Can airlines survive $200-a-barrel oil?

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It wasn’t too long ago that the prospect of crude oil prices hitting $100 a barrel seemed unthinkable. Now with oil prices having smashed through the $140-a-barrel barrier, some are predicting that it could go as high as $200.

Can any airlines really survive $200-a-barrel oil, and how would oil at these prices alter the landscape of the global airline industry? 

Already the global airline industry has found itself in crisis mode as carriers struggle to come to terms with record high oil prices. IATA director general Giovanni Bisignani said at the industry body’s annual meeting in Istanbul in June that, based on an average oil price of $107 per barrel, the world’s airlines would incur a loss of $2.3 billion in 2008.

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And already airlines have been going out of business at an alarming rate, while others have taken drastic steps to slash capacity  and further reduce their costs. 

So what will happen to the airline industry if $200-a-barrel oil does become a reality? For starters, US airline consultant Bob Mann of RW Mann believes it will shrink significantly.

“If oil were to go to that level the airline industry would be much smaller based on revenue,” says Mann. “It would be 30-40% smaller in terms of total revenue and this would drive more than a 30-40% reduction in capacity. We would see a wholesale reduction in the number of aircraft flying and the number of frequencies operated, which would make schedules less convenient for business travellers.”

In a recent research note, Morgan Stanley estimated that US carriers would need to increase their unit revenues by 15-20% “in order to offset current fuel prices”, and that this should be accompanied by a 15% cut in domestic capacity. However, if crude oil hits $200 a barrel, many believe much more drastic action will be needed. “At $200 airlines would have to change their networks drastically, and a 20% reduction in capacity won’t do that,” says US airline consultant Darryl Jenkins.

If oil does hit $200 a barrel, adds Jenkins, “I assume you’d see one major liquidation” in the US market. “It will be a game of last man standing.”

But capacity reduction alone may not be enough to survive oil at these prices. According to Stefano Sala, a partner at Oliver Wyman, the view that airlines will survive if they simply boost revenues by 20% and cut capacity by a similar amount “does not mean much”.

“The key issue is where you are moving on the elasticity curve,” says Sala. “There is no percentage by which you can increase revenues [to be safe] because of demand elasticity – it is not a matter of keeping the system as it is. The issue is not to reduce your costs by 20% but to find yourself with a 10-30% smaller network. Everybody has to cut capacity – the question is, can you survive with that or not? This is not an industry that was built to cope with $130 oil, let alone $200.”

This point is backed up by CTAIRA’s Chris Tarry, who says that grounding aircraft alone will not be sufficient because “you’ve got to think of it as a system”.

Tarry adds that if oil does go to $200 a barrel, “it’s going to be horrendous…it changes the economics of the business. In 25 years following the industry, I haven’t seen anything quite like this. Globally, airlines will have to make a business case for every plane they’re going to buy. Cash reserves will go down, debt will go up and balance sheets will be weaker”.

Damien Horth, head of Asia transport research at UBS Hong Kong, told Airline Business last month that in Asia “UBS has only Singapore Airlines and Qantas profitable with $150 jet fuel. Everyone else is debatable”.

In Europe, UK regional carrier flybe recently said its break even point in terms of the price of a barrel of crude is $170 assuming that demand remains the same.

Its low cost base, where fuel only makes up 25% of its costs, compared with 46% for a carrier like Ryanair, is a major reason for this. Flybe’s cost base is low because it operates mainly fuel efficient Bombardier Q400 turboprops.

However, there is some scepticism over putting a figure on something that could ultimately alter the entire landscape of the airline industry.

“The dynamics of the situation are unprecedented,” says Sala. “I wouldn’t be able to give a price for oil and say ‘airlines can make it at those levels and then no more’.

The whole business system of the carrier needs to adapt to these new levels, and the question is whether it can do it or not.”

In terms of the scepticism that surrounded earlier predictions that crude oil would reach $100 a barrel, Mann points out that “the disbelievers were the ones who left their airlines unhedged and ignored the elephant in the room. Now they’re paying the price”.

But while there seems to be less scepticism over predictions of $200-a-barrel oil, there is also a certain amount of fear about hedging fuel at today’s record prices.

Tim Jeans, managing director of UK carrier Monarch Airlines, says: “It’s a brave old soul that’s going to hedge [jet fuel] at $1,350 a tonne, but it may be necessary. I just don’t see jet fuel returning to $1,000 a tonne.”