Gas Prices Plunge. Will Airfare Get Cheap?

By Markets Fool.com

With oil prices down 40% from their peak, fuel-thirsty airlines are already eyeing the savings expected to result from cheaper jet fuel.

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This has led many consumers to ask whether airlines will pass any of the savings along as lower airfares, or whether there are other factors at play.

Significant savings
Looking at 10-K forms from Delta Air Lines , United Continental Holdings , and American Airlines Group , each carrier estimates fuel usage of around 4 billion gallons of jet fuel for 2014.

Source: Chad Teer, via Wikimedia Commons.

With jet fuel prices down roughly $1 per gallon from their summer peak based on the Gulf Coast Jet Fuel price from the Energy Information Administration, these fuel savings should amount to a few billion dollars for major carriers. It's also important to note that current jet fuel prices are well below the $2.70-$3 per-gallon trading range that existed for most of 2013 and 2014. Even compared to the lower end of this range, today's fuel prices would mean multibillion-dollar annualized savings for the largest airlines.

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It's easy to see why fuel savings are such a big deal for major carriers. These companies' 10-K filings all indicate that fuel expenses have comprised 30% to 37% of operating expenses for the last few years.

Hedging effects
Airlines are saving large amounts on fuel in absolute terms, but the airlines themselves are very large companies generating tens of billions in annual revenue. So before I look at how much of the savings consumers should expect to receive, I'll take a look at what they could save if airlines passed fuel savings along while keeping margins the same.

First, it's worth taking a look at airline fuel hedging programs. American Airlines Group will be one of the first airlines to benefit from falling fuel prices since the airline no longer hedges its fuel costs. However, the savings will take longer to directly benefit Delta Air Lines and United.

In August before fuel prices fell, United noted it had 21% of its 2014 fuel hedged, 19% of its 2015 fuel hedged and just 1% of its 2016 fuel hedged. Delta, long known for its aggressive hedging strategy, expects its hedging book to post a $1.2 billion loss in 2015 with fuel prices at current levels; however, it expects to fully capture the fuel price savings for 2016.In its December Investor Day presentation, Delta estimated hedging adjusted fuel costs for 2015 to be between $2.40 and $2.50 per gallon,while United has not provided a full-year 2015 outlook since the fuel-price slide.

But Delta and United's fuel hedging strategies will have similar effects. Both carriers will come out overall winners from the fuel-price slide since not all of their fuel is locked in at higher prices. However, the hedging will delay when these carriers can see the full extent of the fuel savings by mitigating savings for 2014 and 2015 but having little impact on 2016.

Maximum savings
For the purposes of creating a rough analysis and determining maximum possible savings, I will exclude the effects of hedging nowand instead focus on current fuel price savings and operating expenses. As previously mentioned, hedging is likely to delay and limit the fuel savings seen by airlines, but if fuel prices remain at these levels, the effects of hedges should largely balance themselves out by 2016.

All three major carriers reported fuel as roughly a third of operating expenses; considering fuel prices have dropped by about a third compared to average 2013 and 2014 prices, overall operating expenses should be reduced by about one-ninth as long as fuel prices remain at these levels,all else being equal, of course.

Using these numbers, the maximum amount consumers could expect to save would be about 11%if the airlines decide to pass along every dollar they save in the form of lower airfares while keeping margins the same. Of course, jet fuel prices could fall further, which would open up the potential for greater savings to be passed along.

Savings for you?
Just because fuel prices are down doesn't mean passengers will get every dollar of the savings, however. Airlines are, after all, profit-seeking businesses, and, like any other for-profit corporation, they will do what they can to get the maximum amount of profit.

Source: Robert Alfers, via Wikimedia Commons.

A report from the Associated Pressnotes that carriers as a whole expect to cut fares by about 5% as a result of lower fuel prices. Using my earlier calculations, this would imply that airlines expect to eventually pass along about half of the savings.

However, passengers are likely to see a delay before getting lower fares. Brian Pearce, chief economist at the International Air Transport Association, told the Associated Press, "It's going to be six months or so before airlines are seeing lower fuel costs, and at that point consumers are likely to see a fall in travel costs."

Pearce's comments fit with the hedging programs airlines currently have in place, which were made to protect carriers from price spikes but are now making current fuel purchases more expensive than market rates. The estimated delay of six months gives more time for some fuel hedges to run out and lets carriers more directly see the fuel savings.

If this six-month estimate is correct, passengers should begin to see fuel savings in the form of slightly lower fares by the summer of 2015.

The article Gas Prices Plunge. Will Airfare Get Cheap? originally appeared on Fool.com.

Alexander MacLennan owns shares of American Airlines Group and Delta Air Lines andhas the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines, long January 2015 $30 calls on Delta Air Lines, long January 2015 $17 calls on American Airlines Group, long January 2015 $32 calls on American Airlines Group, long January 2017 $25 calls on American Airlines Group, and long January 2016 $60 calls on American Airlines Group. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.