The double-edged sword of cheaper oil

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Cheaper oil can mean bigger profits, but beware the choices it presents, writes Helen Massy-Beresford.

The sharp fall in oil prices since 2014 is good news for airlines, which are enjoying a welcome boost to their profitability and passing on savings to their customers in the form of cheaper deals on fares. But, longer-term, the picture may not be quite so straightforward.

Brian Pearce, IATA’s chief economist, says: “Aviation is one of the most energy intensive industries. So, a drop in oil prices is critically important for the price of air travel and transport for business. That’s very positive news for the wider economy, air shippers and passengers, because sustained lower oil prices means that the cost of air transport is likely to stay low.”

Patrick Surry, chief data scientist at airfare prediction app Hopper says the effects are already filtering through to consumers: “We’ve seen typical consumer prices fall about 15% worldwide in US dollar terms, starting as oil prices plummeted in the second half of 2014.”

“For the next couple of years, at least, we’re in for a period of relatively low prices. We’re seeing that reflected in the futures markets for oil,” explains Pearce. The futures market is where airlines hedge, buying future quantities of fuel at a fixed price.

Pearce says: “Hedging should be risk management—insurance not a bet. It does stabilise your fuel costs so that’s an uncertainty that you remove. Obviously it comes at a cost.” For some airlines, that policy has delayed the positive effects of lower oil prices.

“The key thing about hedging is it’s far more of an art than a science,” says John Strickland, an airline strategy consultant. “It has risks either way. An airline can be locked in to overpriced fuel or feel the benefit. The key thing is to get consistency on price. Sometimes an airline will tolerate the risk of a higher price to have that certainty.”

Strickland also notes that currency plays a role: “Not all airlines have the full benefit [of lower oil prices]…because fuel is denominated in dollars. Currency changes reduce the impact for some airlines.”

Cheap can be difficult

Hedging policies and currency issues aside, the lower oil price actually presents difficult decisions for airlines and could, paradoxically, diminish profitability in time.

Pearce explains that for network growth generally, it will likely be a horses for courses, situation, with some airlines preferring to focus on their return on capital, rather than market share through new routes. He sees South East Asia as a region that will see network expansion. “You’ve got new entrant airlines, low oil prices and low interest rates, so it’s going to be easy for people to enter those markets [with new routes]. I suspect we’ll see more of that.”

An example of a market that tends to focus on return on capital is North America. “The more mature markets, the US domestic market being one, are more stable in their structure,” says Pearce, pointing out why it is unlikely to be an area of great route development.

In Strickland’s opinion, airlines that focus on return on capital may face a dilemma if their competitors boost capacity. In Europe, he cites Ryanair as an example of an airline with a strict capacity approach, but with the low oil price, he poses the question, “do [such airlines] sit tight or fight back to keep their market position?”

Expand the network or expand the bank balance; improve the fleet’s fuel efficiency or improve the return on capital to share holders; hedge against future prices or buy fuel at the market rate for now. Lower oil prices are a double-edged sword. Which edge is too sharp will likely depend on a lot of factors.