As oil prices fall, the fuel surcharge debate escalates

By Mike Eggleton
Senior Market Analyst

The debate about airlines imposing fuel surcharges (YQ) appears to have been reignited. Writing in Buying Business Travel in November 2014, Amon Cohen called for buyers to press for a “rational restructuring” of fuel surcharges.[1] Airlines have found them useful for reducing their revenue exposure to fare discounts and taxes, beyond their original purpose of sharing some of the increased cost of soaring oil and fuel prices. Cohen’s observations have been brought into focus by the recent rapid retreat of oil prices, to which the airlines have yet to respond with lower fuel surcharges.

But it’s not a new story. In April 2013, website Traveller noted that fuel surcharges “kept rising even though fuel prices are now falling.”[2] It was making the case on behalf of frequent flyers, faced with the rising cost of redeeming mileage – the fuel surcharge. Graham Turner, head of Flight Centre, Australia’s largest travel retailer, claimed that airlines had been much more likely to increase surcharges than decrease them in response to fluctuating oil prices. He called for surcharges to be removed, with fuel treated like any other operating cost, included in the base fare.

That was when oil prices were hovering just above US$100 per barrel. Today, they’re just above US $60.[3]

Airlines are reluctant to lower fuel surcharges

While keeping surcharges unchanged is clearly helping to boost profits right now, airlines are publicly attributing their reluctance to drop surcharges to the volatile nature of oil prices. In the airline’s third-quarter financial results conference call, Southwest’s CEO Gary Kelly noted that lowering fares only to raise them again “would be absolutely the worst thing that we could do.”[4] Richard Anderson, CEO of Delta, has adopted a similar position, assuming that aviation fuel prices will remain on an upward trend over the long term.[5]

In early November 2014, a reader asked The Telegraph, “Why won’t airlines cut their fuel surcharges?”[6] It reported a 15% drop in aviation fuel prices over the preceding three months, but no reduction in surcharges. In part, it attributed this to fuel hedging, suggesting that airlines would only benefit from lower oil prices when negotiating their next period of hedging. But not all airlines hedge, and those that do don’t hedge all of their fuel needs. And with fuel prices being so low, you can be sure that they’re busy pursuing hedges that lock in these low rates for their future needs.

Hedging – a fading excuse?

To protect against the volatility of oil prices – as fuel amounts to one third of their operating costs – airlines hedge a proportion of their future needs. This means they can set the price they pay for a large part of their future fuel purchases, while relying on market rates for the remainder. But by fixing prices at a certain level, airlines risk overpaying for their fuel when oil prices drop. This (they claim) limits their ability to reduce fuel surcharges without damaging their profit margins.

But hedging could be going out of fashion among major U.S. airlines. US Airways abandoned hedging and other financial instruments after oil peaked at US$147 per barrel in July 2008, choosing instead to pay the market price for jet fuel. It has since extended this doctrine to American Airlines, which sold off its last hedges in July 2014. As an insurance policy against oil price volatility, it found that the cost of hedging outweighed the benefits.

The decision in 2008 certainly worked to US Airways’ benefit. The chart (Airline fuel price performance v US Airways) tracks how much more or less its rivals, who were still using hedging, paid for their fuel. And it’s clear that after 2008, they tended to pay more for their fuel than unhedged US Airways. An extra ten cents per gallon may not sound much, but when, like Delta Air Lines, you consume more than a billion gallons of jet fuel in a quarter, that adds up to a lot of money ($100 million in fact).

For now hedging continues, and as airlines are going about it in different ways, it’s not easy to make a link between hedging and an airline’s ability (and willingness) to adjust fuel surcharges in response to oil price movements.

Given that hedging is a forward-looking financial instrument, you’d expect there to be a relationship between oil/kerosene prices and the amount of hedging an airline engages in the following year (Year+1). As the oil price rises, the airline should hedge more to put a future cap on the degree to which its fuel costs rise. In the past, this certainly seems to have been the case with American Airlines. The proportion of fuel it hedged broadly followed the movement of kerosene prices in the previous years.

But the chart also highlights the different approaches to fuel hedging. Southwest Airlines was heavily hedged (95%) in 2006, as it benefited from a hedge put in place some years earlier. But as American ends hedging in 2014, Southwest is busy locking in fuel prices. From just 10% in 2013, it’s hedging 25% of its fuel in 2014, rising to 40% in 2015, 2016 and 2017. While American won’t have hedging as an excuse not to change its fuel surcharges, it will still be available to Southwest.

Should we expect lower fuel surcharges?

“In many cases, airlines operate now with a basic fare and a fuel surcharge of some kind, and the fuel surcharge in many airlines is directly linked to the price they’re paying for fuel.”[7]

With this in mind, IATA director general Tony Tyler expects consumers will soon see some benefit from the falling price of jet fuel that airlines are now enjoying: “You’ll see the fuel surcharge very quickly come down.” Market prices for aviation fuel lag the price of oil by about a month, which makes the airlines’ inertia on fuel surcharges all the more perplexing.

Airlines first introduced fuel surcharges in 2004, after oil prices surpassed US$40 per barrel. Many airlines have increased fuel surcharges more quickly than the rise in the price of oil. According to Graham Turner of Flight Centre, Qantas’ A$760 surcharge on a return Sydney-London flight is more than 12 times its initial surcharge of A$60.[8]

Singapore Airlines introduced a $US20 surcharge on return flights to London in June 2004. At that time, Brent crude oil spot prices were $38/bbl. Today, the surcharge amounts to almost US$360, while oil is trading at US$71/bbl. That’s a 1,700% increase in the surcharge on less than a doubling in oil prices; and that’s with Singapore Airlines using more efficient aircraft.

Case study: British Airways

British Airways first introduced fuel surcharges in May 2004, amounting to £8 per sector on short- haul flights and £35 per sector on long haul. At the time, the spot price for Brent crude oil was trading just below $38/barrel (bbl). It had risen by 45% over the previous 12 months and by 20% since the start of 2004.

Although oil subsequently pushed up to more than $70/bbl by the middle of 2006, BA maintained surcharges at their initial levels. But a 70% oil price hike between January and November 2007 prompted a 60% increase in BA’s long-haul surcharge.

Since then, BA’s application of the fuel surcharge has become more sophisticated, with the fee segmented by haul, distance and cabin.

The chart (BA long haul fuel surcharges and oil prices) presents a snapshot of BA’s fuel surcharge activity between June 2008 and 2011, a period in which oil prices slumped by 70% from peak to trough, but then progressively rose by 209% over the next 29 months.

A comparison of BA’s surcharge behavior and the pattern of oil prices over the period provides some interesting insights, which might be helpful in developing in a view on the current prospects for airline fuel surcharges.

  • It took a 27% fall in oil prices between June and September 2008, before BA dropped its economy surcharge by 12% and its premium economy surcharge by 3%-6% in October 2008. But the business class surcharge remained unchanged.
  • Business class travelers had to wait for oil prices to fall by 60% from their June 2008 peak, before BA reduced their surcharge by 20%-26% in December 2008.
  • BA thereafter maintained its surcharge levels for two years, during which time oil prices rebounded by 63%. It eventually responded in December 2010 after oil prices rose by $8/bbl in the space of two months; then again in February 2011 after an $11/bbl rise over two months; and then again in April 2011 after an $18/bbl rise over two months.

Since April 2011, it has become far more difficult to track fuel surcharges. There have been no reports in the public domain of any further changes to BA’s pricing regime. In fact, the fuel surcharge seems to have disappeared, to be replaced by a “European carrier imposed charge,” which seems to be much higher than the last publicly reported fuel surcharge. As the charge is “based on flight duration,” it clearly replaces the fuel surcharge, but BA does not acknowledge this.

The “European carrier imposed charge” is at least one quarter larger than April 2011’s fuel surcharge. And yet oil prices have fallen by more than one third since then.

SegmentEconomyPremium EconomyBusinessFirst
Short haulECIC£18.50£18.50
YQ£12.00
Long haul <9 hoursECIC£106.50£106.50£159.50£159.50
YQ£85.00£95.00£125.00£125.00
Long haul >9 hoursECIC£138.00£138.00£179.50£179.50
YQ£98.00£116.50£145.00£145.00

YQ = fuel surcharge in April 2011
ECIC = BA’s European carrier imposed charge, December 2014

Lufthansa has taken a similar approach to British Airways/IAG.

Since the start of 2014, it’s replaced its fuel surcharge with an “international surcharge,” which covers “all costs that are not controllable from our side, such as air traffic control.”[9] The airline has conceded that the fuel surcharge element is based not just on the cost of fuel, but also “the competition and the market.” The surcharges are useful, as they’re easier to adjust than net fares, giving the airline greater flexibility to match total ticket prices to both market conditions and competitor activity.

In the U.K., airlines are facing growing pressure to address fuel surcharges, with the U.K. Government weighing in on the issue. In his Autumn Statement 2014 speech, Chancellor of the Exchequer George Osborne stated: “And just as we demand that falls in oil prices should be passed on to people at the pumps, other fuel price surcharges should also come down. We’re going to require airlines to list the charges separately from taxes on tickets.”[10] It’s not clear what this will mean in practice, but it’s encouraging that fuel surcharges have now caught the Government’s attention.

Case study: KLM

KLM introduced a €4 per flight fuel surcharge in May 2004 to recover some of the increased costs associated with oil prices rising above $30 per barrel.[11] It quickly introduced separate surcharges for short- and long-haul flights, progressively increasing them, so that by September 2007, they’d risen to €25 and €70 respectively – with oil prices at $75. At the time, KLM promised that the September

increase (€1 on short-haul and €5 on long-haul) would be “withdrawn as soon as the price of the barrel is stabilised over time below $75.”[12]

Today with oil trading below $60, KLM’s short-haul “carrier imposed surcharge” stands at €41 (Amsterdam-Heathrow); on long-haul flights (Amsterdam-JFK) there’s a €147 fee in economy and €197 in business. It will be interesting to see how long it takes the airline to keep its September 2007 promise, and cut the surcharges back to €24 and €65.

Case study: Japan

In Japan, the government regulates the application of fuel surcharges by the country’s airlines. It has to approve any changes. As a result, there are much higher levels of transparency and accountability.

Japan Airlines (JAL) introduced fuel surcharges in February 2005, adopting a formula allowing bi-monthly adjustments. Each financial year (starting 1st April), it releases a table indicating what fuel surcharge it will apply by international journey group for every $10 oil price band above $60/barrel.

The tariff structure for the year ended 31st March 2015 is detailed below.

Japanese Yen surcharge for kerosene price bands US$
Destination60 to <7070 to <8080 to <9090 to <100100 to <110110 to <120120 to <130130 to <140140 to <150
Korea, East Russia2003005001,0001,5002,0002,5003,0003,500
Greater China5001,5002,5003,5004,5005,5007,0008,5009,000
Philippines, Vietnam1,0002,0003,0004,0005,0006,5008,0009,50011,000
Malaysia, Singapore, Thailand1,5003,0004,5006,5008,50010,50013,0015,50017,00
Hawaii, India, Indonesia2,0004,0006,0008,50011,00013,50016,00018,50020,500
Long haul3,5007,00010,50014,00017,50021,00025,00029,00032,000

Source: Japan Airlines website, rates apply April 2014 to March 2015

By using this table, passengers can track oil prices and know exactly what surcharge they’ll face for specific international trips.

JAL uses a two-month average fuel price for Singapore Kerosene, and fixes the surcharges it makes on international passengers for two months. If the fuel price falls below US$60, JAL will suspend collection of the fuel surcharge.

However, there’s still a four-month delay in market fuel prices feeding through to the surcharge. For example, JAL has recently set its surcharge for the 1st February to 31st March 2015 period; it’s based on the average price of fuel for October and November 2014. While JAL has now announced a big cut in its fuel surcharge, consumers must still wait to see any benefit from the recent fall in oil prices.

By lagging oil prices by four months, they do correlate well with JAL’s fuel surcharge. This gives passengers confidence that the airline’s fees do directly relate to movements in the price of fuel.

Fuel surcharge or total fuel cost?

Fuel surcharges were originally introduced a decade ago in response to the rising cost of oil. They were intended to offset a proportion of the airlines’ increased fuel costs over and above a threshold price for a barrel of oil. But there are concerns that the fuel surcharge (YQ) is now firmly established as a convenient means to cover a significant part of an airline’s total fuel costs. Indeed, Advito reports YQ charges exceeding entire fuel costs on some European routes.[13]

It’s possible to test these claims using the example of a British Airways Boeing 777 service operated between London and New York. The aircraft has a fuel payload of 54.5 tons, and so it’s possible to calculate the maximum fuel cost for the flight for a range of oil prices.[14] As the fuel surcharges are known, it’s also possible to produce a reasonable estimate of YQ revenue per flight at different levels of seat occupancy (seat factor).

The chart (YQ coverage of fuel cost) demonstrates how far revenue from YQ goes to cover fuel costs at different oil prices and seat factors.

While oil was stable at $110/bbl, YQ covered between 60% and 86% of the airline’s fuel bill.

At $90/bbl, YQ would cover BA’s total fuel bill on flights where 90% or more seats were filled. Now that they’re trading at around $70/bbl, even flights that are only 70% full should come close to covering the total cost of 54.5 tons of fuel. Parent IAG’s load factor (it doesn’t report seat factor) on North American flights tends to be around 80%.[15]

Of course it’s not as simple as this. The way airlines buy their fuel and the prices they pay are complex. And the amount of fuel used by aircraft will depend on many factors, including number of passengers, weight of baggage and cargo, weather conditions etc. But the 54.5 tons quoted by BA includes a safety margin “to allow for taxiing and diversions.”[16] So in reality YQ may actually be covering an even higher proportion of fuel costs – the chart compares YQ revenue to the cost of fuel onboard, not the cost of fuel used.

It seems Advito and campaigners like Amon Cohen may have a point.

Summary

  • As oil prices fall, travel journalists have been calling for a review of airline fuel surcharges; others have tried and failed in the past.
  • Airlines are reluctant to cut what has become a useful additional source of revenue and profit; some are using hedging constraints as an excuse for their inertia.
  • Hedging is not as popular as it used to be, and may not be that effective.
  • IATA expects fuel surcharges to come down quickly – and soon.
  • Perhaps in a move to preserve this extra revenue, some European airlines have renamed “fuel surcharge” with a more generic term, making these costs less transparent.
  • Tighter regulation, as we see in Japan, ensures greater transparency of and accountability for oil price movements.

It is possible to show that revenue from fuel surcharges more than covers the total cost of fuel for certain flights.

[1] According to Amon: The fuel surcharge scandal, BuyingBusinessTravel, November 10, 2014
[2] The airline industry’s big sham: fuel surcharges, Traveller, April 29, 2013
[3] BBC market data
[4] Fuel costs ease, US airline profits soar, Associated Press, October 23, 2014
[5] Airline fuel surcharges should drop as oil prices slide: IATA, The Globe and Mail, October 28, 2014
[6] Why won’t airlines cut their fuel surcharges? The Telegraph, 2nd November 2014
[7] IATA director general, Tony Tyler, The Globe and Mail, October 28, 2014
[8] The airline industry’s big sham: fuel surcharges, Traveller, April 29, 2013
[9] Fueling discontent: falling oil prices spark airline surcharge debate, BusinessTravelNews, December 1, 2014
[10] UK Government, Chancellor George Osborne’s Autumn Statement 2014 speech
[11] Air France KLM Finance, First Half 2004-2005 results presentation
[12] Flightglobal, September 25, 2007
[13] According to Amon: The fuel surcharge scandal, BuyingBusinessTravel, November 10, 2014
[14] Surcharges all but paying airlines’ fuel bills, The Telegraph, October 17, 2008
[15] IAG November traffic statistics
[16] Surcharges all but paying airlines’ fuel bills, The Telegraph, October 17, 2008