Are low fuel prices always good news for airlines and passengers?

The prices that airlines are paying for fuel today are some of the lowest in the last decade, whether they are expected to last or not, there is no doubt they are having a significant effect on the airline industry. While the obvious impact is on lower costs for airlines, the story has some troubling twists – billions spent on new technology that doesn’t seem such a good investment in today's conditions, low cost business models undermined by handing lower costs to their competitors, and could the industry be heading for catastrophe when prices rise again?

In the aviation industry few things are as critical or unpredictable as fuel prices. In the early 2010s, fuel prices were rising and appeared likely to rise indefinitely. The logic was simple economics – fuel is a scarce commodity in extremely high demand, under the pressure of an expanding and gentrifying global population. However, this understanding was shattered by disagreements between the major fuel producers on the global political stage.

Figure 1 - Jet fuel price development over the last decade

Jet Fuel Price development over the last decade graph

Today’s prices are around half of those seen two years ago, and the price has held at or below this level for the last twelve months. Although those rules of high demand and scarce resources will have to resume eventually, the OPEC countries (or any other major oil producer for that matter) are continuing with relatively high production levels and so it seems that these low prices are here to stay for at least a little while longer.

The impact that this has on aviation is generally positive. While airlines and airports in geographic areas that rely on oil production such as Brazil, Norway, Nigeria and the North-East of the UK are feeling the pinch as a result of the slump in local industry, the overall effect of lower cost-bases for the world’s airlines is far greater. For example, according to RDC's Apex the cost of operating a typical flight from Manchester to Malaga has reduced by around 22% compared to 2 years ago, with fuel reducing from a 35% share of the total cost of operation to just 17%.

Fuel Price and Investment in New Aircraft

All of this appears to be undermining decades of progress in reducing airline fuel burn. The low cost airlines have been leaders in maximising fuel efficiency through two key policies: reducing cabin weight, flying at high load factors and purchasing the newest most fuel-efficient aircraft available. Fuel-saving will always be important regardless of the price, however the business case for investing current capital to save future fuel cost has changed significantly.

Figure 2 - Breakeven Fare on typical short-haul route with varying fuel price and aircraft type (RDCApex.com)

Breakeven Fare on typical short-haul route with varying fuel price and aircraft type (RDCApex.com)

The chart above demonstrates the differential in operating cost at various fuel prices for both an older aircraft (in this example, a Boeing 737-300) and a newer model (Airbus A319). What we can see is that in 2013 the Airbus A319 would have brought an €18 (12.6%) saving in operating cost per passenger (i.e. breakeven fare) over the 737-300, but at today’s prices the saving is only €11 (9.8%). It is also notable that in our example, the cost of operating the older aircraft is now lower than the 2013 cost of operating the newer aircraft – this means that many marginal routes have become financially viable for airlines even with older fleets.

Figure 3 - Breakeven Fare on typical long-haul route with varying fuel price and aircraft type (RDCApex.com)

Breakeven Fare on typical long-haul route with varying fuel price and aircraft type (RDCApex.com)

The effect of lower fuel prices is magnified on long-haul routes, where the fuel burn accounts for a greater proportion of the cost. In the example above, a new-build 787-8 is compared against an older 767-300ER – a fleet transition that many airlines have made, or are committed to making, including British Airways, Thomson Airways, United Airlines and ANA. We see that the €45 (10.8%) improvement in per-seat cost has been virtually eliminated at today’s fuel prices, with only a €9 (3.5%) improvement over the older model, which of course has cheaper ownership costs.

Figure 4 - Breakeven fare comparison for Norwegian and British Airways on London-New York routes (RDCApex.com)

Breakeven Fare comparison for Norwegian and British Airways on London-New York routes (RDCApex.com)

To take an area of topical interest, Norwegian has been expanding its operations into the long-haul market, including transatlantic from London Gatwick Airport in competition with British Airways at both Gatwick and Heathrow. When the airline originally planned this base in 2013 (for launch in 2014), it would have seen a potential saving in per-seat costs of €84 (27%) over its rival. In 2016 we have seen that this has been reduced to €52 (26%). However, the airline is likely to see itself as a market stimulator (through bargain-bucket fares) rather than a direct competitor to British Airways’ premium product. In which case it should view the overall situation as positive, even if (with the benefit of hindsight) it may have been wise to acquire cheaper aircraft than the Dreamliner.

Are airlines passing this on to customers?

Short answer = probably not, they’re private companies with shareholders to satisfy

Long answer = it is not as simple as that. First of all, we have to remember that most airlines are fuel-hedged to some degree, so it has taken several years to see the full benefit of the drop in fuel prices. But even if we assume market rates, the drop only equates to around £10 on the average short-haul ticket, and in the fast-moving world of airline yield management a number like that often gets lost in the noise. Primarily, airline pricing schemes (especially for LCC’s) are demand-driven rather than cost-driven, meaning that prices are based on consumer willingness to pay – if the price is too high consumers don’t buy and the price comes down to fill the aircraft, likewise if the price is too low and the aircraft is selling out too quickly the price will rocket up.

It goes without saying that a drop in fuel price hasn’t actually changed consumer willingness to pay.

Figure 5 - European LCC Fares compared with breakeven fare of typical European LCC route over time (RDCApex.com)

European LCC Fares compared with breakeven fare of typical European LCC route over time (RDCApex.com)

This effect (or lack of it) can be seen in the above chart. 2015 was a relatively successful year for the European aviation business, with yields significantly higher than previous years, even with a capacity surplus in many areas. The fact that fuel prices were also at a decade low is nothing more than a happy coincidence.

There are some exceptions to this view of the world that need to be mentioned. Firstly, on highly competitive routes lower fuel costs create extra room for predatory airlines to drop prices in order to gain market share – with competitors usually following accordingly. Secondly, if airline profit margins rise, we would expect investment in extra capacity and new routes, which should bring prices down eventually, but again this is a long-term effect on an issue that is not expected to last into the long-term. So in the short-term here-and-now the answer is no – airlines will not be passing on cost savings to passengers.

Summary

While the fuel price remains low airlines will be sure to reap the rewards. Margins will be higher and the incentive to invest in or replace the current fleet has been significantly diminished. However the industry is precariously close to the edge of a metaphorical cliff. In the second half of 2016 we have seen worryingly soft yields (seemingly a combination of Brexit, terrorist activities and/or oversupply in the market). While airlines seems to be able to absorb this for the moment with healthy cost bases, should fuel prices return to 2013 levels and yields remaining worryingly low, margins will be all but wiped out and the industry may find itself in a downward spiral once again.

By Dan Irvine / Connect on LinkedInPicture of Dan Irvine