Cheap oil comes with hidden risks for airlines

January 19, 2015

By Olaf Storbeck

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The falling oil price is a short-term blessing for airlines. In Europe, it might turn into a long-term curse. The real test for the industry is not whether profits increase in 2015, but whether it can limit the negative side effects of cheap fuel.

On average, fuel accounts for 30 percent of airlines’ operating costs. IATA, an industry body, says that lower jet fuel prices have reduced the global fuel bill by $20 billion in 2014. Lufthansa, Europe’s largest carrier by revenue, expects to pay 13 percent less this year than last, with the relief becoming more significant over time as past hedges unwind over the coming quarters.

Investors can follow the logic. The oil price is down by 54 percent over the last six months, and the Stoxx Europe Airlines index is up 31 percent, outperforming a virtually flat stock market.

However, lower fares will not increase demand enough to eliminate Europe’s substantial overcapacity. On the contrary, they are likely to worsen it. For struggling mid-sized airlines – including Germany’s Air Berlin, Italy’s Alitalia and Scandinavia’s SAS – cheaper fuel reduces the pressure to cut costs and capacity.

CityJet could be an indicator, as analysts at Liberum point out. The stricken Dublin-based regional carrier, hived off by Air France-KLM in 2014, finished a refinancing round on Jan. 12, selling and leasing back seven of its jets. It might not have managed if oil were still at $100 a barrel, instead of the current $49.

Cheaper fuel also gives more successful airlines an excuse to make mistakes. Lufthansa, which is involved in an acrimonious labour dispute, may yield to recalcitrant employees who can point to rising profit. On Jan. 15, an arbitration attempt collapsed, with pilots saying future strikes are probable.

Also, capacity increases are more likely to be excessive, if cheaper fuel prompts all the industry’s leaders to invest on the expectation of gaining market share in an expanding market. The likely result is profit-destroying competition.

Over the decades, airlines around the world have too often expanded too much in the good times. Cheaper oil offers an opportunity to repeat this mistake. Investors need to be on guard.

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” The likely result is profit-destroying competition.”

Yeah… competition does not actually destroy profits within an industry. It just spreads the profit over more companies. Cheap cotton did not destroy the shirt.

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