Oil price fueling fears for airlines

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Vueling chief executive Alex Cruz is "worried" and no-one is going to argue when he adds: "I think everyone is worried." It is not, after all, turning out to be a good year for oil.

As airline bosses and other energy price-sensitive business people returned to work after the Christmas and New Year holidays, the International Energy Agency raised the alarm, as several weeks of steady price rises saw the Brent Crude benchmark open January trading with a push to $95 per barrel, its highest price in more than two years.

International Energy Agency chief economist Fatih Birol was blunt: "Oil prices are entering a dangerous zone for the global economy." By early February, Brent Crude had broached $100 per barrier mark, traders fearing a fully-fledged revolution in Egypt, which produces little oil but controls the crucial Suez canal and pipeline routes from the Middle East to the Mediterranean.

 
And as Tunisia's revolt has started to spread, nobody is prepared to say Saudi Arabia will be immune to the wave of unrest.

Regardless of whether rising fuel bills derail economic recovery generally, from an airline industry perspective oil prices - closely tracked by jet kerosene prices - are in a trouble zone.

In 2010, Brent Crude averaged about $80 per barrel, but IATA flags jet fuel prices at the close of the year were more than one-fifth higher than a year earlier. If those prices prevail for 2011, the industry's fuel bill will jump $22 billion, wiping out last year's record $15.1 billion industry profit.

PROFITS UNDER PRESSURE

IATA is forecasting 2011 will see industry profits slump 40% to $9.1 billion, assuming Brent at $84 per barrel. However, director general Giovanni Bisignani warns: "For every dollar increase in the average price of a barrel of oil over the year, airlines face the difficult task of recovering an additional $1.6 billion in costs."

By IATA's calculations then, if oil averages $90 per barrel this year, the industry will return to losses unless it can find significant cost savings. For an industry frantically cutting costs since the 2008 oil price spike took prices into the $140s, major cost-cutting will not be easy. So how worried should airline bosses be? "The oil price challenges everyone in the industry," says British Airways chief executive Willie Walsh.

"There's only so much airlines can do to offset the increased cost. It will drive airlines that are unprofitable out of the industry ­because they just won't be able to survive but, ultimately, it's going to lead to higher prices."

He adds that if five years from now oil is $150 a barrel, the industry will have adapted to the new levels. "There will be fewer airlines and prices will be higher, which will impact on growth."

Michael Cawley, Ryanair deputy chief executive, adds: "There will be a mass of collapses and merger pressure in the future [with higher fuel prices]. Airlines with the most fragile balance sheets will be poorly placed to withstand fuel price increases."

BA's most visible response so far has been a February rise in its fuel surcharge. At Delta Air Lines, the response to an extra $400 million in first-quarter fuel costs has been to reduce planned capacity growth and raise fares.

PASSING ON THE COST

Raising fares is probably the first, obvious response to rising costs. Gareth Williams, chief executive of flight comparison website Skyscanner.net, says of BA's higher fuel surcharge: "The aviation industry suffered some significant setbacks in 2010, with new air duty, the volcano, strikes and snow cancellations. It's not financially viable for airlines to continue to absorb these costs indefinitely and stay solvent."

Aviation consultant Mike Boyd, of Boyd Group International, is optimistic airlines can adapt. "As the fare increases announced in the last week of ­December clearly indicate, carriers are looking over the horizon and pro-actively planning for future shocks to the system - in this case, the near-certainty of spikes in fuel prices."

However, industry analyst Chris Tarry, of CTAIRA, observes price rises only "stick" if there is excess demand for travel.

Asian markets are strong, he says, but in Europe, where the big volume market is for leisure travel, the demand outlook is not good so raising prices would be a volume killer. That condition puts airlines in a bind. They cannot go on absorbing rising fuel costs, says Tarry, but their greatest threat is lack of passenger demand.

Cruz also sees the fares dilemma in these terms. His worry is not his airline's viability but "how much flexibility we will have to pass on the price increases into tickets. Who among our competition might keep their fares low?"

One candidate is Ryanair. "The inevitable response of other airlines [to higher fuel costs] is to increase their fuel surcharges. This creates a slipstream effect," says Cawley. "Passengers vote with their feet and come to us, displacing demand to Ryanair which will inevitably drive up our average fares."

The other short-term response to rising fuel prices is hedging. Essentially a two-way bet against fuel price movements, hedging can keep a carrier's per-tonne fuel bill more or less constant.

According to Leo Drollas, chief economist at the Centre for Global Energy Studies, it is a technique used effectively by "strategic hedgers" such as Air France, British Airways or Lufthansa, which always maintain hedged positions. However, he suggests "tactical hedgers" such as ­Ryanair, which tries to dip into the hedging market when it fears rising fuel prices, often lose.

Airlines which panicked and hedged against sky-high prices in 2008 found themselves paying way over market prices after oil collapsed in August 2008.

Forecasting oil prices, he notes, is a mug's game.

OVER THE HEDGE

Cawley believes hedging plays an important role in cost control. "The first thing to learn [about fuel hedging] is it's impossible to beat it," he says. "We form a rolling view of the trends and try to buy against the trend and buy earlier. You can't anticipate fuel prices. If we could, we wouldn't be running an airline. We simply fix it at a range which we are comfortable with running the business."

Alaska Air Group, as a policy, uses hedges to lock the price of half its annual fuel burn, which chief financial officer Brandon Pedersen admits costs $50-60 million in insurance premiums.

Those costs make US Airways alone among US network carriers in not hedging, and its president Scott Kirby does not see spiking oil prices leading to a rethink of that policy. Transaction and insurance costs, he says, make it "hard to understand how you can make a systematic hedging programme work".

At Vueling, Cruz says hedging must be done at prices near that which the competition is locking in, but what is more worrying to him is, simply, the price level. Hedging at $101 a barrel could be very difficult, he says, adding: "Most airlines will not be able to continue with sustained pricing of $100-plus per barrel. I think we will see airlines falling down at those pricing levels."

HEATING UP THE PRICE

One concern among energy watchers is global oil supplies will soon see an increasing reliance on difficult-to-exploit oil reserves. In other words, the easy oil has just about been used up.

The rising price trend also got a push by a hard winter in Europe and North America. As jet fuel is a derivative similar to heating oil, Leo Drollas, of the Centre for Global Energy Studies, notes refineries have to choose between the two - and he says airlines are paying for a cold winter.

A third pressure is potential for turmoil in the Middle East to spark the sort of oil supply geopolitical shock that has kicked off several recessions since the 1970s. Nobody anticipated this one and it is simply too early to say what may come of it.

One factor mitigating market worries is slack in the supply and storage chain, not the case when prices spiked in 2008.

Forecasting oil prices may be a hopeless task, but before the $100 per barrel mark had been crossed, Airbus's chief salesman John Leahy said the airframer expected a steady rise this year, through $100, but falling back to average in the mid-$90s.

In December, Sabine Schels, commodity strategist for Bank of America Merrill Lynch, forecast Brent would break through $100 in 2011, but average $88. Drollas is less optimistic, expecting Brent to average $93.

The $100 per barrel mark is significant. Schels believes prices above $100 are not sustainable as they cross the "pain threshold" for OECD countries.

Drollas notes the Saudis want to keep oil trading in the $70-90 per barrel range and are raising output in a bid to take the edge off recent rises. So oil in the $85-95 range looks a good bet: not high enough to derail recovery but high enough to keep global growth in check - and airlines sweating over fuel costs.