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USD115 oil: Is this as bad as it gets for airlines? But some bright spots for European airlines

17-Apr-2008
  • Oil prices hit another record level;
  • Unclear what is pushing prices up;
  • European airlines are not so badly affected;
  • In a strong position to acquire shares in US airlines if the open skies agreement is expanded;
  • Centre for Asia Pacific Aviation projects that we are near the top of oil price rises;
  • But the real issue is not costs, but slowing demand.

Oil prices reached yet another record level, at over USD115 yesterday, and jet fuel remained at a further premium of 15-20% higher. The question now is: are we at the peak?

Indeed it is difficult to see why the upwards price forces continue so relentlessly. The US is now in recession that it won’t emerge from for at least 12 months, so demand should be reducing; there has been no particular escalation of the global security situation; nor have there been significant supply line disruptions.

But there are a few reasons:

  • The US government is buying small, but significant amounts of fuel on a daily basis (considered by some commentators as being additions to US reserves in case of oil supply disruptions if there is a Middle East security “event”), thereby increasing “consumption” and creating a wariness among traders - and;
  • China and several other emerging countries are still showing strong growth; and,
  • Most obviously, the very soft US dollar.

Fuel price index: Increases in USD vs EUR: Sep-07 (=1) to Apr-08

Source: Centre for Asia Pacific Aviation, US Energy Information Administration & Oanda.com

Although the major Middle East producers peg their currencies to the USD, necessarily their terms of trade with other countries are affected if their convertible income value falls as a result, even if inflation becomes a threat. So they have been happy to see the oil price rise. Even China, under fire last year for pegging the yuan to the USD, thereby cheapening its exports, has allowed its currency to rise nearly 10% in the last 12 months.

But the biggest gainer against the US currency has been the euro, up by 18% in the past 12 months. This has put European airlines - generally with aircraft finance prices also denominated in USD and a larger share of their revenue in euros – in a very powerful position relative to their US competitors. They will be well placed if the next round of US-EU open skies negotiations actually leads to an increase in the foreign ownership ceiling for US airlines.

The possibility of buying into US dollar-denominated airlines, most of whose stocks are currently graded as junk by the various ratings authorities, will be highly attractive – provided they can acquire reasonably substantial equity levels.

But, apart from this silver lining for some, when does the seemingly remorseless oil price trend reverse? It might be soon.

Despite yesterday’s rise on Wall St, the Federal Reserve will be concerned at the growing spectre of stagflation. US consumer prices rose strongly in March, as the US dollar fell and oil prices rose; yet the economy is clearly slowing rapidly, with home starts dropping 12% last month, to the lowest level for 17 years.

The logical outcome of that should be reduced demand and, at least, a stop to interest rate reductions (and even an increase). If we have to put our money where our mouth is, we suggest that we are near the top. Oil prices should start to level out and then to slide, as economies soften and the US dollar stabilises. That would at least be good for US airlines.

But in reality, the main problem is not costs – but revenues; the threat of globally softening demand is expanding far beyond the slowing US market. That is where the concern really lies.


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