It makes such simple sense. When the price of fuel rises, we should expect airfares to follow, right?

Since fuel is typically an airline's second-largest cost, higher fuel prices mean higher fares. Basic economics, right?

No*. (*Not really)

This week, we offer what we are hyperbolically calling the greatest myth in aviation - airfares rise and fall with fuel prices.

Without diving into just how unexpectedly heated this debate can be, we’ll start with why most people believe fuel prices drive fares:

Because the airlines say they do.

A simple Google search returns dozens of examples of airlines explaining higher fares because of higher fuel prices. Why shouldn’t we believe it? As we mentioned above, it makes sense (which is kind of the point).

Yet, a search for airlines crediting low fuel prices with low fares yields far fewer results. Why is that?

Because low fuel prices do not cause low fares, just like high fuel prices, do not create high fares*. (*mostly)

Why?

Because revenue management, that’s why.

Introducing, Ray

Let’s take an oversimplified walk through the ticket pricing process. Ray, the revenue manager, works at XYZ Airlines. His job is to fill the available seats at the highest possible price. If Ray sees the seats filling too quickly, up goes the price. Conversely, if not enough people are booking tickets, prices drop.

Ray knows the critical rule of airline pricing - a seat that departs empty is forever spoiled. You’ll never be able to sell it - it’s gone. Spoiled.

This means it is in Ray’s best interest to sell that seat for any price, just so long as someone willing to pay a higher price doesn’t buy it. This is why so many seats can be sold below cost. Ray should accept the lower fare for an available seat as long as the passenger is paying the additional variable expenses (taxes, onboard service, a slight increase in fuel burn). It results in higher revenues for the same cost.

Our apologies to Ray (and revenue managers worldwide) for oversimplifying an incredibly complex system. In the end, though, Ray is responsible for solving for a load factor and maximizing revenue.

What happens, then, when Francine from finance comes in and says, “Ray, fuel prices are up. We need to raise prices!”

Ray adds 10% to all prices, and Bob’s your uncle (Bob runs baggage, but that’s not important). Yet, Ray’s 10% price increase means fewer passengers book flights. So what does Ray do, staring at potentially empty seats barreling toward the spoilage of departure? Ray lowers prices.

Francine from finance asked for an increase in ticket prices, but she really wanted an increase in revenues to offset the increased fuel prices. Even though Ray increased prices, he suddenly faced a decrease in revenues since fewer people booked the higher price.

So why didn’t passengers book at the higher price? Didn’t they see the news that fuel prices were increasing? Don’t they know that when fuel prices go up, they should pay more?

The passengers didn’t pay more because the passengers displayed a common condition: human intelligence. Better put, there were cheaper options available on other comparable airlines, which all had a Ray looking to fill empty seats.

This isn’t to say that passengers choose airlines solely based on price—they certainly don’t. However, competition exists everywhere in the airline world, and that competition has a far greater impact on prices than fuel.

Consider the opposite. Fuel goes up, and Ray’s 10% increase in fares results in just as many people booking. Great, but there’s a problem. Ray should have been charging 10% more all along — bad Ray.

Indeed, the data shows the same. Airfares do not move in tandem with fuel prices. In fact, when we adjust for inflation, they have a long-term trend in the opposite direction.

Correlation is not causation

But there are some times when fuel and airfares do move in the same direction. Take 2012, for instance. The price of fuel nearly tripled from $1.25/gal to $3.00/gal in a few months and fares went up.

Correlation is not causation. It’s a phrase you’ve undoubtedly heard before, and here is a great example. Because two things move in the same direction does not necessarily mean one is causing the other.

Take the great example of burglary and ice cream. Both rise in the summer. Does this mean ice cream causes crime?

The same with fuel prices and airfare. Whether the two move opposite or in tandem, it’s better to ask why they are moving rather than assuming they are moving because of each other.

Indeed, in 2012, the U.S. economy was recovering from the Great Recession. With a growing economy comes greater demand for travel, which in turn drives up fuel prices. At the same time, however, the stronger economy brought higher travel demand, raising airfares.

But, this correlation/not causation phenomenon is best illustrated in 2020. Did ticket prices fall because fuel was suddenly so cheap? Not at all

Then, what does drive fares? The number of seats available for Ray to sell. Capacity.

Using the mature U.S. domestic market as a further example, you can see the negative correlation between fares and capacity. This is Ray’s fault.

As simple as we thought the link between fuel prices and airfares was, the real answer is simpler. Supply and demand.

Ticket prices move with capacity and the number of passengers willing to fly. What else happened in 2012 was a stagnation in capacity in the U.S. domestic market. By 2016, growth had returned, and prices had moved accordingly.

(what strikes us is the period before 2001, when ticket prices were incredibly high and never recovered.)

What about fuel surcharges?

Aren’t those literally increases in airfares as a direct result of fuel prices?

Not really. And why is that? Because passengers are humans, and humans tend to display intelligence. (at least when booking travel)

If you look at the resultant pricing of tickets with and without fuel surcharges, you’ll see an odd phenomenon. They’re very similar. Whether it be the base airfare or “fuel surcharges,” it’s just a cost to a passenger.

To further prove this point, remember the fuel surcharges first put in place in the late 2000s when the price of oil topped $140 / barrel? What happened when oil dropped below $50 / barrel? Did they go away? No.

Why?

Ray.

Even if the fuel surcharge were truly a fuel surcharge, Ray would be forced to discount the base fare to keep the seat from going empty. The end result is a sort of market fare - with or without fuel surcharges - driven more by the capacity available in the market and the number of people looking to fly.

What’s with the asterisks?

Frank is the asterisk. Who is Frank? Frank is in Fleet Planning (naturally). Here’s the path from Ray to Frank:

Ray from revenue management doesn’t price based on the price of fuel. Ray fits passenger demand to capacity at the best price. However, Nancy, the network planner, also works for this airline. Nancy builds the network, defining the capacity within which Ray will price to match demand.

Fuel prices go up, and Nancy starts to reconsider whether she should build next Fall’s schedule with so much capacity. But aircraft and employees are expensive and will be paid regardless, and there is a good chance fuel prices are up because overall travel demand is up. Besides, other airlines are adding capacity, so the risk of losing market share keeps the pressure on and the number of seats for Ray to fill high.

Consider the tradeoffs for Nancy keeping capacity high. On one hand, demand could be up, and Ray will be able to price higher. On the other hand, the airline could lose money. Who would do that?

And yet, airlines lose money all the time.

Enter Frank from Fleet. He’s responsible for providing Nancy from Network Planning with the aircraft to build the network and provide seats for Ray.

Frank heard the opposite from Francine in finance - “Fuel costs are too high. Lower fuel costs. Buy more fuel-efficient aircraft, or maybe don’t buy any at all.”

Frank is why the asterisks exist. At some point, the price of fuel has been so high, and the airline has been losing money for so long that it begins to affect the airline’s decision to deploy capacity. Either the airline can’t afford to buy new aircraft after years of losses, or they recognize there is too much capacity in the market.

Frank’s decision not to buy airplanes eventually reduces the capacity available for Nancy’s network. That smaller network gives Ray fewer seats for which to find paying passengers. Prices go up.

But prices went up not because of fuel directly. They went up because capacity was reduced. Capacity was reduced because of years of high fuel prices, but the fuel prices were not the driver for the higher fares.

This leads to the ultimate way fuel can affect airfares: Meet Chip.

Chip is from legal.

Chip files Chapter 11.

In the end, long-term increases in fuel prices can result in higher ticket prices. In fact, the capacity stagnation between 2010 and 2012 could be blamed on this phenomenon. Fuel prices rose during the 2000s, driving airlines to merge, file for bankruptcy, or both.

Capacity left the system, and airfares went up.

While airfares did not increase in 2012 due to fuel prices, it could be argued that fuel prices from 2005 - 2008 played a key role.

The U.S. market offers the best historical data from which to draw these comparisons, but it is by no means unique. The very, very loose link between fuel prices and airfares persists around the world.

So why are airlines so quick to blame fuel prices for high fares? Because we believe it. The great circular reasoning.

And yet, the lively debate persists.

In that spirit, feel free to disagree. Simply hit reply and let us have it.

Our research published this week

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