Your next flight doesn't have to be so expensive. Here's why

0:01NPR.

0:11This is the Indicator from Planet Money. I'm Darian Woods. And I'm Waylon Wong. I think by now it's been a familiar exercise since the war in Iran started. You open a browser tab, you look at airfares for a summer vacation, and then you close your laptop and you throw it into the ocean. Yes, it is a ricochet effect economically about this Strait of Hormuz closing and how that's affecting airline prices. Yeah, jet fuel accounts for around 20 % of a typical airline's costs. And the price of jet fuel has actually shot up more than crude oil, gasoline or diesel. So many people who are shopping for airfares right now are feeling this pain.

0:52Hiking airfares is this obvious lever that airlines can pull when their costs go up. But there's another one that these companies do have at their disposal. It's a strategy known as fuel hedging. Airlines like Cathay Pacific, Lufthansa, and Qantas do it. But most airlines in the U.S. haven't done it for a decade. So today on the show, what is fuel hedging? Why did airlines in the U.S. stop doing it? And what will they do now?

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2:44Jerry Laderman is an airline veteran. He worked in the industry for around four decades, mostly on the finance side. He was treasurer of Continental Airlines and eventually became the chief financial officer at United Airlines. One constant in his career was looking at oil prices. I've been retired for almost two years. I still check it every day. Old habits, huh? Yep, you just get used to it. Yes, it is something that on any Bloomberg screen I can think of in the Treasury Department of any airline, there will be on the screen fuel prices. Sometimes when I drive past a gas station, I look at the price on the sign and do some quick mental math about how much it'll take to fill my tank.

3:28That's your version of what airline executives are doing. Exactly, but they do it on a much bigger scale. The impact for an airline is a lot more than a driver. It's tens of millions of dollars on an annual basis for each movement of just one cent in a gallon of jet fuel. And the war in Iran is making prices spike more than just a cent per gallon. This week, the global average price for jet fuel was creeping towards$5 per gallon. That's more than double what it was a month ago. The CEO of Delta Airlines said in an industry conference last week that the spike in fuel prices has generated$400 million in additional costs so far this month.

4:08It's a big, unexpected hit. And there are two ingredients in the price of jet fuel. The first is the price of oil, specifically Brent crude, which is the global benchmark. The second ingredient is what's called the crack spread. That's a little oil industry jargon for you, which Jerry explains like this. Think of it like the refining margin, the cost of refining the product, the profit for the refiners, transportation, and a whole number of other factors. The crack spread can have its own movements independent of the underlying price of oil. The current crack spread for jet fuel is also way up compared with last month and last year.

4:47One reason is because Middle Eastern refineries that produce jet fuel and other products can't ship through the Strait of Hormuz. Now, airlines can't control the global price of oil or what's happening with refineries. One notable exception in the U.S., though, is Delta. It owns its own refinery through a subsidiary. This vertical integration helps the company save money on refining oil into jet fuel. As for other airlines, former United CFO Jerry Latterman says they generally try to keep their fuel costs down by using more energy-efficient planes and carrying less weight. But for many years, airlines have also done something called fuel hedging.

5:27This practice was common in the U.S., but that changed. And before we get into why that changed, first we should talk about what fuel hedging is. It involves financial instruments like futures contracts. You might be familiar with this term from the stock market. Investors that use these contracts agree to buy or sell a certain asset, like a stock, at a specific price on a specific future date. There are futures contracts for all kinds of commodities, including crude oil. So an airline that is fuel hedging might enter into a contract to buy crude oil at a set price in the future. Let's say it agrees to pay$100 a barrel six months from now.

6:05And six months goes by, and let's say the cost of crude oil has gone up to$150. The futures contract, it locked in a price of$100 though. So now the airline has made a$50 profit. Of course, if oil prices have gone down to$50 a barrel, the airline loses money. Now, it's important to note there are not actual, like, literal barrels of crude oil trading hands here. What we're talking about is the airline making money in the markets on this trade. And that money helps the airline build a financial cushion for when they actually do go to pay for jet fuel. It's really viewed as insurance to protect the financials against a sudden spike in jet fuel.

6:54And for years, this insurance policy worked well. So, for example, American Airlines said in 2003 that it saved almost$150 million in fuel costs thanks to hedging. Southwest Airlines pursued an aggressive hedging strategy. The company estimated that it saved$3.5 billion between 1998 and 2008. It used these savings to expand operations and hire workers. However, Jerry says most of the major airlines in the U.S. eventually soured on fuel hedging. One reason? The Wall Street transaction fees to make these hedges got expensive. Like any insurance, there's a cost to it. You're paying a premium for the privilege of locking it in, and it's sort of built into that price.

7:42And it's expensive. And what I think the U.S. airlines found is that it wasn't worth that expense. Plus, Jerry says, the airlines found that they could make money the old-fashioned way by raising prices. The better answer was to, in a fair manner, pass costs on to consumers. And the industry found that they were able to adjust fares to cover, you know, I'm not saying 100 percent of a spike in fuel price, but a significant increase in fuel. And that's a much, much healthier way for an industry to manage its costs. United, American and Delta stopped hedging in the 2010s. There was an unexpected drop in the price of oil during that period.

8:31Airlines that had bet on higher prices ended up with heavy losses on their hedges. The president of American Airlines told the Wall Street Journal in 2016 that hedging is a rigged game that enriches Wall Street. Meanwhile, Southwest kept going with hedging because it was under more pressure to keep prices low. That's according to Kerry Tan. He's an economist at Loyola University, Maryland, who studies the airline industry. Delta can charge a premium on prices because of the perceived higher quality experience and the clientele being much less price sensitive than your traditional passenger on Southwest.

9:11But even Southwest stopped hedging a year ago. The company said the premiums it paid to make these trades had gotten too costly and that it would find other ways to address fuel prices. Today, none of the major airlines in the U.S. are hedging. Many outside of the U.S. are, but even airlines like Cathay Pacific and Qantas are increasing airfares or fuel surcharges. It appears that hedging alone isn't enough to keep prices low for flyers. So will U.S.-based airlines dust off their old hedging playbooks and get their investment bankers back on speed dial? Kerry says the big variable is how long oil prices will stay elevated.

9:49If you're hedging fuel, you're trying to make a bet that prices are going to go up. But today, right now, it's hard to say whether prices are going to be chronically high or if they're going to revert back or what's going to happen even months from now. Kerry's hedging of statements. Now, it's possible that the airlines believe that they can write out a few months of higher oil prices with higher fares or by implementing fuel surcharges. But if the war persists, then all bets are off. This episode was produced by Corey Bridges with engineering by Jimmy Keely and Maggie Luthar. It was fact-checked by Sierra Juarez.

10:30Kicking Cannon is our show's editor, and The Indicator is a production of NPR.

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