How do oil prices impact flight prices?

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Accepted answer

Many airlines, and other large consumers of fuel (or other volatile commodities) will do what is called hedging. Specifically, fuel hedging works by (in simplified terms), buying fuel ahead of time (in the form of options) at a pre-arranged price. If the actual price of fuel is higher than the contractual price, the airline comes out ahead. If the price drops below the anticipated price, the airline ends up paying more, but at least they had a predictable budget.

From the article:

During the 2009-2010 period, the studies for the airline industry have shown the average hedging ratio to be 64%.

Presumably the 64% is as a percentage of jet fuel and/or crude oil used in the airline industry, not the percentage of airlines which hedged oil. But it's enough to see that it's a very common practice.

This is essentially the same thing you do when you hear that gas prices may jump sharply on the weekend--you go out and fill up your gas tank early.

But imagine if you had the option to store even more fuel than would fit in your automobile. Perhaps you could install a large fuel tank in your back yard, and when gas prices drop, you could fill your backyard fuel store. Then when prices jump later in the year, you fill up your automobile in the back yard. If prices were to actually drop, rather than go up as you expected, you would end up paying more than you otherwise would have, but if the prices do indeed go up, you'll be laughing at all your neighbors for paying double at the fuel tank.

Now imagine if you could do the same thing, but with a contract rather than with a fuel tank. You go to your corner gas station and say "I like the price of fuel today. Can I buy 5,000 gallons at today's price? But I'll pick up the fuel later, when I need it, one tank full at a time?"

Naturally, no gas station will do that. And it of course gets complicated, because when you're doing large transactions like that, you base it on the anticipated future price, not on today's price, etc. But you get the general idea.

But oil wholesalers will, on the commodities future market. And if you're a big enough player, you can buy and sell such futures yourself, and this is exactly what airlines (or other investors) do.

Upvote:4

I am not the expert on this matter, but I know a thing or two.

Airlines sell tickets in advance (way in advance) and in bulk, so a change in the oil price must be long in advance before airlines can act accordingly and change the fuel surcharge. If airlines acted quickly and changed the price according to the current low price and then a few weeks later oil prices go up again, then airlines are screwed because they would have sold many cheap tickets in the future when the price will be higher and the extra profit they made due to the low prices in the current period will not cover the losses in the future.

Another thing, it is a quick, unanticipated extra profit for the airlines, and who doesn't like that.

Regarding the price buffering, most (if not all) airlines make their fuel surcharge according to the highest possible fuel price they faced, and it is too dangerous for them to change it as I said earlier unless the prices are low for a long period.

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