Surging Oil Prices Finally Catch Up to Airlines

 Alan Neuhauser
  7th-Sep-2018

FROM HIGHER PRICES AT the pump to more expensive freight shipping, the rising cost of crude oil has sent ripples across the U.S. economy.

Now it's hitting the airlines.

Jet fuel prices are soaring – more than a third higher than the same period last year, buoyed by global economic growth and surging demand for fuel that's pushed benchmark crude prices to their highest points in four years.

The rebound comes after oil plummeted from nearly $130 per barrel in April 2011 to almost $28 in February 2016 – a low not seen in more than a decade. At the time, jet fuel prices also dropped – a discount that began to be reflected in airfares a few months later.

Like the lumbering jets they fly, airlines don't turn on a dime. Between updating routes, hiring and training crew members, acquiring aircraft and renting or swapping airport gates, it can take as long as two years for a change in fuel price to show up in airfares. Most recently, the average ticket price has continued to fall even as fuel prices have recovered since 2016.

But that appears to be over. While U.S. flyers have seen some of the lowest average ticket prices in more than a decade, the discount is expected to end as early as this month.

"The question we have yet to see is: How much can they push onto consumers?" says Adam Cowburn, managing director and co-founder of Alton Aviation Consultancy. "We'll likely see that translate into higher prices as we leave the summer leisure travel season and transition into the hardcore business travel season in the fall."

Some analysts contend that U.S. airlines will struggle to pass their new fuel costs onto consumers: A steady expansion in capacity by United, combined with competition from low-cost carriers such as Spirit, Frontier and JetBlue, could put downward pressure on airfare.

However, the surge in fuel prices is already having impacts in the industry: Some U.S. airlines last month began eliminating or reducing the frequency of less profitable routes, especially long-haul flights where fuel makes up a far larger share of the cost.

American Airlines, for example, reportedly said Aug. 24 that it would stop service between Chicago and Shanghai as a result of the "current fuel and competitive environment." The announcement came the same day Hawaiian Airlines halted flights from Honolulu to Beijing.

"Very long international routes are disproportionately hurt by high fuel," says Dave Emerson, former head of Bain & Company's global airlines practice and a partner at the firm. "If those routes were great, the increased fuel price wouldn't be enough to sink them. But on the margin, that decision becomes a lot easier and clear and a lot more necessary in a high-fuel environment."

The costlier fuel prices could bode well for airplane manufacturers: Analysts expect that airlines will likely accelerate the retirement of older, less fuel-efficient planes and replace them with more efficient models, such as the latest versions of the Boeing 777 or Airbus A350, or smaller offerings from companies like Embraer or Bombardier.

"I've seen a lot of aircraft substitution where they've used Bombardier aircraft, Embraer aircraft, for these midrange routes – Atlanta to D.C., Atlanta to Hartford, using regional jets rather than those larger aircraft," says Robin Lineberger, who leads the Aerospace and Defense Industry practice at Deloitte.

Fuel makes up the second-largest expense for airlines, behind labor costs. While on a single flight, the price of fuel might make up about a third of the operating cost, industry-wide the share of fuel costs has climbed from 14 percent of airlines' operating expenses in 2003 to an estimated 24 percent this year, according to the International Air Transport Association. Meanwhile, jet fuel prices have steadily climbed nearly 140 percent since 2016.

This spring, U.S. airlines began lowering their profit outlooks for this year, and some executives openly acknowledged that flyers from coach to first class could soon expect to pay more for flights.

I do believe that consumers will pay more," American Airlines Chief Executive Doug Parker reportedly said in April, following a 12 percent rise in jet fuel costs over just two weeks.

According to one rough rule of thumb, for every 10 percent increase in fuel costs, ticket prices climb about 2-3 percent.

"When fuel prices go up, ticket prices have to go up for airlines to stay in business – there's no long-term way for the consumer to insulate themselves from the fare impact of high fuel prices," Emerson says. "Whether it's an ultra-low-cost airline like Spirit or a full-service carrier like American or Delta, everyone's burning a lot of jet fuel. The impact on consumers is that fares will have to rise to cover the increased cost over time."

However, whether airlines have to hike their airfares is a matter of disagreement.

"Clearly their profits are under a degree of pressure" from higher fuel prices, Cowburn says, but with discipline they'll likely remain "at healthy levels even with the recent fuel price uptick."

It is true that U.S. flyers have recently enjoyed the lowest average ticket prices in 15 years: Even as airlines trimmed legroom, in-flight services and other amenities, and introduced new fees on bags, emergency-exit seats and even the ability to choose a seat at all, the average fare this year sunk to about $346 – 20-percent less than the peak of nearly $420 reached in 2014 when adjusted for inflation, according to federal data.

But it would appear that airfares could or should have fallen even lower.

The four largest domestic airlines – American, Delta, Southwest and United – reported a $22 billion windfall after fuel prices plummeted in 2016. And even as fuel prices began to rise, U.S. airlines reported their second most profitable year in 2017, and they're expected to account for almost half of the industry's global profitability in 2018.

From a consumer perspective, analysts say, the past five years have represented an especially unfriendly period for domestic air travel, with relatively little apparent consumer benefit compared to record airline profits.

There are some dynamics that may help blunt the expected impact of jet fuel prices on airfare: Amid the strong global economy, more people are flying, meaning flights are generally more full. Some airlines have also managed to successfully hedge their fuel costs through financial instruments that let them lock in prices in advance.

Southwest, for example, bought such derivatives when prices were low, helping insulate the carrier from rising fuel costs. But Cathay Pacific, based in Hong Kong, bet that prices would stay high, and it's still suffering the consequences of locking in costly fuel prices two years later.

Delta, in a highly unusual move, purchased an oil refinery in Pennsylvania in 2012. The facility got walloped by Superstorm Sandy shortly after, but analysts now say the refinery may give the airline a crucial edge, though whether it pays off over the long term remains to be seen.

"Airlines are no better fortune tellers than any other investors," Emerson says. "The hedging strategy generally is a strategy to allow them to buy time. If it takes six, 12, 18 months to adapt to a higher fuel price without losing profits, if you hedge your fuel you cushion the blow."

However, jet fuel prices have climbed as labor costs for airlines have also been on the rise: After accepting pay cuts, layoffs and other concessions to help keep airlines afloat in the wake of the Great Recession, workers negotiated for wage increases in their next rounds of contracts, which typically come in three- to four-year cycles.

"In this very strong economy and very high relative profits, a lot of U.S. airlines are finding new labor agreements at significantly higher rates," Emerson, of Bain & Company, says.

In many ways, the dynamics reflect what the industry – and its customers – went through about 10 years ago, when benchmark fuel prices were similarly climbing to about $75 per barrel from 2004-2006. Unlike that period, however, where Continental, Northwest and US Airways were among the major airlines competing for customers, the four largest U.S. carriers now make up more than two-thirds of the industry's domestic market share and have relatively few routes that overlap.

By comparison, in more competitive markets such as Western Europe and Southeast Asia, where competition is fierce between budget carriers, airlines have struggled to pass their fuel costs onto consumers.

"It is true that [U.S.] airlines didn't pass along to consumers as much of the declining fuel costs as they did in the past," Emerson says. "As a consumer you might miss those benefits. As an employee, on the other hand, you probably don't miss the regular rounds of concessions and layoffs."

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