Thursday, June 28, 2012

Reflections on the Ascent of Money, Part 2


The Ascent of Money: A Financial History of the World

LCTM thought they had beaten risk, but as This Time is Different shows - it was only delusion.There is always risk involved and that is why we pay financial experts as much as we do - because people are risk averse and would therefore prefer to settle for a lesser, more secure amount if it means putting our risk of losing it all onto another entity. Financial Institutions are supposed to be risk neutral by design and therefore arbitrage the difference between a willingness to pay between a risk neutral individual and a risk neutral opportunity. Financial innovation like this ought to be encouraged.

No matter how much we fault the financial industry for our woes, they really are just the product of market forces. It's popular to attack the people doing the trading, deriding them as speculators, as if they are acting freely on their own accord and not being lead there by the invisible hand. Call it economic determinism, if you will.

Here is a perfect case of so called "speculation": Southwest Airlines.

What is the secret of this budget carrier? How were they able to sneak up on  the competition in the last two decades? They gambled and won on fuel prices. Then lost. Then won all over again.

Basically, they were betting that fuel prices would continually go up faster than the market as a whole predicted they would. Southwest would buy derivatives, known as hedges, that basically allowed them to buy fuel for their planes at a certain price in the future at a price determined today. If the actual price exceeded the expected price, then they would get a large payout from whoever took the other side of the bet. If the actual price was lower than the expected price, then all they would be paying for was the price of the hedge (which can be very expensive). Bigger the difference, bigger the payouts.


They won this bet basically non-stop between 1998 and 2008. Lost big between 2008 - 2009 then started to win again as oil approached $100 a barrel in 2011. This was a strategic advantage as they paid less for their fuel and saved $3.5 Billion dollars. The double whammy of the recession and the loss on the hedges would've put significant financial strain on any other company - American Airlines for example - but they were able to weather a few bad quarters and then move on. A strategic advantage turned into a strategic disadvantage temporarily. It helped, perhaps, that Oil shot back up because of the Middle East unrest and therefore allowing them to take advantage of hedges signed post-crisis; and/or oil became so cheap that it completely outweighed their losses.

When the entire market bets that oil is going to increase in price, oil is going to increase in price. You can make or lose money betting on its speed, but one thing is for sure: expectations move markets. But if expectations prove to be wrong, then the price is going to come back down again as the Invisible Hand makes its corrections - those who make bad predictions lose and those who make good ones win. 

Here is the kicker: When Southwest bets that their fuel contracts are going to become more expensive and they are wrong - they can still win. Yes, you read that right. Hedges have allowed them to minimize their downside risk when oil prices soar, therefore smoothing their budgeting process by adding predictability to the process. That's something worth paying for. Companies are just as risk-averse as the rest of us.

How anyone views what Southwest did as anything but a legitimate business is beyond me? There is no great speculation conspiracy, even if it might make good politics to say otherwise.


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