mean that they are ALWAYS random. There are times when folks can execute a winning trade through research and discipline (and serendipity).

Unfortunately, the fact that the markets are random does not excuse us from having bottom line accountability to our banker (or our wife or our employees or our manager or our owner or our shareholders). It is the game we play, and those are the cards we have been dealt. The fact that markets is difficult or irrational does not excuse a business owner from making educated decisions.

Working with a market professional whom you trust can help you stay away from the cycle of greed, hope, and fear. Professionals can advise you on on the fundamental, seasonal, and technical factors in play in the market. Most importantly, professionals can help you discern the questions to ask yourself about your business. When you understand the questions, you can define the answers...and when you know the answers with certainty, decisions can be made with confidence. It is lonely (and a little scary) to make those decisions in solitude.

I appreciate the role of experts. But we must ask ourselves if those experts are engaging speakers that make declarative statements about certainties or whether they are humble market professionals that ask questions about nuance.

Any thoughts???

China Owns Too Many Dollars

One of my favorite articles over the last several years was "The $1.4 Trillion Question" from the Atlantic Monthly. It discussed how the Chinese were amassing huge amounts of dollar denominated assets, and asked the question "what will happen next?" or maybe "what might go on to get the Chinese to be sellers of their stash of US dollars?"

Paul Krugman opined on this subject yesterday in the New York Times (15 months after the Atlantic Monthly piece was published). Here is a piece of that article:

Some background: In the early years of this decade, China began running large trade surpluses and also began attracting substantial inflows of foreign capital. If China had had a floating exchange rate — like, say, Canada — this would have led to a rise in the value of its currency, which, in turn, would have slowed the growth of China’s exports.

But China chose instead to keep the value of the yuan in terms of the dollar more or less fixed. To do this, it had to buy up dollars as they came flooding in. As the years went by, those trade surpluses just kept growing — and so did China’s hoard of foreign assets......

Was there a deep strategy behind this vast accumulation of low-yielding assets? Probably not. China acquired its $2 trillion stash — turning the People’s Republic into the T-bills Republic — the same way Britain acquired its empire: in a fit of absence of mind.

And just the other day, it seems, China’s leaders woke up and realized that they had a problem.

And the Chinese DO have a problem. They have amassed a position in US dollars that is so large that it does not have ample liquidity for an orderly exit. That's just crazy...US Dollars are the most liquid asset on Earth! This isn't a tertiary market like pork bellies or frozen concentrated orange juice, Mortimer - it is the sovereign currency of the largest economy in the world.

I figured the Chinese knew what they were doing when they were buying all those dollars. I figured they had the best and brightest of the People's Republic in a quiet and stoic bureau somewhere in the governmental center of Beijing, and that those folks were planning for Chinese economic dominance on the grandest scale (like so many drummers at the Olympics Opening Ceremonies).

Maybe it was all an economic accident. And the global economic quandary for our times....

Kamikaze Spending In Japan

The Wall Street Journal Asia Edition has a short editorial today regarding the stimulus effort undertaken by the Japanese government:

Prime Minister Taro Aso yesterday ordered his government to draw up yet another stimulus package to buoy his sinking economy. In an interview with the Journal's Yuka Hayashi published on Monday, Economy and Finance Minister Kaoru Yosano said the program will "far exceed" the 2% of GDP recommended by the International Monetary Fund and will include measures to boost credit, maintain employment and strengthen the social safety net.

This takes fiscal profligacy to a new level. Mr. Aso's Administration and its immediate predecessor have already rolled out about 1.5% of GDP in new spending since the financial crisis hit last year. As of today, Tokyo estimates government debt-to-GDP is at 157.5%. The OECD puts that figure higher, around 180%. Mr. Aso said yesterday he would "not hesitate" to issue bonds to pay for his plans.

I mentioned in the most recent 4+1 commentary that the US dollar stands to be the "least worst soverign currency." Of course, 2 days later the government announced a plan to buy a trillion dollars of paper and the dollar took its biggest one-day hit in almost 50 years.  I am still bullish the dollar - not necessarily because of the strength of the domestic economy, but rather because of the weakness of other economies worldwide.  The stimulus of a slowing Japanese economy is another example of worldwide weakness.      

Who is your Propane or Heating Oil Expert?

The Jim Cramer - John Stewart debate has lit up the national discourse on a good topic - the value of an expert. Jim Cramer is an expert to a section of the stock buying public - but his advice hasn't worked out so well of late. There are only a few folks that have done well in this market, and those investors are to busy counting their money to do a TV show.

But this does highlight a few valid questions - How do we choose the people we trust? And what qualities make a person an expert?

Last week, Nicholas Kristof wrote an excellent op-ed piece in the NY Times. It was on the "Dr. Fox effect." The whole article is worth a read, the following is an excerpt:

The best example of the awe that an “expert” inspires is the “Dr. Fox effect.” It’s named for a pioneering series of psychology experiments in which an actor was paid to give a meaningless presentation to professional educators.

The actor was introduced as “Dr. Myron L. Fox” (no such real person existed) and was described as an eminent authority on the application of mathematics to human behavior. He then delivered a lecture on “mathematical game theory as applied to physician education” — except that by design it had no point and was completely devoid of substance. However, it was warmly delivered and full of jokes and interesting neologisms.

Afterward, those in attendance were given questionnaires and asked to rate “Dr. Fox.” They were mostly impressed. “Excellent presentation, enjoyed listening,” wrote one. Another protested: “Too intellectual a presentation.”

Scary, huh? A good presenter = an expert. Or maybe an "engaging talking head" = an expert (Jim Cramer, maybe?).

Ben Stein goes further to put this in perspective in another NY Times editorial:

Humans can’t consistently pick the right stocks or call markets, foretell political or geopolitical events or successfully predict changes in interest rates or commodity prices.

Life is far too complex and baffling for the minds of mortals to understand it as it happens, let alone to predict it accurately. (I am mindful of how Professor Friedman, a true supernova of brilliance, said of economic forecasting, “If you’re going to predict, predict often.”) Some humans shine like dazzling stars when their predictions turn out to be true, but those same humans can’t ever be counted on to replicate the feats regularly.

Yet, we cry out for someone to tell us the future, like children who want to hear the end of the story. When Mr. Cramer tries to satisfy that need, he is doing no more than answering a deep human wish. But he — and everyone else in a similar situation — should make it clear that these are no more than opinions and guesses, which could easily be wrong and often are.

This is not just boilerplate. This is life. The way it is.

So where does this leave us in our search for market wisdom? What is a retailer to do when he or she realizes that no one can predict the future with consistency and that "the folks that know aren't talking?"

Reevaluate who you trust. What questions do they ask? Do they understand your balance sheet, your customer base, and your business processes? If they don't, they might be a "Dr. Fox" - a false expert.

The value of a market expert is not in helping you make only good decisions. The value of a market expert is to help you understand - in advance - the impact of a bad decision, and then to assist you in steering your business clear of the kind of mistake that it cannot afford.

Before you make your next risk management decision, consider the trader's axiom "The market can remain illogical far longer than individuals can remain solvent." If your purchase decision can withstand the clarity granted by this statement, then it is probably a hedge. If not, you might wind up as frustrated with your "expert" advisor as Stewart was with Cramer.

The Emotions of the Market: Hope

In the 1930's, the economist John Maynard Keynes used the term "animal spirits" to describe human emotion in the marketplace. In the last 10 years, the Nobel Prize has been awarded to economists from the University of Chicago School of Business that have pioneered in the field of Behavioral Finance.

Emotion is not to be discounted in the market. And it plays a huge role in the decision to enter a fixed price contract. There are three main emotions that effect the buying decision, and they work in coordination with each other to help create a poor decision. These are the emotions of Greed, Hope, and Fear. They are not your friends, and when you detect them in your mind they should be dispatched with extreme prejudice. I would venture to guess that HOPE is an emotion that is at play in your mind today.

Consider the market context that we have recently experienced.

• In July, prices were sitting at all time highs ($147/bbl on NYMEX crude)
  
• But by November they had fallen to $37 - $40/bbl MORE than even the most bearish observer thought they could
• The brutality of the fall caused folks all over the industry to examine their existing positions closely, they needed to make sure their positions were flat. Additionally, there were margin calls to work through. This period of time was very busy, as folks were attending to pressing business that could not be put off.
  
• However, it was also (in retrospect) the best time to lock in some product. The wholesale price that was available in the market at this time was one that could be used as a base for a 2009-2010 fixed price program. A margin could be added, and the retail customer would have been interested. A large segment of marketers passed on this opportunity, though...it just wasn't a good time for them to make that leap.
  
• Propane prices are now 30 cents above the price that was available in November.
• Over the last month or so, folks have been thinking about layering into a piece of prebuy. Seasonally, it makes sense to do so as the market often trades on its annual lows in the first quarter.
  
• Last week, an unexpected fundamental (news of the Treasury's plan to buy $1.0 trillion is debt) caused historic weakness in the dollar, and therefore spiked commodity prices across the board (energy prices included).
  
• Those folks that were still waiting to lock in a piece of fixed price product find themselves in a state of shell shock, confused by the market's fluctuations and not knowing what to do.
  
• Here is where the HOPE sets in:

It becomes the natural human reaction to wait for a while before pulling the trigger on a contract. Marketers in this situation are HOPING that the price moves lower and that they are able to get the price they could have gotten previously. They may wind up HOPING in that way for several months, as the price continues to move higher.

Whether you should buy now or wait is really a question that is dependent upon your unique business, customer base, and target margin structure. No one should ever give a blanket purchase recommendation to customers, although there are consultants that do so.

However, what an independent third party can do is offer perspective and encourage a balance between emotional and rational. Is there too much HOPE in your program? If so, consider buying the piece you might have missed out on last week.

Infographic on Global Warming

From the Onion.

Wachovia MLP Primer

100 pages of information - a very thorough review - can be found here.