Why is my airfare still so expensive when the price of fuel is falling? This is all the more annoying because when it goes up, well…the price of the ticket goes up.
This is a question that you often ask us on social networks and that our friends also ask us so we will try to answer it as simply as possible.
Fuel is a major and fluctuating expense
Fuel represents between 17 and 25% of an airline’s costs and, depending on the time and price, is their 1st or 2nd expense item. For example, in 2018, Air France-KLM spent €5 billion on fuel compared to just over €7 billion in 2012.
A major and unpredictable expense: oil rises and falls for reasons that are simply linked to the market (and therefore partly predictable) as well as for geopolitical reasons that are more difficult to anticipate and that can make the evolution of the price of oil epidermal to say the least.
For your information here is the evolution of fuel prices since 2013 compared to a base 100 in 2000, found on the IATA website.
So, as with your car, when the price of oil rises, the price of fuel rises, and so does the price of the ticket, and when it falls, the opposite happens.
Well, not exactly even not at all.
Fuel hedging: the weapon against rising oil prices
For an airline, as for any business, there are fixed costs and variable costs and fuel is part of the latter. However, what is variable is by definition not predictable and businesses hate this.
There is a part of their fuel bill that they control: it depends on the number of aircraft put in circulation, their consumption and the distances traveled. But they don’t control the main part, the price of the barrel of oil, and that keeps the financiers awake at night.
They have therefore found the magic recipe to protect themselves from fuel price increases: fuel hedging.
It is a very simple mechanism: they make an engagement at a given date to buy a certain volume of fuel over a given period, in return for which the oil company, which can thus secure an income over time, guarantees a fixed price.
Otherwise, if the price of kerosene is, for example, $1.75 per gallon (3.78 liters) and an airline commits to buying the x tons of kerosene it needs for the next 12 months, it will pay $1.75 during that period, even if the price goes up!
Some airlines “cover” themselves more or less, over a longer or shorter period. For example, as Les Echos told us last March, “Air France-KLM has already hedged 60% of its needs for 2020 (and even 70% in the third and fourth quarters) at $62 a barrel, […] Lufthansa is 85% hedged for the next eight months at $63 a barrel. As for IAG, the parent company of British Airways and Iberia, the group covered 92% of its needs in the first quarter, 94% in the second quarter, 91% in the third and 82% in the fourth, without specifying at what price“.
Yes, but sometimes the price of fuel drops!
Airlines handcuffed when fuel prices drop!
As you may have noticed, sometimes the price of fuel drops. And besides, when it falls, it tends to fall faster and harder than when it goes up. What happens in these cases?
Well, it all depends on the fuel coverage of the airline. An airline with little or no hedging will take full advantage of the decrease (but would have been very exposed in case of an increase) and for those who are well hedged, it is the opposite! They are bound hand and foot and will buy their fuel at the price they committed to for the specified period. With some margins however: if we take the example of Air France as mentioned above, Air France could buy 40% of its fuel at the new market price (a theoretical assumption at the time of writing, as there is no question of flying a plane for several weeks at best).
And it can be very costly for airlines that anticipated high oil prices and were well covered to see the price of fuel plummet. If Air Franc’s good oil hedging made it earn $50 million in 2019, the collapse of the cost of oil in 2020 could, according to Forbes, lead it to record up to $1 billion in losses on its balance sheet!
It is easy to see why the airline’s hedging policy is determined at the highest level of the business and is a key element of its strategy. Its ability to anticipate oil price trends depends to a large extent on its financial performance through the management of its fuel hedging.
For the record, some people surely remember the 2000s when Air France and KLM merged and the group was giving lessons in good financial performance to the whole of Europe. But these performances were a sham: they were only due to an excellent fuel hedging policy which, in a context of strong growth, contributed 1.4 billion euros to its operating surplus in 2007-2008. Such a beautiful trompe l’oeil that, unfortunately, the airline itself believed in it and did not engage at that time, unlike its competitors, the steps that could have made it really profitable.
But why doesn’t the price of the ticket go down when the fuel goes down?
Oh yes, by the way, that was the original question.
Well, you understand that an airline with limited hedging can almost immediately reflect the drop in fuel prices in the price of the ticketwhile the one with strong hedging will have to wait until it has “exhausted” its hedging, which may take months or even a yearhoping that prices will not rise again in the meantime. Or it will lower its prices to a certain extent, but since its costs do not change, it will logically do so at the expense of its profitability.
On the other hand, in the event of a sudden increase, an airline with weak hedging or a airline that has exhausted its hedging over a given period of time will be forced to buy at market prices. And there it has a magic weapon to pass on the increases on the price of the ticket: the famous “YQ” surcharge hidden in the jungle of taxes and supplements applied to the price of the ticket, otherwise called “fuel surcharge“. And this one is so invisible and painless that they often forget to lower it when it is no longer needed.
Photo : fuel hedging by MikeDotta via Shutterstock
