Fueling the industry overdraft

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This story is sourced from Airline Business
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Profit is the result of a set of large numbers moving in different directions. However, airlines face the problem they have little or no control over the most important numbers, including fuel. While the price of fuel appears to move in mysterious ways, there is little doubt - at least for the near term - that the trend is upward. This reflects both underlying demand and "geo-political" and behavioural factors, which inevitably give rise to "trading opportunities".

Indeed, we have already seen increases in long-haul fuel surcharges by a number of airlines and the inevitable comments in the press about how much more it will cost a family of four to go on holiday.

The ability to pass on this additional cost ultimately depends on the relationship between supply and demand and, even though 2010 may well turn out to be a record profit year, the financial state of the industry is still "fragile" and this is clearly not a cost which can be absorbed.

In short, the combination of too much capacity and rising fuel prices has the potential to be very damaging financially.

Based on expectations outlined by IATA in early February, the industry's 2011 fuel bill is ex-pected to be $34 billion up on 2010. Although some near-term effects may be softened through hedging already in place, in a rising market hedging really only delays the inevitable.

At about $112 a barrel, the spot price of oil is currently about a third higher than it was a year ago. To put this in context, even if the fuel bill goes up by only the forecast $34 billion, this is more than last year's operating profit and greater than the forecast increase in industry revenue between 2010 and 2011.

While it is interesting to look at what is happening to competitors, ultimately all that really matters is what it means for your own business and what you can do to counter the issue/problem.

Near-term, the initial reaction is to try to increase fare revenue, whether or not this involves a surcharge or a fare rise. However, market dynamics will be in play and individual companies will respond differently, depending on their business model and competitive position.

Surcharges are more likely to be an early response in long-haul markets because, while fuel is a bigger component of cost, ­competition is often more measured. To put this in context, depending on aircraft type, each $100 per tonne increase could add up to $10,000 to the cost of a flight between London and Los Angeles, stepping up the cost per passenger by $25 to $30.

Short-haul is a different proposition. Fuel represents a lower proportion of costs for each flight but each $100 increase still adds $2.50 per passenger, based on an hour's flight on a 150-seat aircraft with a load factor of 80%.

Yet it is difficult to increase fares or levy a surcharge because short-haul is highly contested and capacity widely increasing.

That said, Delta has already cut its first quarter 2011 capacity grow plans from 5-7% to between 3 and 5%. Although some of this reflects the impact of the winter storms, it is also a response to higher fuel prices. For the full year, Delta's capacity is now only expected to be up 1%. However, while Delta is claiming some success in getting fare increases to stick, questions remain over what its competitors will do during the next few months.

EasyJet's recent interim management statement sets out the issues very clearly. A year ago the spot price was $681 a tonne and when it reported it was $897 a tonne. On a per seat basis, easyJet expects fuel to be 9.6% higher than last year. This was based on the current fuel price at the time and an exchange rate of $1.60: £1. While sterling has remained close to this level, the fuel assumption may be more testing.

As a consequence, easyJet's management expects first-half losses to widen from £78.7 million to £140-160 million.

Stock markets tend to be unforgiving so this caused its share price to drop 19%, although of late it has begun to recover.

At this time of year, fare sales are de rigueur in European markets but they seem to be lasting longer than normal, suggesting too much capacity in a weak market. Perhaps the key questions still outstanding are whether the only way is up for fuel and how much profits will drop in 2011, compared with 2010. Time will tell.