Will Airfares Drop Because of Cheaper Oil?

thic0029258Thinkstock(Royalty-free)Composite close-up of an airplane landing with blurred lights of the airport in the bac
Getty Images

An unexpected gift consumers received at the end of 2014 was a steep drop in oil prices, which, as always, has led to declines in the costs of their derivatives. One big benefit consumers are enjoying from this movement is significantly lower prices for gasoline.

As part of the same trend, the cost of aviation gas is also sharply lower of late. So that means that airline tickets will soon be getting cheaper, right? Well...


The decline of oil was one of the big macroeconomic stories in the dying days of 2014. Since hitting its 2014 peak at over $115 per barrel this past summer, the spot price of Brent crude declined sharply and now changes hands a few dollars shy of $60.

That drop is going to save airlines an awful lot of money. Fuel is far and away the most significant cost item for air carriers, even ahead of salaries. Take United Continental Holdings (UAL), for instance. In the first nine months of 2014, the company spent $9.1 billion on fuel, compared to $6.7 billion for salaries and related costs.

Meanwhile, overall operating expenses amounted to $27.8 billion. In other words, fuel comprised nearly one-third of that total.

Data from the International Air Transport Association indicates that the fall in oil price will end up lifting the profit of the global airline industry to a record $25 billion for the entirety of 2015. That's 25 percent higher than the just under $20 billion expected for this year.

Hedged In

That rise in profit won't happen right away. Unlike consumers at the gas pump, airlines don't reap the immediate benefits from an oil price drop.

That's because the airlines typically "hedge" a chunk of their fuel expenses, agreeing to lock in certain prices with suppliers for a defined amount of time. This is a good-news/bad-news proposition, depending on the direction the oil price goes. If it rises, the hedger has successfully avoided the extra cost. If not, the unlucky airline pays more than the prevailing market rate.

Nearly all of the major, and quite a few secondary, carriers hedge their costs to some degree. The length and amount varies, and as a result the gain or loss from the activities can differ wildly. Delta (DAL), for example, reported a hedging loss of $238 million for its third quarter. That figure in the same period one year previously was a gain of $337 million.

Since hedging is rife in the industry, many carriers will continue to be on the hook for pre-decline oil prices for at least several months. One notable exception is American Airlines (AAL), which did away with hedging this past summer.

So even if they wanted too, most carriers would cut into their profit margin if they were to reduce prices immediately.


Another key factor mitigating plane-ticket fire sales is that there is not an awful lot of competition in the business.

A little over a decade ago, 10 airlines ruled the skies over America. After a series of mergers, those 10 are now four: American (which includes the former USAirways, TWA and America West), Delta (Northwest), United (Continental) and Southwest (LUV) (AirTran).

Generally speaking, industries with more robust levels of competition tend to offer goods or services that are more advantageously priced for the consumer. This is because, of course, the fight for business is that much tougher, and the opportunities to compete on other factors more limited.

According to researcher IBISWorld, the big four airlines held an estimated 67 percent of the domestic market in 2014. And they tend to fly planes that are rather full; according to the most recent IATA data, domestic carriers boasted a load factor (i.e., the measure of how full the plane is) of 81 percent from last January to October.

In other words, demand remains high and supply is controlled largely by a handful of companies. In that sort of environment, there's not much incentive to cut prices.

Red-eye to Boise Now Boarding

Some industry observers expect carriers to plow their savings into service -- boosting their total numbers of flights, and offering increased service on less-traveled routes and off-peak flying times to various destinations.

Nevertheless, some research suggests that there will still be a bit of wiggle room left to shave fares -- the IATA anticipates that average fares in 2015 will be roughly 5 percent lower on a year-over-year basis. That isn't much, and it's likely the carriers won't be in a great rush to offer even that modest level of savings.

Motley Fool contributor Eric Volkman has no position in any stocks mentioned. Nor does The Motley Fool. Try any of our Foolish newsletter services free for 30 days. Check out our free report on one great stock to buy for 2015 and beyond.​