ANALYSIS: Looking beyond the short-term impact of low oil prices
Recent and apparently continuing falls in the oil price – with Brent trading below $50 per barrel today – provides further evidence of the difficulties associated with forecasting, writes CTAIRA analyst

Recent and apparently continuing falls in the oil price – with Brent trading below $50 per barrel today – provides further evidence of the difficulties associated with forecasting, writes CTAIRA analyst Chris Tarry.

All the justifications for the drops to date – which predominantly relate to too much supply relative to demand, and the continual resetting of what might be the lowest point – fall more into the category of a view than a forecast with a demonstrable causal chain.

To this end, is what we are seeing a short-term change or a structural resetting of the oil price? Nobody really knows with any certainty. Most recently, we have had analysts at an investment bank suggesting that Brent could fall to $40 a barrel, and BP suggesting it expects oil to be in the $50-60 per barrel range for the next two to three years.

At the simplest level, the fall in the oil price demonstrates the inescapable relationship between supply, demand and price. It also clearly illustrates why a systems approach, rather than an isolationist one, is necessary when looking at events and their consequences.

For the airline industry, what's important is not only the impact that the fall in oil and fuel prices might have on financial performance – as a result of lower input cost – and on decisions regarding new aircraft orders. There is also the question of what effects the lower oil price will have on GDP growth and, particularly, disposal income, given the importance of economic activity as a driver of underlying traffic growth.

In the near term, the fall in the oil price is more likely to rebalance household incomes by reducing the share of expenditure on fuel, rather than to materially increase them.

In terms of economic growth consequences, the latest expectation for 2014 is that GDP grew by 2.6%, a rate broadly similar to the 2.5% reported in 2013 and representing a worse outcome than originally expected for 2014. For 2015, the latest forecast from the World Bank suggests an outcome of 3%, rising to some 3.3% by 2017.

In a recent report, the World Bank says the fall in the oil price will "support global activity and help offset some of the headwinds to growth in oil-importing developing economies. However, it will dampen the growth prospects for oil-exporting countries, with significant regional repercussions." Politicians in some countries have pointed out local economic impacts: in the UK, it has been suggested the oil price fall will add half a percentage point to growth in 2015.

However, even in those economies where the oil price fall is seen as positive, we should not assume this will lead to a near-term improvement in the underlying rate of fare-neutral traffic growth.

For the airline industry, the fall in the fuel price has a potentially positive benefit, but what happens next will be crucial to ensure this is retained rather than given away. At the simplest level, the financial impact of lower fuel prices on airlines results from lower operating costs. The extent and timing of the decline depends on the degree of hedging – both of fuel and, where necessary, the US dollar, too.

Inevitably, this results in a lagged impact. The fall in the fuel price will also undoubtedly focus attention on and result in debates on airline hedging policies. Hedging provides a greater degree of financial certainty against budget, rather than being a profit centre in its own right, which would have significant implications for risk management. Given this, the current fall in the fuel price should not result in a material change in hedging policy.

As an aside, those airlines without hedging in place for whatever reason – policy or lack of financial capacity – will benefit from the fall immediately but, conversely, are the first to feel a direct impact when prices rise.

A key concern is the potential for too much capacity to come into service, particularly in the short-haul market. Looking into 2015, this remains a problem, given the expected fall in yield of some 5% outlined in IATA's latest forecast. The risk is that while operating costs over time will decrease, there is a greater-than-expected increase in capacity, which results in greater pressure on fares. This would remove the potential for improved profits, despite the benefit arising from higher load factors.

On the subject of aircraft orders, some commentators have suggested that the fall in the oil price will result in cancellations and deferrals of existing orders. We have also heard the view from one manufacturer that the fall in the oil price will enable airlines to make more money, and that when they "make more money they tend to buy more aircraft".

These views reflect either end of what is a wide spectrum, where the change in the oil or fuel price is not the only determining factor in the choice and timing of aircraft ordering.

Despite the excitement at the time of the launch of the Airbus Neo and Boeing Max families, if we go back over a longer period of time it is clear there is no real link between oil price and the placing of orders for future delivery.

Aircraft are acquired to satisfy demand arising from a need to meet forecast growth, and to replace older aircraft already in service. Decisions are taken after what should be an exhaustive evaluation process. While fleet planners' assumptions need to be as close as possible to reality a number of years into the future, this has become increasingly difficult to predict in recent times.

In the narrowbody market, the combination of lower fuel prices and the lower ownership cost of older aircraft increases their attractiveness, relative to new-generation aircraft. But the notion that lower fuel prices alone will result in near-term deferrals and cancellations is likely to prove misplaced, as is the view that it will result in more orders.

The change in the apparent economics of the aircraft at today's fuel prices may well provide a convenient excuse for some airlines to cancel orders, but this will only occur when overambitious expectations are overtaken by an increasingly painful reality.

While the new-generation narrowbodies offer better fuel efficiency, there is a higher ownership cost. With the fuel price where it is now, there is a widespread recognition that the higher cost of ownership more than offsets the advertised efficiency gains. However, it is important to remember that, irrespective of whether the decline in the fuel price is transient or structural and long-lasting, orders for new aircraft will reflect growth plans of airlines.

Given that the aircraft in the future will be the Max and the Neo, and the supply of current-generation aircraft – with more attractive economics at current fuel prices – is constrained, the adjustment mechanism with respect to new aircraft will have more to do with price than volume

CTAIRA was formed in 2002 by Chris Tarry, recognised as the world's leading independent airline analyst.

Our focus is on all aspects of commercial aviation. Our clients include small, medium and major airlines, private equity houses, Government and regulatory bodies, airports banks and manufacturers. Our continually expanding client list is primarily based in Europe, the Middle East and Asia. Where necessary CTAIRA forms teams of established experts focused to address particular issues and it is also brought in to other groupings to add our independent and specialist perspectives. To find out how CTAIRA could help your business please call 01892 520207, or email christarry@ctaira.com.

by  Chris Tarry - 19th January 2015

Back to Top

###

Source: http://www.ctaira.com