I just flew Spirit Airlines roundtrip from Managua to Ft. Lauderdale. I’ll spare you all my personal review of the airline, but the general public’s opinion is undeniable. They like the prices and hate the service. On the occasion of my return, it was late at night, there was a massive storm barreling across the country, and a Delta flight had earlier in the day skidded off the runway at La Guardia, shuttering the airport for hours. A lot of people were in air travel purgatory that night, and I overheard on more than one occasion “I am never taking Spirit again.”
Airlines, like most companies that offer services, not goods, have high fixed cost. They have to pay their staff and buy and fuel airplanes, whether they are full or not. And any time an airplane is not flying, it is unused capital. Spirit has done an excellent job managing this challenge. By positioning themselves in a South Florida hub, Ft. Lauderdale, they can easily access Central America, the Caribbean, and parts of Central America. Many airlines leave their regional planes at the gate overnight. But Spirit gets them to Ft. Lauderdale, and then sends them on return red-eyes to the Caribbean, Central America, and Colombia. By 6:00 AM planes-full of passengers arrive in Ft. Lauderdale, and either stay in South Florida, or continue on other Spirit flights to their final destinations, whether they be Chicago, New York, Dallas, or elsewhere. Spirit simultaneously tapped what was an under-served market and increased the utilization of their 65 airplanes strong fleet (as of the end of 2014).
The downside of this is that they have no buffer in their schedule. On the occasion on my flight from Managua, we were nearly an hour delayed. The plane had been getting more and more late throughout the day, having already made a few trips between Ft. Lauderdale and La Guardia before heading to Nicaragua. Then, as soon as we got to Ft. Lauderdale (late) the plane was scheduled to immediately head out to another domestic destination. It certainly departed late, starting off its next day of work on a bad note, and probably continuing late for the foreseeable future. This gives the airline absolutely no buffer in its schedule. Many airlines leave their regional jets idle overnight. So if an airplane scheduled to arrive at its final destination of the day at 10:00 PM doesn’t get there until 11:30 PM, that’s not a problem for its next departure, at 6:00 AM. However, Spirit does not have this luxury with its fleet.
The result: the worst on-time performance among American airlines. 67% of flights land on-time (within 15 minutes of their scheduled arrival time) in 2013. That’s dead last in the United States, Mexico, and Canada, according to Bloomberg.
Many people complain about how Spirit “nickles and dimes” its passengers. But truly, travelers who are honest about their baggage and pay ahead of time will find themselves paying less for flights than on other major carriers. The true cost comes in late arrivals. For someone with a tight itinerary, Spirit may not be the right choice.
Having now written four articles on oil, its price, and the consequences that has for everyday uses of oil, such as gasoline and airfare, I have decided to turn these into a series of posts I am calling the Economics of Oil.
As always, comments are welcome and encouraged, even if you disagree with me on any point.
*And yes, you will see just how much similarity Bitcoin mining has to oil
Tags: airfare, airlines, Bitcoin, Bitcoin mining, Bitcoins, conspiracy, derivatives, diesel, economics, flying, gas, hedge, hedging, oil, options, price of gas, price of oil, Saudi Arabia, swaps, United States
With 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.
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:
Tags: air travel, airline, airplane, airport, American, American Airlines, aviation, bankrupt, bankruptcy, commercial aviation, counterparty, Delta, derivative, Detroit, economics of air travel, flying, fuel, fuel surchage, fuel surcharges, gas, hedge, hedging, jet fuel, oil, oil & gas, oil and gas, oil prices, option, price of oil, refineries, refinery, Southwest, surcharge, swap, US Airways