Following on this Professor Ribstein post and this reply post here over the weekend regarding most airlines’ failure to hedge fuel costs, this NY Times article reports that the hedging of fuel costs also varies widely in other fuel intensive businesses. One reason is that the practice is risky:

In a vexing illustration of the risks associated with hedging, though, not every company has been so fortunate.
For instance, the PanOcean Energy Corporation, which produces oil in West Africa, lost $1.4 million in the most recent quarter by essentially agreeing to sell oil for about $30 a barrel when the price of oil climbed much higher – just below $40 a barrel last Friday. PanOcean made the bet as part of a loan agreement with its bank.
“It’s a crap-shoot, isn’t it?” said David Lyons, chief executive of PanOcean, no stranger to risk after developing a natural gas field in Tanzania in East Africa to complement operations in Gabon. “Personally I feel hedging activities are overdone, but it’s something our financial agreements require us to do.”

Many companies find it less risky (albeit more incompetent) simply to avoid hedging and pass along the increased fuel costs to their companies:

Many choose instead to raise costs for their customers, contributing to concerns about rising inflation.
One company opting for a fuel surcharge instead of hedges is Waste Management, the Houston-based garbage collection company with a fleet of 20,000 trucks around the nation. Heather Browne, a spokeswoman for Waste Management, said fuel costs still remain a relatively small amount of the company’s revenue, about 3 percent of $11.5 billion.

Nevertheless, hedging fuel costs is increasingly important for fuel dependent companies that serve a limited geographical area:
For companies with a more limited geographic reach and more dependent on the fuels that are becoming a bonanza in the oil patch, hedging is increasingly considered a necessity. Southwest Airlines exemplifies this trend, with 80 percent of its fuel needs hedged for this year and 2005, and 30 percent for 2006 at prices below $30 a barrel.
Alaska Air, which operates Alaska Airlines and Horizon Air, is also among the few that hedged a large share of its fuel consumption, about 40 percent this year and next, at prices from $25 to $27 a barrel. But even that was not sufficient, the company acknowledges.
“We’re not at the Southwest level,” Bradley D. Tilden, Alaska’s chief financial officer, said in an interview. With the company consuming about 400 million gallons of jet fuel a year, each penny increase in the price of the fuel costs the company $4 million a year, he said. Jet fuel prices have climbed to $1.17 a gallon from 76 cents a gallon this time last year.

Nevertheless, many major airlines remain slow to hedge:

Other airlines are struggling with the prospect of large losses after hedging fuel needs at relatively high prices, like Continental Airlines, which secured 80 percent of it fuel consumption at $40 a barrel this quarter and 45 percent at $36.40 a barrel for the third quarter.
Delta Air Lines and Northwest Airlines did not hedge at all this year and American Airlines, the nation’s largest carrier and a unit of the AMR Corporation, hedged less than 10 percent of its fuel needs for the second half of the year, according to a report by Lehman Brothers. Prying information from companies that placed erroneous bets on the price of fuel is sometimes akin to pulling teeth.

Finally, the NY Times piece observes correctly that the risk of hedging is not a reason to avoid it:

“People get their feelings hurt when they hedge poorly,” said J. C. Whorton, executive vice president of StratCom Advisors, a company that provides risk-management services. “But it’s most often the case that those companies that fail to hedge at all have done a very poor job.”

My prior post noted Warren Buffett’s distaste for investment in the airline industry because of its traditional lack of profitability. Could it be that the airline industry is simply an example of Mr. Buffett’s following observation about troubled businesses?:

“When a manager with a great reputation takes on a company with a poor one,
it is the company’s reputation that survives.”

Professor Ribstein is inclined to agree with Mr. Buffett.

This NY Times article provides a good analysis of the the difficulty that Russia’s largest oil and gas companies are having in translating their huge reserves into stature among the world’s major oil and gas companies in the marketplace for investors. The article starts by noting the huge potential in the Russian oil and gas business:

By rights, Russia should have a world-class energy company. It has 6 percent of the world’s oil reserves and pumps 10 percent of daily global production, rivaling Saudi Arabia. And its economy has rebounded as oil-consuming nations east and west turn increasingly to Russia for energy supplies.

However, that potential has not yet translated into success. The article uses the example of Lukoil, one of the two Russian majors:

But the very things that make Lukoil work in Russia are holding it back in the rest of the world, analysts and industry experts say: Lukoil remains a very Russian company, with all that has come to imply, from its complex structure and opaque finances to its inefficiency and dependence on the good will of the Kremlin.

In short, the lack of business management development under the old Soviet Union’s economy continues to bedevil Lukoil in comparison to other major oil and gas companies:

Though publicly traded as a single entity, Lukoil is structured more like a decentralized web of fiefs, and some investors say it is often unclear how profits flow to the center of the group or whether its published accounts fully capture what is going on.
“Some of the units within Lukoil, like Permneft, are, in management terms, very autonomous,” said Ian Hague, co-manager of Firebird, a hedge fund specializing in Russian investments. “The amount of oil they’re producing, as compared to net income, seems to show that large sums – hundreds of millions of dollars – are going places not clear to investors.”
“Investors don’t like things that are difficult to explain,” Mr. Hague said. “If Lukoil is running an expensive ship, meaning more of their money goes to administrative costs than others, investors view that as a problem.”

Stocks of American majors like Exxon Mobil and ChevronTexaco are now trading at price-to-earnings multiples in the mid-teens, based on estimated earnings over the next year. But Lukoil’s multiple is just 7.9, in the middle of the Russian oil pack.

Now a decade and a half after the fall of the Soviet Union, is it fair to ask whether Lukoil and Yukos (the other Russian oil and gas major) will be able to achieve stature equal to the world’s oil and gas majors in the marketplace for investors without the importation of Western oil and gas management expertise?

This NY Times article reports on Houston-based Continental Airlines‘ plan to respond to the recent spike in fuel prices that are straining profits of all airlines. Fuel is the second-biggest expense for airlines, after labor costs, and typically totals about 10% of operating costs.
Continental raised fares across the board late yesterday and said it will have to consider furloughs and wage cuts if jet-fuel prices do not decline from their current record levels. Continental raised ticket prices $10 each way for flights of as much as 1,000 miles, and $20 each way for longer trips. However, under heavy pressure from discount airlines, major carriers such as Continental have seen previous attempts to boost ticket prices fail when competitors decline to match. Even if this current increase sticks, Continental said it would offset only 15% of its higher fuel tab.
At current prices for oil, Continental faces an additional $700 million in annual operating expense over what it originally had planned for 2004. As a result, Continental CEO Gordon Bethune said he expects Continental to suffer a significant loss for 2004.

During a political season, you will not hear much about the benefits of higher oil prices. But this Wall Street Journal’s ($) Holman W. Jenkins, Jr. Business World column dissects the issue and concludes that increased oil prices are not all bad. First, Mr. Jenkins addresses the current price spike and the reasons behind it:

The futures market puts oil for delivery next summer at $35, well under today’s $41. Seers are not hard pressed to explain why. On April 24, three small boats operated by suicide commandos hit Iraq’s southern oil terminal and a few days later kamikaze gunmen shot up a Saudi petrochemical plant. Osama bin Laden has a plan: Get control of Saudi Arabia through subversion and put himself in charge of its oil, foundation of a new Islamic empire. That is, Saudi survival can’t be taken for granted.
Traders say five to ten bucks of today’s price is due to terrorism fears. Notice also that the biggest speculator out there is the U.S. government, which has been frantically topping off the Strategic Petroleum Reserve ever since November 2001, yelps from private energy buyers notwithstanding.

Then, Mr. Jenkins focuses on the real issue, which is not a shortage of oil:

Note that the issue is not whether the world is running out of oil. The debate concerns a theoretical milestone called Hubbert’s peak, after which output from any given field slows and becomes more costly to produce long before the last drop is lifted. Half of Saudi Arabia’s oil comes from the giant and venerable Ghawar field; much of the remainder comes from four other aging giants that may be at or near their Hubbert’s peak. . .
How much oil is left is far less significant than how quickly and cheaply it can be extracted, especially from a relative handful of large, cheap-to-produce fields that have carried industrial man for a century. Some believe that getting much above today’s 80 million barrels a day would be horrendously costly if not impossible. If they’re correct, two billion Chinese and Indians, right now beginning to trade their bicycles for Toyotas, would be stuck trying to achieve modernity by outbidding the rest of us for a share of the world’s current rate of oil production rather than benefiting from additional output.
All this has some petroleum engineers predicting resource wars, famine and pestilence, preventable only by a massive effort of central planning to shift the world to a less hydrocarbon-intensive lifestyle. If so, we might as well pass around the cyanide caplets right now. Such global planning is certainly beyond the wisdom and power of politicians to manage.

Which brings Mr. Jenkins to his central theme — i.e., the benefits of higher oil prices:

Yet the unwillingness of doomsayers to credit price signals with eliciting changed consumption behavior, new technology, a thousand substitutions and other adaptive responses is more than a little peculiar here. Oil companies have held back from investing in deep-water searches, Canadian oil sands and Venezuelan bitumen for fear oil prices will plummet to $15. Shareholders have kept Big Oil on a short leash, tolerating only low-risk investment projects that will generate cash flow in a small number of years. Won’t this change now if higher prices seem a permanent feature of the landscape?
Motorists might or might not be willing to swallow price hikes, but what about other industries that use petroleum as feedstock? They’re price sensitive and would be expected to adapt in ways that aren’t all easy to foresee from today’s vantage.
Scare talk is a hardy perennial in the global petroleum business, a passport to fun and attention from the media. Industrial society is frequently painted as a fragile, vulnerable machine, yet all the evidence suggests the opposite: It’s a machine that has grown more resilient and adaptable the more complex and interdependent the world becomes. In short, as long as the price mechanism is allowed to work, mankind seems likely to muddle through. Hallelujah, then, for higher oil prices.

Amen.
On a related note, although not quite as insightful as Mr. Jenkins’ piece, this NY Times editorial strikes the correct theme that short term spikes in energy prices is not a cause for overreaction.

In the wake of this news regarding oil prices, Morris A. Adelman is a professor emeritus of economics at Massachutsetts Institute of Techonology and long has been one of America’s leading energy economists. In this article, Professor Adelman eviscerates the myth that humanity?s need for oil cannot be met and that a gap will soon emerge between demand and supply. The entire article is a must read during the current season of political demagoguery, and here are a few snippets to pique your interest:

There is not, and never has been, an oil crisis or gap. Oil reserves are not dwindling. The Middle East does not have and has never had any ?oil weapon.? How fast Russian oil output grows is of minor but real interest. How much goes to the United States or Europe or Japan ? or anywhere else, for that matter ? is of no interest because it has no effect on prices we pay nor on the security of supply.

The doomsday predictions have all proved false. In 2003, world oil production was 4,400 times greater than it was in Newberry?s day [Newberry, a geologist, predicted in 1875 that the world was running out of oil], but the price per unit was probably lower. Oil reserves and production even outside the Middle East are greater today than they were when Akins claimed the wolf was here.
World output of oil is up a quarter since [Jimmy] Carter?s ?drying up? pronouncement, but Middle East exports peaked in 1976?77. Despite all those facts, the predictions of doom keep on coming.

If the cost of finding and developing new reserves were increasing, the value per barrel of already-developed reserves would rise with it. Over the period 1982?2002, we found no sign of that. Think of it this way: Anyone could make a bet on rising inground values ? borrow money to buy and hold a barrel of oil for later sale. With ultimate reserves decreasing every year, the value of oil still in the ground should grow yearly. The investor?s gain on holding the oil should be at least enough to offset the borrowing cost plus risk. In fact, we find that holding the oil would draw a negative return even before allowing for risk. To sum up: There is no indication that non-opec oil is getting more expensive to find and develop. Statements about nonopec nations? ?dwindling reserves? are meaningless or wrong.

U.S. oil policies are based on fantasies not facts: gaps, shortages, and surpluses. Those ideas are at the core of the Carter legislation, and of the current Energy Bill. The Carter White House also believed what the current Bush White House believes ? that, in the face of all evidence, they are getting binding assurance of supply by opec, or by Saudi Arabia. That myth is part of the larger myth that the world is running out of oil.

Professor Adelman’s piece dovetails nicely with this Fred Singer article on the ill-conceived Nixon and Carter Administrations’ energy-related policies that were implemented in response to perceived shortages of oil.
Hat tip to Professor Kling over a EconLog for the link to Professor Adelman’s timely article.

As noted earlier here, Houston-based Reliant Resources and four individuals are facing a criminal prosecution in San Francisco in connection with the shutting down of California power plants in 2000 allegedly to increase the price of electricity in that state.
William Anderson over at the Mises Economic Blog has posted this cogent analysis that persuasively contends that the indictment makes no sense from an economic standpoint and can only be explained in political terms. The entire post is well worth reading, and here are a couple of Mr. Anderson’s points:

The California electricity fiasco has been well-documented in the press, and on this page as well. Economists like George Reisman have destroyed the many myths that sprang up while the state was suffering through rolling blackouts and extremely high wholesale rates. However, as is usually the case when energy issues come to the fore, in the end the political classes always lay all the blame upon energy producers. (This is logical, as the only other alternative would be for politicians to blame themselves, which is an impossibility in this politicized age.)
* * *
[A]t the risk of being a voice in the wilderness, let me say that the only fraudulent thing here is the indictment itself. As one who has devoted much of his time to the study of federal crimes, I can say that once again we have a case in which government prosecutors have built a series of ?crimes? around an activity that was perfectly legal. Furthermore, the indictment not only alleges criminal behavior where there was none, but also goes one step further: it attempts to repeal the laws of economics. (In other words, if Ashcroft is correct here, then perhaps one can expect federal goon squads to conduct raids on economics professors whenever they attempt to explain laws of supply and demand.)

Mr. Anderson then addresses the fundamental economic illogic of the theory of the government’s case:

There is another problem, one that the government has conveniently ignored. If a reduction in supply of a good, ceteris paribus, leads to price increases, then the addition of supply must lead to price decreases. In other words, if Reliant?s alleged actions first led to price increases, then when Reliant?s plants came back on line ? and other producers rushed into the market to take advantage of the price increases by providing more electricity ? the prices would then fall.
Unless there were government interference in the market for electricity, withholding electricity in order for a company to enjoy higher prices would be a self-defeating strategy. As noted previously, not only would the addition of later supplies drive down the price, the higher prices would entice companies selling electricity elsewhere to divert their supplies to California, thus placing more electricity for sale than had been their previously.
Second, since shutdowns and startups are costly activities, companies like Reliant that would use such strategies would likely be making themselves worse off in the long run. That is because the gains from higher prices would be short-lived at best, and when one factors in the startup and shutdown costs, then the company would ultimately earn a lower net income than it would have received had it kept the plant on line.
Now, I am not saying anything that would be particularly profound, at least to an economist or someone in the electricity business. Furthermore, the article does not say if the ?scheme? even worked. Yes, it does say that prices rose, but it does not say that later they came back down. In other words, if Reliant had the ?power? to ?manipulate? the market, as the DOJ indictment alleges, then why did electricity prices eventually fall, as was the case in California, and prices were falling even before the government stepped in with unwise price controls over the western power grids.

Mr. Anderson then sums up with laser-like precision:

The California electricity crisis provided the opportunities for people to learn about the dangers of price controls. Instead, we have learned yet another lesson about the political classes and how they will ?manipulate? the political ?markets? (if I may use such a term) to turn the truth on its head. Furthermore, this indictment sets a very bad precedent in the energy markets as a whole.
That is because the United States has not seen a new oil refinery built since the Gerald Ford Administration in the mid-1970s, and refineries are being pushed to the limits. That means that any time a refinery is temporarily shut down for explosions, accidents, or even simple maintenance, that the DOJ now is going to look to see if criminal indictments can be handed down against oil producers for ?withholding fuels.?
As the power of governments at all levels has grown exponentially in recent decades, so has the prison population of this country. That is no accident. Today, we see more and more the government using criminal charges as a way not only to punish supposed ?criminals,? but also to engage in political manipulation. The Reliant indictments simply are another cog in the giant wheel of federal injustice.

A suggestion for defense attorneys in the Reliant Resources case — Mr. Anderson just might be a wonderful defense expert witness!