Blog Archives

… 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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… Ebola Screening

Sorry that I have not posted in a while. I have been a bit busy and I recently came down with the flu. It is only fitting that this article is about disease. I’ve also got a climate change post in the works. I wanted to post it a few weeks ago when all eyes were on New York, so I guess I’ll just have to post it with a back-date now.

Two aspects of the Ebola case in Dallas bother me a lot. The first is that the patient went to the hospital with symptoms, told the hospital he had recently been in West Africa, and nevertheless he was turned away. I can’t know for sure, but I assume that the patient is uninsured, and the admitting nurse, who is instructed to turn away patients who are unlikely to be able to pay their hospital bills, simply saw the hospital’s finances as a greater danger than Ebola.

o-EBOLA-570

Because of this episode, the White House is considering establishing States-side Ebola screening in airports. However, people seem to be at a miss on how to implement this. They say that there are just too many airports and too few West African passengers. That’s the second aspect that bothers me a lot. It is fairly easy to identify which airports have the highest rate of passengers coming from Liberia, Guinea, and Sierra Leone. Here’s how:

I assume that the FAA has a database of all passengers coming and going from the US. If not Homeland Security, the airlines, or probably the NSA does. Gather this data and discard all trips that do not originate in West Africa. Then count up all the trips by the airport that they terminate in and convert this into a percentage. And there you have a crude estimate of the most likely entry points for Ebola into the United States of America. I’m assuming that JFK will be high on the list. Maybe Chicago, LA or San Francisco, and maybe Dallas and Miami will be high on the list as well.

Now that will only cover some of the possible passengers who could carry the virus. People could travel to an infected country on a different ticket, and then later come back to the United States. For instance, last year my friend went to West Africa for work, and on the way home he spent a few days in London. I assume that his Africa-London ticket and his London-US tickets were different.  These would be harder to track because I don’t know if there is reliable data available on these trips. Maybe Homeland Security, the NSA, the FBI, or the CIA tracks these trips, but I think it would be difficult for even an economist at the CDC with security clearance to obtain this information. However, on landing cards for the US you are asked, “Countries Visited on this trip prior to US arrival.” Of course these are not digital, but it is possible that Homeland Security has some stats they can share. I won’t dive into how to process these stats, since we have no idea what form they could take.

Landing Card

Lastly, another way to capture the elusive passengers who visited West Africa on non-US terminal tickets is through a random sampling method. First, collect a list of all possible one-stop destinations from Liberia, Guinea, and Sierra Leone. I think that one stop is reasonable. There are very few non-stop flights from West Africa in general, but I think that two-stop flights may be casting the net a bit too wide. From this list, eliminate any flights that terminate in the US (those are already covered by the supposed-FAA data) and any flights that do not terminate in an airport with flights direct to the United States. From the FAA data, randomly select passengers departing from these airports to see what airports they are arriving to in the US. The random sampling could even be weighted, giving higher preference to more likely airports, such as those in Europe, and lower preference to less convenient flights, such as East Asia. Simply add this sampled data to the FAA-obtained data and you have a more complete, albeit less-than-perfect, picture.

The last obstacle is time-frame. Peoples’ flight patterns and behaviors have changed since many airlines have cancelled flights to West Africa. So this data should probably only be collected over a six month period or so. Otherwise we would be setting up screening centers in airports that are no longer seeing passengers coming from West Africa.

If these data are properly parsed and analyzed, the government would have a list of the most likely ports of entry for Ebola. With this information they could set up screening centers in a cost effective manner that interrupts and inconveniences air travel as little as possible.

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