Debunking the myths behind airline fuel surcharges

Fuel surcharges are a PR exercise designed to shift blame for higher fares away from the airlines, but the reality is that consumers have been getting a great deal at airline shareholders' expense.

Virgin Australia’s move to get rid of the fuel surcharges on its flights to the US will presumably be emulated by Qantas, ending one of the sillier faux controversies of recent times.

Virgin, which only imposed the surcharge on its flights to the US (unlike Qantas, which surcharges all its international routes), made the decision to scrap its surcharges after several weeks of controversy over the failure of the surcharges to reflect the plummeting price of oil and therefore of jet fuel.

Even the Australian Competition and Consumer Commission got into the act, saying it would investigate whether the airlines were misleading their customers.

It is instructive that while Virgin has removed the $680 surcharge it imposed on return journeys to the US, it has said its fares on the route will fall by $40 for economy and premium economy class flights and $50 for business class.

All Virgin is doing is absorbing the cost of fuel into its core fares, as it would with any other type of expense.

In time, the lower oil prices might be reflected in further reductions in costs as the full impact of the fuel cost reductions flow through (airlines’ hedging arrangements mean that lower oil prices don’t have an immediate impact), although the sliding Australian dollar will offset some of the benefit.

The more fundamental point, however, is that the fuel surcharges were always more a public relations exercise designed to shift the blame for the higher fares caused by rocketing fuel costs away from airlines rather than an addition to a 'normal' fare. Airlines could simply have increased their fares to recover the higher fuel costs, without specifying any surcharge.

When the oil price cracked last year but the surcharges weren’t reduced, the PR exercise backfired.

The reality of the aviation industry is that airlines compete on 'all-in' prices. Whether or not a particular airlines breaks out a fuel surcharge, it has to price competitively against similar carriers or it will be flying half-empty planes.

That’s why the absorption of the surcharge by Virgin, and Qantas if it follows Virgin’s lead, will have only minimal impact on the overall pricing of its fares. For Qantas frequent flyers, where their use of frequent flyer points attracts the surcharge, there would be a more material benefit if surcharging was abandoned.

Virgin made the point today that over the period since 2009, when it first began flying the trans-Pacific route, average airfares had fallen by nearly $US500.

That’s despite the surcharging and the soaring fuel costs the surcharges reflected (although not in their entirety) and were designed to highlight. It’s also why fares aren’t going to fall in line with jet fuel costs, regardless of whether surcharges are retained or the cost of fuel become invisible within ticket prices, like any other cost.

With the International Air Transport Association estimating that fuel costs represent about 26 per cent of the industry’s costs, there is an interesting question as to what the impact of the halving of oil prices will ultimately be when the full benefits are available to the airlines.

Qantas has said it only benefitted by about $30 million in the December half but expects to experience significantly lower fuel costs in the June half. With a fuel bill of about $4.5 billion last year, the impact of its growing exposure to the lower jet fuel prices could be considerable.

Its international business, while apparently profitable in the December half, lost about $500m last year after losing about $250m in 2012-13 and nearly $500m in 2011-12. It hasn’t been a money-spinner in recent years: in fact it has destroyed capital.

International aviation is (and always has been) a lousy business. IATA last year calculated the industry’s cost of capital at about 7.5 per cent and, despite an expected 80 per cent rise in industry profitability last year, its return on capital was at about 5.4 per cent.

Despite consistent growth in demand, and regardless of fuel costs or financial performance, average fares keep falling in real terms because the industry keeps adding capacity at a rate beyond the rate of growth in demand.

The underlying state of the industry might have improved towards the end of the year because of the steepness of the fall in oil prices but the basic dysfunction within it -- the over-capacity and irrational/uncommercial behaviour -- means that even airlines with aspirations to behave commercially are overwhelmed by it.

The industry has probably destroyed the best part of $US50bn to $US60bn of shareholder value in the past three years alone.

The fall in jet fuel prices, when it does flow through fully to the carriers and if it is sustained, will give them an option. They could pass it through to their passengers, lowering fares meaningfully. Or they could retain the savings and improve their bottom lines.

The rational action would be to seize the opportunity to improve their profitability/reduce their losses and sub-economic returns. Given that rationality has never been a feature of the industry in the past, however, it wouldn’t be that much of a surprise if the potential benefits were competed away.

There are those who believe that the tardiness in removing or at least reducing the fuel surcharges as the oil price has halved is evidence that the industry is taking advantage of consumers.

The long-held reality of the industry, however, is that it is the consumer that has been getting too good a deal from the airlines, at airline shareholders’ expense. With or without surcharges on international routes, that is unlikely to change anytime soon.