On fuel, airlines gambled and you lost

December 22, 2014

With Christmas a few days away, we are in the heart of the holiday traveling season, and most people have already decided their mode of transportation after weighing expense versus convenience. On the topic of expense, earlier this month, Senator Charles Schumer called for a federal investigation into airfare prices, asking why tickets remain so expensive when gas has become so (relatively) cheap. Since fuel prices account for half of airlines’ costs and gas prices have been steadily falling, travelers should be seeing trickle-down savings, he reasoned.

But fueling-up an airplane isn’t just a matter of pulling up to the nearest ExxonMobil station and filling up on unleaded. For starters, it’s an entirely different kind of fuel, although some people seem intently obtuse on the subject. More importantly, because they purchase jet fuel in such huge quantities, many airlines take a different approach to their purchasing strategy than the average driver. They use financial derivatives to hedge their bets against rising fuel prices.

In July, American Airlines stopped hedging, deciding that hedging risk was more risky than the gamble on fuel prices itself. As The Motley Fool explains, “Most airlines hedge with call options, which allow them to cap their fuel costs without locking them in if oil prices happen to fall. The downside of this strategy is that the airline has to pay a premium for each call option. Unless oil prices rise by a significant amount before the option expires, the airline will lose money on the hedge.”

As this Reuters graphic shows, that’s what is happening to many carriers now. Oil prices have been falling since June, causing many to absorb the cost of premiums without enjoying the benefit of hedges against higher prices, so for these airlines lower prices aren’t actually great news. In the case of American Airlines, Schumer is correct, as control over ticket prices serves as a natural hedge to the ebb and flow of fuel prices. But since airlines generally mimic one another when pricing tickets, American has been happy to pocket the money it’s saving rather than reducing prices.

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