david's web-log

The following is paraphrased from an email I, trying to explain derivatives, sent to my grandfather. I thought the note might be interesting to post online as well. (There’s a high-to-very-high probably no one else thinks it’s interesting, but then you must remember that I don’t care what this “no-one-else” guy thinks. God, I’m hilarious.)

Okay, derivatives. I’d try explaining, but there’s no way I could do a better job than Warren Buffett. Start reading on page 14 of Berkshire’s 2002 Annual Report (then click here for Wikipedia’s take and here for the Fool’s.). This letter to shareholders contains a famous passage about derivatives, instruments which Buffett likens to “financial weapons of mass destruction” (though this sentiment is oft-debated). As always, he’s clear, concise, and likeable.

Here’s how I think about derivatives, though. In essence, they are financial tools that are derived from the value of another asset. One of the most popular kinds of derivatives is called a futures or forward contract. Think of it this way:

You’re the CEO of Southwest Airlines. You run an extremely successful and popular company known for low-cost tickets and outstanding service. What are you worried about? Well, of course, you’re worried about competitors offering cheaper fares and taking your customers. You’re probably also really worried about the cost of jet fuel, which comprises somewhere between 20% and 30% of the operating costs of your company. Think about that; one-third of each ticket goes directly to oil. (The other 2/3 must go to pilots, flight attendants, mechanics, ticket officers, baggage handlers, websites, executive salaries, beverages, airport rent, airplanes, and, most importantly, shareholders.)

The problem with having to buy so much oil is that its cost is extremely volatile. For example, from 2002 to 2006, the cost of jet fuel rose from $0.708 per gallon to $1.97 per gallon — an almost three-fold increase. In fact, this volatility has caused the cost of fuel to soon become the single most important factor to whether your airline turns a profit. (This is actually true; JetBlue, always profitiable in years past, lost $42.4 million in the fourth quarter of 2005 — primarily because of unexpectedly high fuel costs.) In essence, your company’s performance is really not based on how efficiently you can fly planes anymore; your company’s performance is based on how well oil companies can find and supply oil (i.e., keep down the price of fuel).

What does this mean? Those in the financial industry would say your airline is exposed to, or at risk to, the cost of jet fuel. Here’s where derivatives come into play. In your case, and in most useful applications of them, derivatives can be used to hedge your company’s risk. What you could do is enter into a futures contract in jet fuel. A futures contract is an agreement between two parties to exchange an asset at a future date. In your case, you could purchase a futures contract on fuel that stipulates that you have the obligation to buy fuel at a specific price in the future.

For example, say jet fuel costs $1 per gallon at the moment. As CEO of Southwest, you’re not an expert on the oil industry, so you don’t know whether the price will go up or down. In fact, you’re risk averse to the price of oil — you’d be worse-off if oil prices sky-rocketed than you would be better-off if oil prices plummeted. (Basically, you hate bankruptcy a lot more than you like record profits). You want stability, and you’re willing to pay a little more for some insurance against high prices. A futures contract provides this stability.

What you do is make an agreement with another party to buy jet fuel for a specific cost, say $1.10, into the future. If jet fuel goes down to $0.75, you lose money because now you still have to buy it at $1.10. If jet fuel goes up to $1.25, you gain money because you can buy it at the cheaper price of $1.10. So what you’re doing is essentially locking in, or hedging, the cost of jet fuel. Now, you can again concentrate on what you do best — transporting passengers in an eccentric and often overly cultish manner. (Ha! A joke!)

Two points:

First, who would be the other person willing to sell you jet fuel at a constant price? Well, in our economy, lots of people would: oil companies, for example, might want to protect themselves from falling prices. Naturally, lots of speculators and investment firms (think: a hedge fund) would like to bet on the price of oil because it’s so volatile.

Second, when you enter into a futures contract, there’s actually no fuel being exchanged by the two parties. In reality, you buy oil from the same place you’ve always bought it at whatever price you’re charged. If the price of fuel rises to $1.50 per gallon, you still pay this amount to your oil supplier. But now, the other party in your futures contract simply pays you the difference between the $1.50 and the $1.10 in cash. Remember, a futures contract doesn’t involve the actual buying and selling of oil; a futures contract derives from the buying and selling of (the price) of oil.