Fuel costs represent one of the biggest expenses for the aerospace and airline industries. On average, fuel costs account for 29% of all operating expenses and 27% of the overall airline industry revenue. Because the fuel costs per gallon declined by 6.4% in 2014, the decrease accrues to the airline industry's bottom line. If there is complete pass-through and all other factors remain constant, the 6.4% decline in the cost of fuel improves the profit margin for the airline industry by almost 1.7% in absolute terms. However, the fuel cost savings usually do not accrue fully and immediately since airline carriers often sign forward purchase agreements that fix the fuel price a few years in advance.
For the airline industry, jet fuel represents one of the largest expense items along with other non-fuel costs such as airport charges, flight crew costs and airplane maintenance. Airline carriers sign purchase contracts with oil refinery operators, which refine oil into jet fuel. Oil is the main component in the production of jet fuel, so the price of oil and the price of jet fuel are positively correlated. As the price of oil declines, so does the price of jet fuel.
The extent to which the declining fuel cost affects profitability in the airline industry depends on the proportion of fuel cost in the total airline industry's revenues. In 2014, jet fuel costs accounted for almost 27% of the airline industry's revenue, while the profit margin was 2.7%. If there is an immediate pass-through of fuel costs savings to the airline industry, the 6.4% decline in jet fuel costs would result in the profit margin improving from 2.7% to almost 4.4% (0.27*0.064 + 0.027).
The fuel cost decline is highly unlikely to result in immediate improvement in the airline industry's profitability ratios. Airline operators often hedge their exposure to fluctuations in jet fuel prices a few years in advance by locking into a certain fixed price. If an airline company locks into a hedge with a price that turns out to be much higher than the future price, it cannot take full advantage of lowering jet fuel costs. Therefore, the pass-through of declining fuel costs is far below 100% and the airline industry accrues the benefit of the 6.4% decline in fuel cost over multiple years in increments.
Instead of hedging jet fuel costs, certain airline operators take unprecedented measures of investing in their own jet fuel production. In 2012, Delta Airlines invested $150 million into an oil refinery, bypassing the jet fuel market and taking full control over its fuel production. By doing so, airlines can take full advantage of declining fuel prices, which improves their profitability much faster compared to long-term hedging. However, such a strategy does not work well when the oil price increases because it makes the jet fuel cost high. In this case, hedging the jet fuel price works better.