The airline industry is concerned that high oil prices will slow economic growth and stop its own financial recovery
Airlines seemed well positioned just a few months ago to absorb higher fuel costs, which were forecast to rise through 2011 along with rising crude oil prices. Of course, that was barring any shocks to the system. Now all bets are off, with oil supplies in Libya and some other oil-producing countries at varying degrees of risk and crude oil prices at their highest level in two years.
The oil price spike of 2008 caught the world’s airlines flatfooted, tipping the industry into near-record losses. In response, airlines reduced capacity and ditched unprofitable routes. When prices stabilized at $85 per barrel and economic recovery sparked increased travel demand, yields rose enough for the world’s airlines to generate $16 billion in profits last year. With better hedge positions, healthier balance sheets and greater access to credit, the airline industry appeared in a much stronger position to deal with prices in the $75-90 range.
But there is a tipping point, depending on how high crude oil prices go, and that is what has the industry and the financial community concerned.
The(IATA) issued a strong reminder that things might quickly change for the worse if fuel prices stay where they are, not to mention go beyond. The global economy could reach an inflection point at around $120 per barrel, analysts have warned. Another recession might then be unavoidable with possibly deep structural effects on the airline industry.
IATA already has downgraded its financial forecast for the world’s airlines, halving it from last year’s $16 billion to $8.6 billion. And this is on the assumption that $96 per barrel remains on average for the balance of the year. The industry will remain profitable if demand for air travel is strong, but if there’s a shock that affects economic growth, the industry could tip into the red, says Brian Pearce, IATA chief economist.
The $500 million difference between the earlier forecast and the current one looks comparatively insignificant, but behind it are two strong trends that could cancel each other out.
A $1-per-barrel increase costs the industry more than $1 billion, but that effect is dampened through hedging policies. IATA predicts the industry will have to spend $10 billion more on fuel in 2011 than it did last year. Oil will be 20% more expensive and fuel costs will on average represent 29% of an airline’s operating costs.
On the other hand, demand is currently still stronger than IATA anticipated. The trade body now expects air travel to grow by 5.6% in 2011, up from its previous forecast of 5.2%. Cargo traffic will grow by 6.1%, up from 5.5%. Passenger yields are expected to improve by 1.5% and cargo yields by 1.9%.
But IATA Director General/CEO Giovanni Bisignani warns that “stronger revenues will provide only a partial offset to higher costs.” He emphasized that “today oil is the biggest risk. If its rise stalls the global economic expansion, the outlook will deteriorate very quickly.”
And that is the wild card. The conflict now raging in Libya has taken a crucial part of the world’s oil supply offline. Although news is unclear, the International Energy Agency, an energy watchdog, estimates that Libyan oil production has fallen by about 800,000 barrels per day, and the country has a total capacity of about 1.6 million barrels per day.
Out of the world’s daily production of 85 million barrels per day, this doesn’t seem like much, but Libyan crude has an outsize effect on transportation. The low sulfur content of Libyan oil—and its proximity to European refiners—make it particularly well-suited for use as jet fuel. “It’s the Champagne of oils,” says John Kingston, editorial director of Platts, which, like Aviation Week, is a unit of The McGraw-Hill Companies.
Saudi Arabia, with 3.5 million barrels per day of spare capacity, has begun upping production to offset the loss of Libyan oil. But Saudi oil has a higher sulfur content; therefore it is problematic as jet fuel. “Refiners will have to scramble to make up the difference in transportation fuels,” says Kingston.
With the price of Brent futures already topping $116, is the break-even point for airlines within sight? It depends on whether rising crude prices choke off an economic recovery and kill demand for corporate and leisure travel. “In terms of economic recovery, at $100 per barrel, we’re nervous; $150 would be bad, and at $200 we’re pretty damn sure economic growth would stall,” says Adam Sieminski, Deutsche Bank chief energy economist.
For airlines, the inflection point could come sooner. Breakeven is at $110-120, says Michael Lowry, project manager for Aviation Week’s Top-Performing Companies study. “If oil gets past $120, we’ll see losses, including at Southwest [Airlines].” At $150, airlines will scramble to cut capacity. “$200 per barrel is liquidation territory, when we can expect to see airlines go out of business,” says William Swelbar, an economist in the Massachusetts Institute of Technology’s Department of Aeronautics and Astronautics.
Some carriers already have begun slowing down expansion to prepare for higher-than-expected operating costs.decided to trim capacity growth to 3% from 4.2% as planned earlier. will increase capacity by no more than 5%, when it originally wanted to add around 7%. More carriers are likely to follow. International Airlines Group (IAG), consisting of and , said in late February that it is closely watching the situation and was prepared to cut back on capacity if needed. Other airlines hope that higher fuel surcharges will stick without detrimental effect on demand.
Egyptair is among airlines most affected by political unrest in the Middle East and North Africa. It has seen its traffic plunge. The airline is postponing the launch of two new services to North America as a consequence of a massive decline in traffic. Egyptair originally planned to start flights from Cairo to both Washington and Toronto in the summer, but that will have to wait until later this year, Chairman Hussein Massoud says. The airline is also considering the deferral of future aircraft deliveries, but has not yet made a decision.
Egyptair has kept the fleet busy recently by operating numerous evacuation flights from Libya in the past few days when most other carriers—including Emirates,, British Airways and —pulled out over security concerns. On Feb. 28 alone, Egyptair had 16 flights to Tripoli, two to Sirte and 10 to Djerba, mainly to fly compatriots out of the country. Massoud says that while there will be a decline in traffic in 2011, Egyptair hopes the recovery could be relatively quick, particularly because it has built an international connecting network in Cairo that is not solely dependent on traffic to and from Egypt.
The situation in North Africa and the Middle East remains volatile and could deteriorate—with dire consequences for both the world’s economic recovery and the airline industry. “I don’t think we’ll get to $150 per barrel this year,” says Sieminski. “But if social unrest takes one more exporting country—Algeria, Oman—offline, we’ll get there.”