Oil prices are down almost 50 percent from their peak this year, and jet fuel has plunged 33 percent since last December. Given energy costs consume almost a third of airline operating expenses, shouldn't we expect airfares to decline as well? In short, don't hold your breath.
As one might expect, airfares react more quickly to a rise in the price of a barrel of oil than to a decline. As economists would say, the prices are sticky on the way down. Long-term contracts, a lack of competition, and profit maximization all play a part, and airlines aren't in any hurry to give up that extra income at a time when seats are already packed for the holidays.
In the U.K., there's some good news. The government said that airfares have begun to decrease along with the lower fuel costs. Could the same thing happen on this side of the Atlantic?
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The numbers don't look good so far. The price of an average airline ticket climbed 1.63 percent this year through October, compared with a 6.96 percent decline in energy prices over the same period, according to Consumer Price Index data. And even as the decline in oil prices accelerated in recent months to a five-year low, carriers haven't cut their airfares as a result, according to George Hobica, founder of airfarewatchdog.com.
"Airlines are going to use this windfall to buy new planes, refurbish terminals … there's no incentive to reduce prices," he said. "In the past, when fuel goes down, airfares don't."
Inflation-adjusted airfares have increased in three out of the last four quarters for which data are available, while oil prices have declined in all four, on a year-over-year basis, according to U.S. government data. In the second quarter of this year, average airfares were up 2.5 percent from a year earlier, compared with a 0.8 percent decline in the price of oil.
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According to the International Air Transport Association, jet fuel constituted 30 percent of airlines' total operating costs in 2013, and the price of it was down 33 percent at the beginning of December from a year earlier. All else being equal, that means airline operating costs are about 10 percent lower than they were last year.
A few key facts
Let's look at three facts we can glean from an analysis of the historical data from the Department of Transportation. First of all, oil prices are much more volatile than airfares. Second, looking at the quarterly data, the two move in the same direction only about two times out of three. Third, when airfares and oil prices do move in the same direction, on average a 17 percent change in oil price is associated with a 1 percent shift in average airfares. This implies that a 50 percent drop in the price of oil should yield a 3 percent fall in fares.
Whether airlines will actually pass those lower fuel costs on to the consumers will depend on their energy hedging strategies and the intensity of competition in the industry.
Fuel hedging, which involves signing contracts that keep the cost of fuel fixed for a designated period of time, makes sense if the airline expects prices to rise. If an airline hedges, and the price of fuel falls as in the present situation, the carrier will find itself paying more for fuel than it should. And it can be assumed that many airlines are in that situation now, meaning that even though prices are down, their fuel costs may well be above the market rate.
European carriers have already begun ending their hedges as early as this summer, according to Bloomberg. And it seems U.S. carriers are following suit. This suggests the airlines are indeed already taking advantage of the drop in jet fuel prices and as a result simply fattening their profit margins, rather than lowering airfares.
Competition and collusion
And that can be explained by the state of competition in the industry, one of only two things that typically cause airfares to decline, according to Hobica (the other being a recession). Competition among the major carriers in the U.S. is insufficient to create incentives for passing the fuel cost savings along to passengers. The mega-mergers and consolidation over the last decade have left the U.S. market with only four large airlines, plus a few smaller carriers such as Alaska Air and JetBlue.
While one might think that four rivals is enough to create a competitive landscape, the fact that the airlines interact continually and operate in so many markets can lead to what economists refer to as tacitly collusive behavior. In other words, there's soft (little or no) competition over prices but not explicit price fixing.
Moreover, mergers have substantially increased the number of routes in which the major airlines are competing with one another. While it might seem like that would lead to more competition and lower prices overall, in fact economic studies suggest increased so-called multimarket contact can lead to collusion. That is, the airlines would keep prices artificially high rather than try to undercut one another with cheaper fares out of fear their rivals will harm them in another market where they both compete.
Are the mergers to blame?
This kind of soft price competition might also be responsible for the airlines' unwillingness to get rid of fuel surcharges. At the very least, we can assume airlines view the current depressed oil market as temporary and would only consider cutting their fares if energy prices remain low for an extended period of time — a year in my opinion.
Overall, I remain cautiously optimistic that the current plunge in oil prices will eventually result in a drop in the cost of air travel. Any decline, however, will almost certainly be modest given the reduced competition in the industry. Indeed, whether fares do fall over the coming quarters will provide compelling testimony as to whether the U.S. Department of Justice was right to grant approval to all those mergers in the first place.
This article is part of a series on airline travel. Click here to see other stories in the series.
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