How airlines could adapt to rising fuel prices
Just like the airlines began their recovery from the COVID-19 pandemic, the sector was hit by another challenge: a rapid spike in fuel prices. Since the start of 2022, the price of jet fuel has increased by around 90% and costs around 120% more, on average, than in 2021, at the time of writing.
This price increase represents a significant challenge for airlines as fuel is often the largest operating cost, accounting for around 25% of total costs depending on the year.
Unexpectedly, high fuel prices are not necessarily bad for the industry. While this causes short-term pain, it also increases the marginal costs of flying, which can promote greater ability discipline. This, in turn, promotes a healthier economics of the industry and can contribute to profitability.
This article examines what airlines have done in the past when fuel prices were high and suggests strategies that airlines might consider to mitigate the effects of fuel price increases. We believe this is particularly important at a time when a potential recession looms and pressure is mounting for airlines to improve sustainability.
Soaring jet fuel
The price of crude oil and jet fuel has risen steadily through 2021 and reached new highs in early 2022. As of June 27, 2022, a barrel of West Texas Intermediate (WTI) crude oil is hovering around $111, rising around $135. percent since the start of 2021. Prices for refined products have risen further, with jet fuel now hovering around $4 per gallon in the U.S., up about 90% since the start of 2022 and around 215 % since January 2021 (Figure 1).
Additionally, a “perfect storm” leads to increased price volatility in some local markets, such as New York. Refining capacity declined significantly after COVID-19 as refineries, seeing less demand, shifted their jet fuel production capacity to other fuels. In addition, Russia’s invasion of Ukraine contributed to lower exports of crude oil and refined products, particularly to Europe. These factors have pushed up world prices for crude oil as well as middle distillates such as diesel and jet fuel. In addition to these global price increases, local logistical constraints to meet the sudden increase in aviation demand, in places like the Northeastern United States, have caused additional local price spikes specific to the jet fuel where the price per gallon exceeded $8.
These soaring energy costs represent the next hurdle for an industry still recovering from the COVID-19 pandemic. A major US airline recently stated in its annual report that for every penny a gallon the price of jet fuel increases, the airline’s total fuel bill will increase by $40 million.
Therefore, the recent 195-cent increase in jet fuel equates to an approximately $8 billion increase in annual fuel costs for this airline.
The right medicine?
Contrary to headlines, high jet fuel prices may not be as bad for airlines as expected, for three reasons. First, the major pain points are mostly short-term. Carriers differ in the degree to which they hedge fuel, but many will have already sold part of their tickets assuming lower fuel prices and have to carry passengers at higher fuel prices. However, the booking window has shortened considerably during COVID-19, so the share of tickets sold at the lower price assumption is relatively small and represents a short-term pain point.
Second, airlines can pass on some of the price increase to consumers, as they have done in the past. Analysis of past periods of high fuel price increases suggests a positive correlation with unit revenue (Figure 2).
Third, higher fuel prices mean higher marginal costs of flying, which can lead to greater capacity discipline. The airline industry has long been challenged in terms of creating shareholder value, and overcapacity has contributed to this. For an asset-intensive industry, the barriers to entry are surprisingly low, both to start an airline and for an airline to start a new route or flight. Moreover, the marginal cost of operating a flight is low. Typically, between 30 and 35% of an airline’s operating costs are fully variable depending on the flight (cost of kerosene, but also landing and passenger fees at the airport, as well as screening fees air traffic and in-flight catering).
This incentivizes airlines to add capacity, as most of the costs have already been incurred, such as aircraft leasing, flight crew salaries and overhead. Thus, an additional flight does not result in significantly higher costs while allowing the airline to pursue market share as the “golden ticket” to profitability. At the system level, however, this leads to overcapacity, eroding value.
With rising fuel prices, the marginal cost of operation increases, which in the past has led to a more disciplined deployment of capacity. Better discipline restores profitability. As an example, the period between 2010 and 2012 saw relatively high fuel prices – on average, the cost of jet fuel was about 70% higher than it had been between 2003 and 2005. report to GDP growth) improved and the average operating margin during this period was significantly higher than it had been from 2003 to 2005 (Table 3).
While there are certainly other factors at play, including consolidation, the much improved margin despite rising fuel prices stands out. Higher marginal costs have forced airlines to reassess route profitability, in some cases choosing not to fly certain routes because keeping them operational would cost more than keeping the aircraft grounded. This has led to more streamlined capacity behavior across the industry. For an industry where overcapacity is one of the main challenges to sustainable profitability, this reaction has been beneficial.
A potential way forward
Although high fuel prices are painful for airlines in the short term, it is possible for airlines to remain profitable in times of high and low fuel prices, and they have done so in the past. Deploying capabilities well is vitally important, especially given the increased pressure to be environmentally friendly and reduce emissions. The operation of ghost flights becomes unsustainable and flights in marginally profitable markets become less attractive. Higher interest rates and inflation will also create pressures, as the cost of borrowing to support an unprofitable operation can compound future earnings issues.
Going forward, airlines could consider ways to be more disciplined in deploying capacity and strategically focus their growth in areas of current strength and in markets where the carrier has a unique advantage, rather than aligning with competitors’ growth plans. It might also be worth considering updating fuel hedging strategies which can, in some cases, mitigate the impact of fuel price spikes.
Note: As oil prices are a commodity, they will continue to fluctuate, the views in this article reflect the overall scenario.