Airlines come out for regulation -- of the derivatives market

    Airlines and banks tend to be on the same page when it comes to regulation of business -- they don't want it.

    Now, the airline industry has decided some regulation isn't so bad. Carriers have become big champions of limitations in the financial sector, especially around reforms related to derivatives trading.

    So, why the change of heart? It comes down to oil. Airlines are blaming the unchecked derivatives trading market for severe price swings that have made it impossible for them to control their fuel costs. In a note to employees on April 23, Delta Air Lines (DAL, Fortune 500) CEO Richard Anderson summed up the issue for his company: "Prices are artificially inflated and volatility is created as a consequence of excessive speculation and trading by parties with no tangible need for the commodities."

    In other words, hedge funds and other investors with no intention of taking delivery are betting on oil futures, and it's making fuel hedging harder and more expensive for the parties that actually burn the jet fuel-the airline carriers.

    Fuel hedging started out as an innovative way to smooth out the price of fuel for carriers and match supply to the demand for air travel. By controlling costs, airlines could run their businesses more predictably. Now, they're arguing their fuel hedging market is turning into just another financial table game in the Wall St. casino.

    Proposed regulation by the Obama Administration and Congress around derivatives trading would limit speculation and require that derivatives trade on exchanges, making the process more transparent. AirTran Airways (AAI) has publicly voiced its support of the reforms, saying that consumers are the ones who ultimately suffer from the price spikes. In addition to his internal comments, Delta's Anderson wrote a letter to Sen. Blanche Lincoln backing her legislation on reining in derivatives trading.

    "We're going to be able to manage and predict our fuel expenses with much greater clarity and at a much lower cost with these new financial regulations," Virgin America CEO David Cush told Fortune. Cush says that right now the transaction cost for hedging a barrel of fuel runs between $7 and $10 for an airline, a cost he's hopeful will ease with stipulations on greater transparency.

Oil as an asset

    At the core of the issue is the transformation of oil from strictly a commodity to an asset class. "One of the reasons why we have such volatility in the fuel market is that you've had this huge amount of financial interest," says Mike Masters of Masters Capital Management. So while airlines cry foul, investors merely consider crude another market to arbitrage.

    According to Masters, last week, crude prices dropped $11 a barrel not because of supply and demand issues, but because crude acts like the stock market rather than an inventory market.

Liquidity at what price?

    The counter argument from commodities traders is that they add liquidity to the market, in essence allowing airlines to hedge in the first place. But Masters says it all comes down to balance-having enough liquidity in the market to hedge versus excess liquidity that ends up distorting prices due to speculation. "In this case, more speculative liquidity hurts the very hedgers the market was supposedly set up to help," he says.

    Airlines point to roller coaster prices during 2008 (oil fluctuated from about $150 to $35 a barrel) as the prime example of why the price-stabilizing derivatives market -- free of speculators -- is needed. Delta has said that the volatility during that period led to its slashing 10,000 workers from its payrolls and dropping seat capacity by 10%.

    For AirTran, fuel moved from its third or fourth largest cost to being more than half of its expenses during the year, says the airline's CFO, Arne Haak.

    Industry executives note that it's not necessarily that the increases that are unpalatable. Rather it's that, in an unregulated market, they become unpredictable. What airlines fear most is the day some big investor sees a way to make a killing in the oil market -- at their expense. "Even if prices are more stable and slowly going up," says Haak, "you can manage that."