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Spotlight on Economics: Jet Fuel Costs and Airfares

Airfares and jet fuel prices do not move in lock step because jet fuel costs merely reflect one of the supply factors.

By Siew Lim, Assistant Professor

NDSU Department of Agribusiness and Applied Economics

Jet fuel accounts for about 30 percent of an airline’s total operating costs. In April, U.S. carriers are paying $2.13 per gallon of jet fuel, which is nearly a 30 percent drop from the 2014 year-to-date fuel cost.

According to the International Air Transport Association, if oil prices continue to be low in 2015, the fuel cost share will drop to about 26 percent of total operating expenses, which is a level last seen in 2006.

Will the lower fuel costs translate into lower airfares for consumers? We have not seen considerably lower airfares for consumers, despite the downward pressure on oil prices since the second half of 2014. Why?

On July 1, 2008, the jet fuel spot price reached a peak of $3.89 per gallon and began to drop sharply in the following months until Feb. 1, 2009. After that date, the price of jet fuel began a steep and volatile climb.

Airfares also began to decline gradually after July 1, 2008. However, it was not until June 1, 2009 (not Feb. 1) that the airfare consumer price index started to rise. Starting late summer 2014, the jet fuel spot price has dropped sharply, but no comparable decline has been observed in airfares.

The story here is that airfares and jet fuel prices do not move in lock step. Jet fuel costs merely reflect one of the supply factors. Airline earnings are susceptible to jet fuel price swings, but airfares usually do not immediately respond to a change in jet fuel prices. If anything, airfares respond to jet fuel price changes with a lag.

In fact, lower fuel prices could mean good and bad news for the airline industry, depending on the carriers’ fuel hedging positions. Fuel hedging is a common practice in the airline industry. Because jet fuel prices swing unpredictably, airlines have a harder time planning their operational expenses.

To mitigate the jet fuel price risk, airlines resort to fuel hedging. For example, if an airline expects to use X barrels of fuel in three months and faces fuel price volatility, it has the option of going unhedged, or it could hedge the fuel price risk by taking a three-month futures (or forward) contract now to buy X barrels of fuel and lock in the fuel price. However, hedging exposes airlines to basis risk. Their hedging strategies may be unsuccessful and may result in huge financial losses, so there are winners and losers even when oil prices decline.

There is no consensus on whether an airline should hedge. Some airlines do not hedge at all. For example, the drop in oil prices has benefited American Airlines because it ceased to hedge about two years ago. Meanwhile, United Airlines, according to Reuters, has been “burned after hedging against rising oil prices only to see prices fall.”

A paper by Peter A. Turner and myself (http://tinyurl.com/airlineoil) discusses the risks of jet fuel hedging and strategies.

Fuel costs aside, airfares are determined by a number of other factors. Market structure or the degree of competition that an airline faces in a route plays a big part in airfares. In a free market, demand factors also determine how much we pay for our air tickets.

Strong macroeconomic performances, such as an economic recovery or expansion, rising incomes and seasonal travel, are some of the demand drivers that push airfares higher. Therefore, a host of supply and demand factors jointly determine ticket prices.

Airlines already are operating at or near full capacity, unless the demand side contracts (let’s hope not), the current lower jet fuel prices likely will not translate into lower airfares in the near future.

NDSU Agriculture – April 28, 2015

Source:Siew Lim, (701) 231-8819, siew.lim@ndsu.edu
Editor:Rich Mattern, (701) 231-6136, richard.mattern@ndsu.edu


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