Ailing airlines

Richard Branson once said, “To become a millionaire, start with being a billionaire and then start an airline!”

The global airline industry is in tatters, thanks to the record high levels of jet fuel prices compounded with slowing traffic due to an impending global economic slowdown. The recent surge in the crude oil prices to record highs has caused jet fuel prices to escalate to its highest levels. This translates into higher operating costs for the airlines. Jet fuel costs now account for approximately 40% of the airlines’ operating costs. In 2007, fuel expenses accounted for approximately 29% of airlines’ total operating expenses, while in 2002, jet fuel costs comprised of approximately 12.5% of the airline industry operating expenses. Rising fuel costs are compounded with slowing traffic both in terms of passengers and cargo. Global air passenger traffic has declined due to increased ticket prices due to the application of fuel surcharges by the airlines compounded with constrained purchasing power due to high inflation rates, especially in emerging markets. The impact of inflation in emerging markets on global air passenger traffic is severe owing to an air travel boom from 2003-2007. The global economic slowdown has impacted the growth in air freight. This is reflected in a significant drop in cargo growth to 1.3% in May 2008, significantly down from a 4.3% y-o-y cargo growth in 2007.

Airlines world wide are trying new measures of liberating themselves from this vicious circle of low revenues and increased costs. One such measure of increasing the passenger load factor is the rationalization of the airline’s route network. Currently, airlines operate on a number of unprofitable routes, where even the break-even load factors are not achieved. Due to this, although the variable costs such as passenger servicing charges are reduced, fixed costs such as fuel costs and airport landing and parking charges remain the same. Therefore, on these routes, the airline operates with higher operating cost per passenger. In view of this, efforts are being made to rationalize the airlines’ route network, by either reducing or altogether stopping services on such routes or employ smaller aircraft to such routes. However, I believe that the benefits of rationalization of routes will be partially offset by high cost of flying for passengers due to levy of fuel surcharges. Owing to this, air travel demand is likely to be affected further, as passengers already reeling under high inflation are subjected to higher costs of flying.

The recent fuel price spike is another very significant issue bothering airlines worldwide. To mitigate the impact of increased fuel prices, airlines worldwide are trying to hedge their fuel requirements. Almost every airline company in the world, save for Ryanair, are hedging their fuel requirements. The prime example would be Southwest Airlines. According to media reports, Southwest Airlines’s fuel hedging plan is the most successful program of its kind in the airline industry. According to the Associated Press, Southwest Airlines has saved approximately US$3.5 bn since 1999. In 1Q 08, Southwest Airlines’s net profit was US$34 mn, which was exceeded by its hedging gains of US$291 mn. This is because Southwest Airlines has hedged 70% of its fuel requirements at US$51 per barrel, relative to the prevailing spot prices of more than US$140 per barrel. However, majority of the airline companies were not wise enough to hedge at such levels. Therefore, they are left with no other option but to hedge at higher prices. In addition, hedging at higher levels restricts airlines to hedge a lesser proportion of their fuel requirement. This leaves the airlines exposed to high fuel prices.

According to the International Air Travel Association (IATA), when the fuel price per barrel goes up by US$1, the fuel bill of the airline industry as a whole increased by US$1.6 bn. IATA estimates that if crude oil prices keep hovering around US$135 per barrel level, the airline industry could face a loss of US$6.1 bn in 2008. I am of the opinion that the airline industry’s structure is not sustainable given the prevailing high fuel cost environment, worsened by slower traffic growth. Although, the airline industry has improved its efficiency levels over the years, especially after 2002, when it recoded a loss of US$11.3 bn, with the average oil price being for the year being US$25 per barrel. This level of price in 2002, translated into a fuel bill of US$40 bn for the global airline industry. Since then, fuel efficiency has improved 19%, sales and marketing unit costs have plummeted by 25% and ex-fuel costs declined 18%.

In line with IATA forecasts, I believe that 2008 and 2009 would be years of very weak performance from the airline industry. I believe that crude oil will average US$101 per barrel in 2008 and then decline to an average of US$49 per barrel in 2009 and increase to US$68 per barrel in. I believe that the performance of the airline industry would improve from 2010 onwards, given stabilizing fuel price, induction of new fuel efficient aircraft ordered in 2006 and 2007. Furthermore, I view the ongoing consolidation going in the airline industry as a positive coupled with the anticipated benefits arising out of the newly signed open-skies agreement between the US and Europe.