Oil Prices and the Aviation Industry

Oil prices may have slumped but airlines cannot assume the trend will continue.

The price of oil has dropped about 50% compared with 12 months ago. And there are plenty of reasons to suggest that the trend is not about to end any time soon. US shale production has increased the overall supply of oil as have the Canadian Tar Sands and the return of Libyan oil to the market. At the same time, the Organization of the Petroleum Exporting Countries (OPEC) has said that it has no intention of cutting production from its 30 million barrels a day quota even if oil fell to $20 a barrel. OPEC’s major player, Saudi Arabia, has enormous cash reserves, and although it may need oil prices to double to balance its budget, it can afford to be patient.

Combined with this, demand has dropped thanks to a strong dollar that makes oil more expensive while the performance of the Chinese and EU economies remains uninspiring. Stuart Elliott at energy specialist Platts has suggested that the oil market has entered a new chapter of its history, “which is now starting to operate like any non-cartel commodity market”.

All things being equal, by mid-2015 oil stocks may come close to the alltime high of 2.83 billion barrels reached in August 1998. At that point, the price averaged a little over $11 a barrel. It seems like good news for the airlines and, by and large, that’s true. With fuel accounting for 30-40% of an airline’s total costs, the reduction affects the bottom line significantly.

That’s good news for air service development as airlines will look to re-invest any surplus cash into new aircraft and routes. But there is lot more to this story than meets the eye, and airlines shouldn’t be counting their chickens just yet.

The x-factor

For a start, the bigger picture in terms of the future price of oil is very hard to judge. It is reported that OPEC and US shale oil producers are waiting to see who will blink first – that is, cut production – as the current price of oil is simply unsustainable if many existing wells are to continue production. Arctic oil, for example, does not work at less than $100 a barrel, says Brendan Cronin at Poyry Managing Consultants, so any plans for polar drilling are likely to be shelved for the foreseeable future. And at $50 a barrel, North Sea oil is unprofitable.

So it could be that just as the world economy starts to boom and air travel follows suit, oil supply will fall dramatically. This would lead to tremendous upwards pressure on oil prices and potentially a greater spike than seen during 2008.

The need to adapt

Even if prices do stay low, however, airlines may not be wallowing in the extra cash any time soon. “Falling fuel prices have never been more than a temporary boost to airlines and their shareholders,” says Brian Pearce, chief economist at the International Air Transport Association. “Competition and the nature of airline economics means that a uniform cost reduction like this gets passed on to consumers, once the delay caused by hedging passes. However, airlines will need to use some of the cash from any reduction in fuel costs to pay down debt, renew old fleet, and invest in service improvements.” Fuel hedging means that most airlines are either not yet benefiting from lower fuel prices or they are reporting mark-to-market losses – depending on the type of fuel hedge, according to Pearce.

Fuel supply remains a concern too. It’s not just about Africa either, where the security of supply is under threat in several countries. At London Heathrow, for example, there is only enough tankage for 1.7 days. It should be at least double that. Other issues will also come into play from refinery capacity to the demand for biofuels. How it all plays out could have a fundamental effect on airline strategy. The low cost of fuel could tempt low-cost carriers in to the long-haul market, for example, which could have a shattering impact on the existing network.

Such uncertainty means airline strategy going forward is far from clear. “It is fuel price volatility that makes life so difficult for airlines,” says Pearce. “They can adapt to periods of high or low fuel prices, as we have seen with improving profitability in the past two years. If airlines could be sure low prices will persist they could start to adapt.”

The futures market suggests the price will recover to about $70 by 2019, with most experts agreeing on a $40-$80 range. “The challenge for forecasting price is that oil markets are driven just as much by strategic supplier decisions as market fundamentals,” concludes Pearce. “This makes it hard to predict. But it is likely that airlines will not plan on the basis that fuel prices will stay low.”

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