Delta's Half Billion Dollar Failure

It should come as no surprise that fuel is one of the largest costs for any airline. Unfortunately fuel is at the same time a very volatile market, where prices can surge unexpectedly and quickly. Unexpectedly high fuel costs can quickly eat into profit margins and turn a great year into a financial loss with little to no warning.

In an effort to minimize this risk, Delta bet big by signing a hedge contract with fuel companies. The way this contract works is that Delta pays higher costs on fuel than are currently on the market right now. These contracts however fix the price, so that if fuel prices jump up, the fuel price will not fluctuate. Delta was gambling that the fuel price on the market would go up, and if so, these contracts would save Delta a whole lot of money since they would be locked in at a price lower than market rate should the market price increase as expected.

Like any gambling move though, there is a huge downside to making a move like this. If the market doesn't move in the upward direction as expected, Delta would lose out on the savings of paying market rate for fuel. That is exactly what happened to Delta. Oil and subsequently jet fuel prices have not increased at the rate anticipated by Delta. Since this remains the case today, Delta had two options, either stay under the contract and continue to lose money on the higher fuel prices, or cancel the contract and pay nearly $500 million dollars for backing out. Delta went for the latter option and now are going to have to write off the loss.

Why did Delta take such a huge loss? Fuel is such a huge cost for an airline, Delta is betting that fuel prices have remained low and will likely remain that way for the near future. Their likely thought here is that the money they will save on the lower fuel costs will make up for the loss incurred by cancelling the contract. Once again this is a bit of a bet, since no one can predict the fuel market, but I'd go with Delta on this move now. Seems that we're in for lower fuel prices for a little while still.