With gas prices heading in the wrong direction, companies must choose whether to eat the increases -- and lose margin -- or pass them on to customers and risk losing business.
According to AAA, gas averaged $3.28 per gallon in January, with prices forecast to go even higher in February. UPS (NYSE:UPS), as the leading package delivery company in the United States, has a business highly affected by the price of gas -- though not necessarily in the ways you might expect.
Amazon.com (NASDAQ:AMZN), which has built its business on quick, inexpensive delivery, is one of UPS' main customers. It can see its thin profit margins erode if gas prices rise, which may force the company into making some tough choices.
How bad is it?
According to AAA, all 50 states had gas prices over $3 a gallon in January with Hawaii averaging over $4 and Connecticut ($3.64), Alaska ($3.64), New York ($3.63), and California ($3.59) coming in as the next four highest. The national average price was slightly lower than 2013, but February is historically a month where prices climb.
In 2013, the peak price average price of the year -- $3.79 per gallon -- came in February and AAA expects similar increases this year. Bad weather, however, can lead to unpredictable prices. Winter storms can lower demand, sending prices down, but they can also cause refinery shutdowns or regional shortages that cause them to spike.
Rising costs equals rising prices, less driving?
"Whenever fuel costs rise, businesses generally have two choices," said AAA Public Relations Manager Michael Green. "They can either reduce other costs or they can attempt to pass those fuel costs along to consumers by raising prices."
Green explained that there is no specific cost per gallon where companies decide to pass increases onto customers, nor is there a magic number where people decide to drive less. "Prices affect everyone differently based on attitudes and financial security. For example, a driver with a high income is not going to be as affected by a price of $3 per gallon as someone with a lower income."
In 2013, AAA conducted a survey to examine the potential breaking point of the average consumer. They found that half of U.S. adults consider gas prices to be too high when it reaches $3.44 per gallon. The survey had some other interesting statistics such as:
- 46% believe gas is too high when the price reaches $3 per gallon
- 61% believe gas is too high when the price reaches $3.50 per gallon
- 90% believe gas is too high when the price reaches $4 per gallon
As the leading package delivery company in the United States, UPS would seem to be greatly dependent on the price of gas for its profit margins. That, however, is not the case.
"UPS and all carriers use a fuel surcharge that passes the increase (or the decrease when there is one) on to customers," said UPS spokesman Dan McMackin. "The practice is industrywide so you'd get the same response from other companies in the industry."
According to McMackin, the surcharge is not built into any shipping rates. The surcharge is based on the On-Highway Diesel Fuel Prices Index reported by the U.S Department of Energy for the month that is two months prior to the adjustment.
And while UPS does not lose money when gas costs more, the company's business is affected if prices get too high.
"When there is an extreme spike in fuel, we have in the past seen some trade-down from premium services to our deferred services," McMackin said. That is, customers who might have used next-day or two-day delivery opt for cheaper, slower choices.
It's all about delivery
Amazon, which has no physical stores and is entirely delivery-based, does not directly pass on UPS surcharges to customers. That leaves the company, which had a razor thin .94% profit margin in December 2013, especially vulnerable to increased costs.
Currently, Amazon has a wide range of shipping prices depending upon product category, speed of delivery, and whether the customer is willing to wait until an order can be shipped whole. Those prices can relatively easily be changed to reflect increased costs. But, where the company has less flexibility is its Amazon Prime customers. Prime Customers, of which a March 2013 study from Morningstar and Consumer Intelligence Research Partners estimate number around 10 million, pay $79 for free two-day shipping on all orders.
CNNMoney reported Feb. 3 that Amazon is considering raising the price of this service (which offers other goodies like free videos) by as much as $40.
Does price matter?
UPS and other carriers seem largely insulated from the impact of normal gas price fluctuation as long as the industry remains united in its implementation of the fuel surcharge. Amazon, however, faces a risk should it raise the price of Prime, because, even if it remains a good value, a backlash like the one when Netflix (NASDAQ:NFLX) raised its price by 60% in 2011 and lost 805,000 customers in a single quarter, is possible.
In a Time article on the possible price increase, Neil Doshi, a tech stock analyst in San Francisco with CRT Capital Group, thinks most people won't mind a $20 increase but a $40 jump "might be hard for consumers to swallow."
Still, while there might be some customers who balk at any price increase, Amazon Prime, even at $119 a year, remains a value for heavy users of the site. Assume an average per item charge of $3.99 and Prime becomes a value after 30 orders -- not a hard number to hit with a company that sells everything from books to office supplies to groceries .
Even at the higher price, Prime itself remains a risk for Amazon. Because the free shipping is locked in for a year, Amazon is vulnerable to spikes in gas prices driving its costs up with no means to pass them on to customers.
Daniel Kline has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Netflix, and United Parcel Service. The Motley Fool owns shares of Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.