Economic populism relies on disregarding reality
Last week, Senator Chuck Schumer (D-NY) said he wants the Department of Justice and the Department of Transportation to investigate why airfares are not decreasing along with falling oil prices.
On the surface, Schumer’s observation makes sense. Crude oil and jet fuel prices are strongly correlated, and on average jet fuel comprises a third of airlines’ operating expenses. As such, the declining cost of oil, and therefore jet fuel, should reduce airlines’ expenses, thereby giving them the opportunity to charge lower airfares to consumers.
The key word here is “opportunity.” Even though Schumer says “it’s safe to say that the airlines can afford to pass at least some of these savings onto the consumer,” reality is far from this populist idealism.
The airlines’ first obligation is to their shareholders and employees, who have legitimate claims to these savings in the forms of higher dividends and wages. Then there is the issue of the government telling private businesses how they should set their prices—as if Washington bureaucrats know the first thing about airline pricing strategy, arguably the most complex in existence.
Economic philosophy aside, there are serious flaws with the rationale underlying Schumer’s desired investigation. These flaws are the result of an utter disregard—whether by design or by way of tremendous ignorance—of the financial and economic realities of the airline industry of present, past, and near-term future.
1. Airline Fuel Hedging
With oil prices trending toward a 50% decline this year, one would expect to hear the airlines breathe a collective sigh of relief as the pressure on their bottom lines eased. After all, airlines operate on razor-thin profit margins of 2.4%, or about $5.42 per passenger, according to Tony Tyler, CEO of International Air Transport Association (IATA). Compare that to the S&P 500’s average profit margin of 9.5%.
However, because they engage in fuel hedging, most airlines have not experienced any savings this year and, most likely, will not in the short-term. Fuel hedging refers to the variety of investment strategies an investor, speculator, or company can use to lock-in a predetermined price for a future purchase of fuel or use to obtain the option to do so. These various hedges basically act like insurance policies that pay out if fuel prices rise above a certain level.
All major domestic airlines, except American Airlines and Allegiant Travel, use fuel hedging, and thus entered this bear market for oil with a lot of money tied up in the expectation that oil prices would instead be rising (or remain at current high levels).
So, some airlines are even losing money right now. Depending on the type of fuel hedging strategy, the airlines have to either write down the defunct hedges as losses or exercise them and purchase fuel at above-market prices. For example, Delta announced that despite estimated cost savings of $1.7 billion for 2015, it would have to write-down a $1.2 billion loss for its useless fuel hedges.
2. Rising Demand for Air Travel
Airlines are spending major amounts this year and next to upgrade their fleets and terminals and buy new planes. Why? Demand for air travel is growing and is slated to increase further. The growing demand also helps to explain high ticket prices.
IATA estimates that the airline industry’s 2015 profit will be $25 billion, up from $19 billion this year (up from the $18 billion estimated before the precipitous fall in oil prices). Falling fuel prices not only buttress airlines’ bottom lines, they induce increased consumer spending, which inevitably will include more air travel. Most of this buoy in demand will come from North America.
3. Incentives (Or Lack Thereof)
Economics is all about incentives. What incentives do the airlines have to reduce ticket prices? None. Why should companies with sky-high debt and a history of bankruptcies and bailouts not want to expand their profit margins whenever possible, and when, as demonstrated in the previous point, it is economically viable to do so?
In fact, no company or industry acts against their profit-maximizing motives. Airlines for America, an industry trade group, released a statement challenging Schumer. In it they write, “Airlines should be treated like every other business. When the price of coffee beans falls, no one asks Starbucks why his or her latte does not cost less. You want Starbucks to expand its stores and products, give back to its baristas, and reward investors. Airlines are no different.”
Furthermore, airline executives know the glut in oil prices isn’t guaranteed in the long-term, and not necessarily even in the short-term. Changes in national economic policy, politics, war/terrorism, and weather all play roles in determining oil prices, and airlines would rather improve their cash stockpiles now than find themselves in a serious bind later.
In his zeal to expand the role of government in private commerce, Schumer has selected easy prey. For mostly legitimate reasons, airlines get a pretty universal bad rap; it is unsurprising many are not rushing to their defense.
But just because we’ve all had more than one or two bad experiences with airlines, don’t jump on Schumer’s populist bandwagon without looking at the economic facts. Despite his dual degrees from Harvard, Schumer has not spent one minute of his professional life working in the private sector, let alone the airline industry.
It seems the old quip that goes “those who can, do; those who can’t, teach” should be changed to “those who can, do; those who can’t, legislate.”DONATE
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