Wednesday 7 December 2022
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Why domestic airfares are soaring: 3 reasons

Why domestic airfares are soaring: 3 reasons

A cause of this inflation in airfares is the link of the ATF prices to global crude oil rates, which have skyrocketed due to the Russia-Ukraine war, but that's not all

Even as Indians want to break free of the monotony of a ‘house arrest’ they were in for two years due to the China-origin coronavirus turning into the global Covid-19 pandemic, prohibitive airfares are coming in the way of their travel plans. The economy of travel is not working out as, on 16 June, oil marketing companies (OMCs) hiked the aviation turbine fuel (ATF) by the steepest margin ever, taking the prices up by 16.3% or by Rs 67,210.46 per kl, the 10th hike since January 2022.

Due to the spike, the ATF now costs Rs 1,41,232.87 per kl in Delhi; Rs 1,46,322.23 per kl in Kolkata; Rs 1,40,092.74 per kl in Mumbai. In Chennai, it’s Rs 1,46,215.85 per kl. This sharp increase in ATF, along with the depreciation of the rupee, has left the domestic airlines with soaring air tickets. These factors have “left us with no choice but to immediately raise airfares,” Ajay Singh, Chairman and Managing Director, SpiceJet said. In January 2021, the ATF was priced at around Rs 76,000 per kl; it is now nearly double that sum.

I. ‘Crude’ behaviour of airfares

One of the main reasons contributing to this inflation in airfares is the link of the ATF prices to global crude oil rates, which have skyrocketed due to the Russia-Ukraine war. Industry experts say the ATF makes up about 30-40% of an airline’s running cost. An increase in the cost of this fuel directly impacts the profit margins. The rising fuel costs make tickets more expensive, passing the burden on to travellers.

Airlines are alarmed over the rising ATF prices, saying that a consistent rise in jet fuel prices will impact the profitability of Indian carriers. It will also impact the for air travel, they say. “While the traffic was 3-4% higher in the first week of June on a month-on-month basis, it has slowed down. Growth has remained flat in the first fortnight of June on a month-on-month basis,” founder of aviation blog Network Thoughts Ameya Joshi said.

II. Depreciating

Furthermore, Indian airlines are already struggling with the depreciating since fuel, maintenance, and overhaul costs, lease payments, are all priced in US dollars.

The record increase in ATF prices, combined with the depreciating rupee, is set to increase the cost of operations for airlines, which could lead to an increase in air fares by up to 15%.

Airlines have been facing the consequences of the fall in the value of the domestic currency — the is 5.7% weaker since June 2021 against the dollar — since costs like lease rentals, payments to foreign airport operators and expatriate pilots are all “dollar-denominated”, says The Indian Express.

The airline industry had sought respite from high fuel prices through a cut in excise on ATF or by bringing jet fuel under GST, which would have brought down prices and also allowed airlines to claim input credit tax on the paid.

While bringing ATF under seems unlikely for now, the Ministry of had requested the Ministry of Finance to reduce excise on jet fuel by 2 percentage points to 9%. The finance ministry, however, did not reduce taxes on ATF.

III. No hedge

Then, most of Asia’s airlines don’t hedge jet fuel, making them more vulnerable to price increases. Four methods of hedging jet fuel, as per Investopedia, are explained below.

1. Purchasing current oil contracts

To mitigate the cost, an airline purchases large amounts of current oil contracts for its future needs. This is similar to a person who knows that the price of gas will increase over the next 12 months and they will need 100 gallons of gas for their car during that time. Instead of buying gas as needed, the car owner decides to purchase all 100 gallons at the current price, which they expect to be lower than the price of gas in the future.

2. Purchasing call options

A call option gives the buyer the right, without obligation, to purchase a stock or commodity at a specific price before a specific date. If an airline buys a call option, this means it is by buying the right to purchase oil in the future at a price that is agreed upon today.

If, say, the current price of oil is $ 100 per barrel, but an airline company believes prices will increase, it could purchase a call option for $ 5 that gives it the right to purchase a barrel of oil for $ 110 within a 120-day period. If oil prices increase to above $ 115 per barrel within 120 days, the airline will end up saving money.

3. Implementing a collar hedge

Similar to a call option strategy, airlines may execute a collar hedge, which requires it to buy both a call option and a put option. Where a call option allows an investor to purchase a stock or commodity at a future date for a price that’s agreed upon today, a put option allows an investor to do the opposite: sell a stock or commodity at a future date for a price that’s agreed on today.

A collar hedge uses a put option to protect an airline from a decline in the price of oil if that airline expects oil prices to increase. In the example above, if fuel prices increase, the airline would lose $5 per call option contract. A collar hedge protects the airline against this loss.

4. Purchasing swap contracts

Finally, an airline can implement a swap strategy to hedge against the potential of rising fuel costs. A swap is similar to a call option, but with more stringent guidelines. While a call option gives an airline the right to purchase oil in the future at a certain price, it doesn’t require the company to do so.

A swap, on the other hand, locks in the purchase of oil at a future price at a specified date. If fuel prices decline instead, the airline company has the potential to lose much more than it would with a call option strategy.

All indicators point in the direction of no hedging in India. SpiceJet has made it clear that a minimum hike of 10 to 15% in ticket pricing is required to meet its increasing costs on operations. IndiGo has flagged the concern about the rising fuel prices and sought government intervention. “To facilitate recovery of the aviation sector and to make flying viable for everyone, we would request the government to at least bring ATF under so that the benefit of the input tax credit can be availed,” IndiGo said in a statement.

“ATF prices have increased by more than 120% since June 2021. This massive increase is not sustainable and governments, central and state, need to take urgent action to reduce taxes on ATF that are amongst the highest in the world,” SpiceJet’s Ajay Singh said recently.

Some airlines have requested the government to remove the upper and lower price bands for domestic flight tickets that were brought in 2020 following the resumption of services after the pandemic-necessitated lockdown. The Ministry of Civil Aviation is likely to make up its mind on this soon.

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