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… Airfare

airplaneWith the plummeting price of oil the news is filled with articles about how even though jet fuel is the number one cost that airlines incur (around one quarter to one third of total operating expenses), airfares are not going to go down anytime soon. Airlines tack-on “fuel surcharges” to their ticket prices, which can be especially high for international flights. A few airlines are publicizing that they are decreasing or eliminating their fuel surcharges, but for the most part, they are staying in place for now. Intuitively, this does not make sense. In fact, it does not even seem fair. And to me this illustrates the possible existence of a market failure which ought to be explored and if it is found to exist, eliminated, insofar as it can be.

The market for air travel is an oligopoly – a very cramped one, at that, in the United States, which I have written about before. And this in and of itself lends itself very sticky prices. However, disregarding that reality of the market, I believe that there are other forces at play colluding to keep the price of airfare high through those pesky fuel surcharges, despite the falling price of oil, and commensurately, jet fuel.

Oil_Jet Fuel Price Change

Airlines purchase hedging derivatives, called swaps which are based on the price of oil and/or jet fuel. Basically, they are bets on the future price of the commodity (jet fuel is refined from oil, but other variables, such as refinery capacity, make it so that jet fuel and oil do not move 1:1). If an airline thinks that oil is going to go up, which would increase their costs, they can buy a swap that says that over a certain dollar amount, say $100, the counterparty (such as a bank) would have to pay the difference. Then, if oil moves to $110, the airline would only have to pay $100 and the bank would pitch in the last $10. If, on the other hand, the price of fuel dropped to $90, then the airline would be caught buying fuel at $90 and having to pay an additional $10 to the bank. Other forms of derivatives, such as options, can also be used with similar results.

So, as you can guess, the airlines have purchased a lot of upside protection, so right now they are still paying high prices for jet fuel, based on their derivative contracts, even though prices have plummeted. This is one of the reasons why fuel surcharges still hang over airline tickets. Anyone who has read my blog in the past may be thinking to themselves that this sounds vaguely familiar. In fact, it is very similar to the interest rate swaps debacle that Detroit got itself into.

Right now, Delta and Southwest, who were both lauded a few years ago for wise hedging strategies, are reeling the most from the swing in oil prices. American Airlines, on the other hand, has less derivatives exposure, so it is set to gain more from the drop in the price of oil. Importantly though, even though American Airlines is set to gain, the oligopolistic nature of the market will mean that few of the saving will be passed on to travelers. American can keep its prices high precisely because Delta and Southwest can’t drop prices. The only people who are set to gain are American Airlines shareholders (and the bankers, of course).

The fact of the matter is, for any swap, the two counterparties take contrarian bets. In our case, the airline wins when prices go up, and the bank wins when prices go down. So to be on the other side of the bet, the banks must have seen the potential for oil prices to decline. Rarely do you hear that banks are the ones suffering from being on the wrong side of hedges. Maybe the banks are superior pricing models, or maybe they account for such a large share of international volume that they can influence the price through clandestine means. I don’t know, but it seems that their clients are always the ones taking outsize bets and losing the house. I completely fail to see the wisdom by which everyone espouses the abundant use of derivatives.

And now, with oil so very far off its relatively recent highs, airlines, especially in Europe, are looking to lock in new hedging positions, betting that prices for oil won’t drop below $40/barrel. I think it is only a matter of time before an international airline blows-itself up financially up with a backfiring derivatives strategy. Not only do airlines hedge their jet fuel risk, they engage in foreign exchange hedging, and refineries, which have close financial ties to airlines, hedge as well.

This is part three of a four-part series of posts on the Economics of Oil. Previous posts:

The Economics of Gas Prices

The Economics of International Oil Price Conspiracies

The Economics of Bitcoin Mining



… International Oil Price Conspiracies

Last September I posted an article on gas prices (to which someone had a very thoughtful Reddit response), why prices were falling, and how to account for price discrepancies within the United States. Since then, the international price of oil has kept falling and falling. Earlier this week the price even punctured the $50 a barrel mark.

Crude Prices

This precipitous fall in the price of oil has caused conspiracy theorist to claim that the United States is secretly engineering markets to put pressure on our international enemies such as Venezuela, Russia, and Iran. Do I think that the United States is doing this? Yes, absolutely. But do I think this is a conspiracy? Hardly.

Exhibit A is the recent appointment of Department of the Treasury Under Secretary for Terrorism and Financial Intelligence, David S. Cohen, to the Number Two spot at the CIA (Deputy Director). The White House is not hiding anything about this guy. They say he administered anti-terrorism funding programs, particularly against ISIS, as well as sanctions against Iran and now Russia. Economic espionage is official government policy, and it does not seem to me that they are trying to hide that at all from anyone.

Oil producing countries, particularly the members of OPEC, have been using the price and quantity of oil as a foreign policy tool for decades. Exhibits B & C, the 1967 & 1973 Oil Embargoes, where Arab countries used their leverage in the energy market to place political pressure on the United States. The United States, too, has used oil as a political tool in the past. Many historians claim that Pearl Harbor was the result of Japan’s hand being forced by an Allied embargo on oil reaching Japan.

To return to the economic, not political, side of things, the market for oil is an oligopoly. There are a few large suppliers, and there are significant barriers to entry (primarily being that certain countries simply do not have the natural resource underneath them in the ground). More specifically, the market for oil resembles a Dominant Firm Oligopoly, with Saudi Arabia being the dominant firm. As the world’s largest producer of oil (13% of world production), it commands a great deal of pricing power – power that smaller “firms,” such as Venezuela, Ecuador, Nigeria, Iraq, Iran, Libya, and Qatar cannot match. So theoretically, Saudi Arabia could sell its oil at a lower price, and the other countries would have to lower their posted price, or else their clients would turn to Saudi Arabia, which has plenty of oil to supply if it wants to.

And that is exactly what Saudi Arabia is accused of doing, through an arrangement made with the United States (many people point to a meeting Secretary of State John Kerry had in Saudi Arabia back in September). The conspiracy theorists claim that Saudi Arabia is selling its oil at a lower-than-market rate by keeping productions levels too high relative to international demand in order to drive down the price of oil internationally, in an effort to put pressure on the governments of Iran, Syria, Russia, and Venezuela. These countries all conveniently happen to be enemies of the United States and Saudi Arabia, and they are all also conveniently highly-dependent on oil prices for government revenue and social pacification.

Saudi Arabia, from a purely economic point of view, has an incentive to cut production, which would send prices higher. Higher prices mean higher profits, which is better for their economy. Other oil producing nations feel the same way. However, the stars may have aligned this time for the US and Saudi Arabia to strike a deal and keep prices down. The US gets the assist of pressure on its enemies; and not just Russian and Iran. At the meeting between Kerry and the Saudis in September, the Saudis agreed to join the US coalition against the Islamic State. Saudi Arabia, on the other hand, may have bought itself support in its fight against the Assad regime in Syria, and the low prices will put pressure on producers in the United States and Canada, where it costs a lot more money to get the stuff out of the ground than it does in Saudi Arabia. Everyone at the table (a table set for two) gives a little and takes a little.

So do I think that the United States and Saudi Arabia are at least in part engineering the fall in oil prices for their own political motives? Yes, absolutely. But do I think that this is a conspiracy? Absolutely not. This is just business as usual for the United States, where an economist is going to be our Number Two Spy.

This is part three of a four-part series of posts on the Economics of Oil. Other posts:

The Economics of Gas Prices

The Economics of Airfare

The Economics of Bitcoin Mining

… Gas Prices

I hope I’m not biting off more than I can chew with this post, but it is important and interesting. Gas prices are going down – 8% since the end of June, and maybe further as we continue into the fall. And that is certainly good news. American consumers will spend less on gasoline, which means more money left over to spur other sectors of the economy and to retire debt and save.

A lot of times big news outlets only focus on a few determinants of gas prices when they talk about the economics of gas and oil, but it is a vast and complicated market that is not homogeneous worldwide or within the United States.

gaspump66% of the price of a gallon of gasoline is determined by the price of oil. Big news outlets like to talk about a few themes when they talk about the price of oil: rising consumption in emerging markets, such as China, and rising production in the US, coming from North Dakota’s Bakken Shale. In addition, they cover the price of oil. The most commonly cited price of oil are West Texas Intermediate (WTI) contracts traded on the NY Mercantile Exchange (NYMEX). However, unlike stocks and bonds which can be traded and transferred digitally, ultimately, for every oil contract, someone has to take delivery of the physical commodity. And due to the realities of geography, climate, and geopolitics, it isn’t possible to charge the same amount all over the world.

When we talk about gasoline, the buyers of the crude oil that we care about are the refineries. The US has refineries on all of our coasts: the East Coast, the West Coast, and the Gulf Coast. But all of these regions are sourcing oil from different parts of the world. Increasing levels of the North Dakota oil are heading East. The Gulf is importing high quality overseas oil, so that leaves the West Coast importing more expensive oversea oil, which is more expensive to refine.

One man that is embroiled in what very well may be the world’s most important logistical system is everyone’s favorite octogenarian, Warren Buffett. A large part of his conglomerate’s business is rail shipping, which includes North Dakotan oil. However, given capacity constraints, he has to balance oil shipments with grain shipments. When he is taking on too much oil the agriculture industry and food security experts get in a fuss (Warren even had a private talking-to with the Agriculture Secretary last week), and when he is shipping grains instead of black gold, every who cares about gas prices is up in a huff.

Ever since the Arab oil embargo the United States government has banned the export of US crude oil. Therefore, despite the rising domestic US oil production, it only has a muted effect on international oil prices. So all the refineries importing foreign oil, especially those on the West Coast and the Gulf Coast (since most of the good stuff from North Dakota is heading to the East Coast), are still beholden to international geopolitics. The good news is that international prices are down 16% since the end of June (US prices are only down 11% in the same time period).

Ukraine! Gaza! ISIS! Syria! Libya! Ebola! Egypt! How is it that international prices are down? The fact of the matter is that many of these conflicts have not adversely effected oil extraction and shipping to enough extent to disrupt prices. But I personally feel like there is still a lot of possibility for a shock event to push prices higher. For instance, the capital of Yemen, Sana’a has recently resembled a battlefield. Who knows how this could affect prices if there is an unexpected outcome. Even more so, if Ebola spreads through Nigeria and other West African countries that are large oil exporters there could be widespread export disruptions, driving up prices. That’s not to mention if Russian sanctions over Ukraine spill over into the energy sector, if ISIS expands its territory and the world blacklists its oil, or the Libyan conflict turns into a more disruptive civil war.


Right now the cheapest gasoline can be found in the South, and the most expensive in the Northwest. State gasoline taxes also play a huge role in the final price at the pump, but this is purely a political phenomenon, not an economical one. Next time you fill up or hear or read a news story on oil or gas try to remember that the economics of the issue is a lot more complicated than the story may lead you to believe, and that prices may not stay this low forever.


The Economics of International Oil Price Conspiracies

The Economics of Airfare

The Economics of Bitcoin Mining




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