… Airfare

airplaneWith the plummeting price of oil the news is filled with articles about how even though jet fuel is the number one cost that airlines incur (around one quarter to one third of total operating expenses), airfares are not going to go down anytime soon. Airlines tack-on “fuel surcharges” to their ticket prices, which can be especially high for international flights. A few airlines are publicizing that they are decreasing or eliminating their fuel surcharges, but for the most part, they are staying in place for now. Intuitively, this does not make sense. In fact, it does not even seem fair. And to me this illustrates the possible existence of a market failure which ought to be explored and if it is found to exist, eliminated, insofar as it can be.

The market for air travel is an oligopoly – a very cramped one, at that, in the United States, which I have written about before. And this in and of itself lends itself very sticky prices. However, disregarding that reality of the market, I believe that there are other forces at play colluding to keep the price of airfare high through those pesky fuel surcharges, despite the falling price of oil, and commensurately, jet fuel.

Oil_Jet Fuel Price Change

Airlines purchase hedging derivatives, called swaps which are based on the price of oil and/or jet fuel. Basically, they are bets on the future price of the commodity (jet fuel is refined from oil, but other variables, such as refinery capacity, make it so that jet fuel and oil do not move 1:1). If an airline thinks that oil is going to go up, which would increase their costs, they can buy a swap that says that over a certain dollar amount, say $100, the counterparty (such as a bank) would have to pay the difference. Then, if oil moves to $110, the airline would only have to pay $100 and the bank would pitch in the last $10. If, on the other hand, the price of fuel dropped to $90, then the airline would be caught buying fuel at $90 and having to pay an additional $10 to the bank. Other forms of derivatives, such as options, can also be used with similar results.

So, as you can guess, the airlines have purchased a lot of upside protection, so right now they are still paying high prices for jet fuel, based on their derivative contracts, even though prices have plummeted. This is one of the reasons why fuel surcharges still hang over airline tickets. Anyone who has read my blog in the past may be thinking to themselves that this sounds vaguely familiar. In fact, it is very similar to the interest rate swaps debacle that Detroit got itself into.

Right now, Delta and Southwest, who were both lauded a few years ago for wise hedging strategies, are reeling the most from the swing in oil prices. American Airlines, on the other hand, has less derivatives exposure, so it is set to gain more from the drop in the price of oil. Importantly though, even though American Airlines is set to gain, the oligopolistic nature of the market will mean that few of the saving will be passed on to travelers. American can keep its prices high precisely because Delta and Southwest can’t drop prices. The only people who are set to gain are American Airlines shareholders (and the bankers, of course).

The fact of the matter is, for any swap, the two counterparties take contrarian bets. In our case, the airline wins when prices go up, and the bank wins when prices go down. So to be on the other side of the bet, the banks must have seen the potential for oil prices to decline. Rarely do you hear that banks are the ones suffering from being on the wrong side of hedges. Maybe the banks are superior pricing models, or maybe they account for such a large share of international volume that they can influence the price through clandestine means. I don’t know, but it seems that their clients are always the ones taking outsize bets and losing the house. I completely fail to see the wisdom by which everyone espouses the abundant use of derivatives.

And now, with oil so very far off its relatively recent highs, airlines, especially in Europe, are looking to lock in new hedging positions, betting that prices for oil won’t drop below $40/barrel. I think it is only a matter of time before an international airline blows-itself up financially up with a backfiring derivatives strategy. Not only do airlines hedge their jet fuel risk, they engage in foreign exchange hedging, and refineries, which have close financial ties to airlines, hedge as well.

This is part three of a four-part series of posts on the Economics of Oil. Previous posts:

The Economics of Gas Prices

The Economics of International Oil Price Conspiracies

The Economics of Bitcoin Mining

 

Sources:

http://www.reuters.com/article/2014/12/23/us-oil-hedging-airlines-idUSKBN0K10AJ20141223

http://www.indexmundi.com/commodities/?commodity=jet-fuel&commodity=crude-oil

http://en.wikipedia.org/wiki/Fuel_hedging

http://www.cnbc.com/id/102336174#

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Posted on January 14, 2015, in Air Travel, Finance and tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , . Bookmark the permalink. 5 Comments.

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