Airline margins: squeeze is on as Brent crude oil touches USD80
On 17-May-2018 Brent crude oil touched USD80 for the first time since Nov-2014. As of 17-May-2018, the average Brent crude oil price for the year to date was USD69 – a 28% increase on 2017's average price of USD54. If the price were to remain at USD80 for the rest of the year, the average for 2018 would then be USD76, which is 40% up on last year.
Based on the year to date jet fuel price of USD83 per barrel, IATA estimates that the world's airlines will pay USD39.3 billion more for fuel in 2018 than in 2017. With net profit at USD34.5 billion in 2017, this is a significant additional cost.
It is a sign of the airline industry's greater resilience that it can face the prospect of such a significant increase in fuel costs without the prospect of losses. Nevertheless, it is likely to be a factor in taking airline operating profit margins further down from recent cyclical peaks.
- Oil prices are up more than 50% year-on-year and jet fuel costs could rise to 23% of airline industry revenue in 2018 (vs 17% in 2017).
- Annual oil price changes move broadly with global GDP but the recent price rise goes further, and is likely to squeeze airline margins.
- Airlines' ability to raise fares/surcharges enough to offset the additional cost will depend on the supply/demand balance.
Oil prices are up more than 50% year-on-year
On 21-May-2018 oil prices retreated from USD80, falling to USD78.5, but this was still up by more than 50% year-on-year.
Brent crude USD per barrel: Jan-2000 to May-2018
Fuel costs could rise to 23% of revenue in 2018 (vs 17% in 2017)
Oil prices drive jet fuel prices and the airline industry's fuel cost. Not surprisingly, there is a close relationship between Brent prices in real terms and fuel costs as a percentage of revenue in the airline industry.
However, the relationship is not exact, since a number of factors introduce distortions. These include fuel hedging, which smooths out and delays the impact of price fluctuations, currency movements, and long term improvements in the fuel efficiency of aircraft engines and airline operational processes.
In 2017, the world airline fuel bill was USD130 billion, or 17.2% of revenue (according to data from IATA). This percentage of revenue was a significant drop in only three years from 29.2% in 2014 (and from a peak of 32.3% in 2012), and the lowest since 2004.
The Jan-2018 CAPA world airline operating profit forecast modelled a Brent crude price of USD61 and estimated that fuel costs would be around 19% of revenue in 2018.
Extrapolating year to date Brent prices through all of 2018 could take fuel costs to 23% of revenue or more (depending also on what happens to revenue).
Brent crude oil price per barrel* and airline industry fuel cost as a percentage of revenue: 1979-2017e
Annual oil price changes move broadly with global GDP, but the recent rise goes further
Historically, there has been a broadly positive correlation between the annual change in real oil prices and the annual change in global GDP (also in real terms). This is not surprising, since healthy economic growth increases the demand for oil and, hence, the price of oil.
However, this relationship is far from perfect, since oil prices are affected by a range of factors, including artificial limits to supply, geopolitical events, and developments in the means of oil production.
This recent oil price increase far outstrips anything that could directly be attributed to increased global GDP growth. In Apr-2018 the IMF increased its global GDP growth forecast for 2018, but only modestly – from 3.3% to 3.4%.
The OPEC countries, effectively led by Saudi Arabia and Russia, began limiting oil supplies in 2017 in order to push up the price of crude. More recently, oil prices have been further boosted by renewed US sanctions on Iran and the collapse of the economy in Venezuela (an oil producer).
Annual change in real Brent crude price and real world GDP growth: 1971 to 2017
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This is likely to squeeze airline margins
The increase in oil prices will mean that fuel costs increase as a percentage of airline revenue. This is likely to have a negative impact on the operating profit margin of the world airline industry.
Historically, there has been an inverse relationship between fuel costs as a percentage of revenue and operating margin.
But margins grew as fuel costs rose in 2003 to 2007
The only period during the past four decades when this has not been the case was in 2003-2007, when both variables increased at the same time. Airlines were able to increase their margins, in spite of rising fuel costs, thanks to the strength of demand and a noticeable tightening of supply.
Demand was driven by three years of healthy world GDP growth (in the range of 3.5%-4.0% in 2004 to 2007) and a reduction in global fleet growth to around 3%-3.5% in those years, after several years in the range of 4%-6% previously.
The favourable supply/demand balance created by these conditions allowed the airlines to recover increased fuel costs from customers through fuel surcharges during that period.
Airline fuel cost as a percentage of revenue and airline operating margin: 1979-2017e
Airlines' ability to raise fares/surcharges enough will depend on the supply/demand balance
Historically, average passenger revenue per passenger has risen and fallen broadly in line with oil price fluctuations. A rising oil price environment will almost certainly mean that fares will increase.
Indeed, fuel surcharges have started to reappear recently at some airlines, but airlines' ability to offset the impact of increased fuel costs in full (whether through surcharges or just plain fare hikes) will depend on the balance of supply and demand.
The outlook for GDP is healthy, but not exceptionally so. Moreover, the IMF's Apr-2018 economic outlook said "upside and downside risks to the short-term outlook are broadly balanced", but it added "risks beyond the next several quarters clearly lean to the downside".
World airlines: passenger revenue per passenger* (USD) and Brent crude oil price per barrel (USD), 2004 to 2017e
Higher oil prices should lead to increased aircraft retirement rates
CAPA's world airline operating margin model forecast of Jan-2018 noted that supply – as defined by growth in the commercial jet aircraft fleet – was set to stay above 4% throughout 2017 to 2019, the highest growth rates since the early 2000s.
Higher oil prices could serve to reduce fleet growth if they lead to an increase in the retirements of older, less fuel efficient aircraft. Historically, retirement rates have increased broadly in line with increases in fuel costs as a percentage of revenue.
Aircraft* retirements as a percentage of deliveries (left hand axis) and airline fuel cost as a percentage of revenue: 1979-2017e
Cutting ex fuel costs should now come more into focus
The world airline industry's recent period of historically high operating margins can largely be attributed to lower unit fuel cost.
As oil prices climb once more, the pressure is growing on the industry to cut ex fuel unit costs – something on which it has not done a great job in recent years. The industry is unlikely to be able to rely on fare/fuel surcharge increases to offset higher fuel costs.
World airlines: revenue per ASK and cost per ASK (USc), 2003 to 2017e
The next update to the CAPA world airline operating margin model will be published in Jul-2018
If the average Brent crude oil price does increase by as much as 29% to 40% in 2018, this could put considerable strain on airline margins. These kinds of oil price increases are approaching those associated with previous rapid downswings in the profit cycle.
Nevertheless, margins are starting from a higher level than in previous cycles when oil prices have jumped, and airlines now have a more profit-focused approach than in previous decades.
Their ability to absorb the additional fuel cost will be determined by the balance of supply and demand.
Demand is largely driven by the strength of the economy, whereas supply is more controllable by airlines. A prolonged period of higher oil prices may encourage more aircraft retirements, helping to limit supply growth.
However, the size of the aircraft order backlog may also encourage airlines to continue with older aircraft, since delivery slots are some time away in the future.
Forecasting oil prices is fraught with uncertainties, and is certainly not a prediction in the purpose of this report. The trend has been upwards over the past 12 months, but they could also fall if higher prices choke demand.
CAPA's next update to its world airline operating margin forecast will be published in Jul-2018. It will incorporate a view on the impact of higher oil prices on world airline margins, already projected to be on a modest declining curve after the peak of 2016.