Thursday, 26 June 2008

Even more on Airlines

Airlines have gotten some tough love recently, both in the real world and in the media.

However, are the some additional things that pundits should be looking at, when thinking of the near future of aviation?

Here's a quick checklist to go through.
  1. Hedging. Derivative fuel price protection hedges may work as long as oil futures curves are inverted. They are now normal. This means that it is difficult to hedge effectively via futures contract and it also makes subsequent derivatives sold by 3rd parties much more expensive for any airline to buy. That is, the price of the hedge may negate much of the price rise in oil. Example: Qantas fuel hedges incurred a loss of -$39.8M and derivatives a loss of -$71.4M. These are significantly worse from 2006, when the hedges results in positive gains.

  2. Fuel efficient fleet. Airlines which have planned to renew their fleet with fuel efficient planes: A380, Dreamliner 787, A350XWB and the like can offer -20% to -30% savings in fuel usage, depending on existing fleet (other things staying the same). This can significantly reduce fuel costs. For instance, Qantas 2007 flee consists mostly of 717 to 747 aircraft and some A320/A330 series. The improvements of earlier mentioned aircraft on fuel savings are significant (on order of -10% to -30% for kerosene), even if they are not guaranteed to negate the effect of fuel price changes. A380 and 787 become operational in 2009 for Qantas, but of course only part of the fleet is switched over to the new craft.

  3. Revenue seat factor. When this goes down, so do the profits, rapidly. A Change of -1% can be significant, when the airline is already operating near profit-loss margin. This is not yet the case for Qantas, but it is reality for almost all US operators. The more pruned down the operations are, the harder it becomes to cut more. As such, the effects of revenue seat factor loss become progressively more severe IF airlines are forced to keep cutting expenses year after year (i.e. price of oil keeps going up steadily). Also, see recession for extra effects.

  4. Fare price changes. An important portion of the recent growth in air fares is not just from business travel, but from middle class flying further and more frequently. This demand is highly price elastic and adjusts rapidly as fare prices increase, again bringing down the revenue seat factor. Thus, airlines are constantly optimizing how much can they even theoretically increase fare prices (which causes a loss in demand), because fuel prices have increases. Currently this theoretical increase is not possible for many, due to overcapacity in the industry. However, below this easily adjusting demand there is demand that may not be cut as easily (e.g. bulk of business demand in a non-recession scenario), which may offer a period of support for profitable fare price increases, but only up to a point. In a recession scenario, this support can rapidly fall apart.

  5. Recession. During recession people fly less. Revenue seat factors go down and so do fare prices, both can incur great losses. This may also happen before the fuel prices drop due to shrinking demand, causing a short period of extreme financial losses. Personally if we go to recession and Asian demand growth for oil doesn't significantly drop while bringing down the oil prices, we can expect a lot fewer airlines, with a lot less routes and much lower frequency of flights.

  6. Emission trading. If EU emission trading starts in 2011 for airlines (doubtful), then this will eventually spill over to other areas and at the very least to operations to Europe for any airline, including Australian airlines. The effects can be significant. In 2007 the EU airline industry was able to make a combined profit of €3.7 billion in a time of extreme growth and fairly high economic growth. The emission trading scheme for EU airlines alone is currently estimated to cost €15 billion a year. This would totally wipe all the profits and force many airlines bankrupt in a just a few years. Thus, it is unlikely that airline emission trading scheme will start in 2011, the year when even the conservative IEA assumes a major oil supply/demand crunch, much worse than what we are experiencing now. BTW, Chris Skrebowski's (of Petroleum Review) current estimate is that we'll be peaking globally roughly by that time.

  7. Kerosene Crack spread. Kerosene has risen in price faster than crude oil (i.e. kerosene crack spread). This has been probably due to refinery mismatch and the very rapid rise in demand for diesel (a mid-distillate like kerosene). Until the refinery balance is restored or demand for diesel drops (unlikely, as it is used in electric power generation, not just cars), kerosene crack spread may remain well above the historical averages, or may even rise. This incurs an additional price increase of c. $25USD/per barrel over the crude oil price currently.

  8. Fuel delivery disruptions. This is the bogey nobody wants to talk about. Everybody assumes that the markets will operate without disruptions, and that only the prices will fluctuate. Readers of this board however are aware that when spare capacity is as tight as it is, unexpected disruptions anywhere in the fuel chain can easily cause temporal geographic losses in either crude or fuels. It's not generally known how well airlines are insured against these, but a loss of operations fuel for even days would be severe to many, both on financial and reputation level. If the margin remains tight for supply/demand, the likelihood of disruptions increases as a function of time. Again, barring worldwide recession, which may bring us more spare capacity, but which will bring different kind of pain to the airline industry.

It would be very interesting to find out if there are any additional upside factors that are already on the horizon for the aviation industry. Syn-fuels and bio-fuels are unlikely to make any significant impact in the next few years (too low volume, too high cost). Wing tips and weight reduction in planes is mostly already in use and the effects are marginal (a couple of percentages at top).

The only positive big event for the airline industry would be that the price of oil would plummet to $70-$90 per barrel (current dollar value) and the kerosene crack spread would normalize, both for some unimaginable reason (a black swan). If this was to happen without a worldwide economic slowdown, then airlines would at least get a breather. However, whether it would be anything more than a breather is in serious doubt. Things look pretty severe beyond 2011 and by 2015-2017 we are probably into uncharted territory.

Now, if things got really severe, what additional developments could happen?

Consider the potential of (re)nationalization. Shareholders don't like losing money, so they will abandon sinking companies. Historically most countries have had a national airline. It wouldn't be impossible they were re-nationalized again if things get ugly enough. Somebody needs to fly all those business suits all over the world for loss. And it sure isn't going to be private owners, so they could demand that the government picks up the tab for them. When/if things pick up again, airlines can again be privatized. Remember this may not be an on/off matter, it can be a matter of how many shares each party owns and who covers the losses in the end.