Don't Expect Low Oil Prices to Mean Cheap Airfares

By Markets Fool.com

Everybody knows fuel is one of airlines' largest costs, and oil prices have halved since autumn. How has this affected the price of airline tickets? They've barely budged. And that's unlikely to change.

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The quick response to stagnant airfares likely has to do with fuel hedging. Most airlines hedge the cost of jet fuel to some degree. When fuel prices rise, they're protected, but when fuel prices fall, the airlines are stuck paying the higher, hedged price. Hedges often go out months or years, and some airlines are still paying those higher fuel prices.

But not all jet fuel is hedged, and even once the hedges expire, airfares are unlikely to drop. Three powerful, longer-term forces are at work.

No. 1: A healthy U.S. economy
In case you snoozed through Economics 101, two forces can lower a commodity price: Demand can go down, or supply can go up.

Falling demand typically means deteriorating economic conditions. Businesses are producing less and require less oil to do so. Companies with high fixed costs -- such as airlines, which incur the same cost to fly an empty plane as a packed one -- often lower prices to attract more customers.

That's not what's happening today. The current oil price slide is driven by oversupply. More oil is available for sale than there are customers to buy it, largely driven by the ramp-up in U.S. production in recent years.

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US Crude Oil Production Chart

Source:U.S. Crude Oil Production data by YCharts.

The U.S. economy is as healthy as it's been since the financial crisis, and demand for airline seats remains high. Airlines' load factor -- a measure of how full planes are -- is at an all-time high.With already-packed planes, airlines have no incentive to lower prices.

No. 2: Airline consolidation
Whether for cell service, cereal boxes, or airline seats, competition benefits consumers. A wave of mergers in airlines has consolidated the industry. A quick recap:

  • 2008: Delta acquires Northwest Airlines.
  • 2010: United Airlines and Continental Airlines merge to form United Continental .
  • 2011: Southwest acquires AirTrain.
  • 2013: US Airways and AMR Corp (parent of American Airlines) merge to form American Airlines Group

These four megaairlines command about 75% of all revenue passenger miles.Air travel remains a commodity, with few people willing to pay more to fly on a "brand-name" airline. Fewer competitors, though, means less competition, and that means less pressure to undercut the next airline's fares.

No. 3: Strong airline financials
The tailwinds of domestic economic growth and lower competition have translated into healthy financial lives for the major airlines. Returns are high, margins are increasing, and debt is being paid down.

Source:Capital IQ.

Source: Capital IQ.

If financials were weak -- low cash generation, high debt payments -- airlines might be more pinched to fill every last seat, even if it takes cutting fares to get there. The growing profits are more likely to be reinvested in terminals and new aircraft or returned to shareholders through dividends and buybacks.

What it means for that Costa Rica trip
Travelers have a right to be bummed about static ticket prices. But passengers are also employees and investors. While sipping coffee at 30,000 feet, they can take solace in the fact that the forces keeping airfares dear are also keeping their employment secure and their stocks healthy.

The article Don't Expect Low Oil Prices to Mean Cheap Airfares originally appeared on Fool.com.

Alex Pape, CFA,has no position in any stocks mentioned. 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.