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AIRLINE SUBCOMMITTEE

CHAIR; Damy Clifford, Director, Military & Government Sales, Delta Airlines

The short-, medium-, and probably long-range future of the airline industry can be summed up in one word--oil. All foreseeable financial roads for airlines lead to--and through--this ancient energy source, which after a few conversions, is aviation fuel.

A bit of history here may put things in perspective. Ten years ago fuel comprised 15 percent of an airline's operating expenses. Five years ago, that number was 29 percent. Today, with the world market price for the benchmark West'Texas Intermediate (WTI) being Si00 per barrel, an airline's fuel costs make up 35 percent of all operating costs.

Many financial experts who specialize in oil and gas are predicting that over the long term the price of oil will go up significantly. Goldman Sachs recently raised its forecast for WTI from Dollar120 per barrel to Dollar 130 by the end of 2012. Others are predicting Dollar 1 50 per barrel within the next twelve months, and still others are indicating that Dollar 200 per barrel is not out of the question over the next few years.

What is driving this increase? Well, a number of factors. The more "artificial" ones being the weakness of the dollar--when the dollar is weak against foreign currencies the price of oil goes up--speculators in commodities trading, the political instability of the Middle East (which threatens oil production), the civil war in Libya (which reduced worldwide production by 2 million barrels per day), and the status of the worldwide economic recovery.

But the real driver that underpins higher oil prices is quite basic--supply and demand. The thriving economies of China and India, and related consumption of oil, is the primary catalyst behind increased worldwide demand. The economies of Saudi Arabia and Brazil also add to the demand curve. On the supply side, many experts suggest that worldwide production is decreasing. Exxon recently reported that it is replacing every 100 barrels of oil it produces with only 95 barrels of newly founded oil. That does not bode well for matching worldwide demand with commensurate supply.

All of this presents unique challenges for airline operations moving forward. How do airlines cope with the challenges of much higher fuel costs? In the short to medium term, hedging is the most effective means to control an airline's expenditures on fuel. At least the use of hedging gives an airline some control over what it will pay in the future for its aviation fuel.

How does hedging work? Simply put, hedging is making advance purchases of fuel at a fixed price for future delivery to protect against the shock of anticipated rises in price. Hedging has become quite sophisticated, with complex formulas and algorithms being used to determine the best time to hedge and at what levels. Hedging often involves not just setting a ceiling on the price of fuel, but also floors. It often produces a range within which an airline can operate with some cost predictability, at least for the fuel that is purchased in advance. Airlines typically do not "bet the farm" and hedge 1 00 percent of fuel--the risk is coo high in the event prices actually fall. A more likely ratio of hedging is 40 to 60 percent of total fuel consumption over a period of time...

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