Airline fuel price hikes = opportunity to limit overcapacity.

At the start of 2022 the rise of jet fuel increased by approximately 90% and cost roughly 120% more than it did in 2021. This is particularly challenging as around 25% of an airlines operating cost is fuel and this ultimately increases the marginal cost of flying although this may foster greater capacity discipline.

Why has jet fuel increased In June 2022 West Texas Intermediate (WTI) crude oil was up 135% at $111 from the previous year. Refined jet fuel prices rose even more with the price per gallon at $4 which was a 90% increase since the start of 2022 and 215% since January 2021. The cause of these increases are:

• Refining capacity dropped significantly post-COVID-19 as refineries, seeing less demand, had shifted capacity away from producing jet fuel towards other fuels.

• Ukraine war had meant lower crude and refined exports especially to Europe.

• Supply side constraints in meeting the sudden demand for aviation fuel after the ending of the lockdown

American Airlines reported that the price it paid per gallon of jet fuel had risen more than a third over 2022, from $1.48 in 2020 to $2.04 in 2021. At the time, it said that each sustained one-cent rise in the per-gallon price would increase its fuel expense for 2022 by about $40 million.

But there are positives for the airlines McKinsey & Company identifies 3 reasons why high jet fuel prices might not be as bad for airlines as expected.

• Airlines can employ hedging strategies to protect themselves from rising oil prices. They can purchase large amounts of fuel contracts for future needs. This is at a price which they believe will be lower than in the future. They can also purchase a ‘call option’ which means buying the right to purchase fuel in the future at a price that is agreed today.

• Inelastic demand – airlines can pass on some the price increase to consumers as they have done in the past. Carriers typically pass on to consumers as much as 60% of a volatile rise in the price of fuel. However, the industry has been able to pass along costs more quickly, in large part because of high demand and a shift in consumer behaviour during the pandemic toward buying tickets closer to the date of travel – people need to travel after being locked up for two years. Analysis of previous years with high fuel prices suggest a positive correlation with unit revenue – see below:

• Higher fuel prices mean higher marginal costs (MC) of flying although the MC of operating a flight is low. Typically between 30-35% of an airlines cost is fully flight-variable – jet fuel, landing and passenger charges, air traffic control and food. This encourages carriers to add more capacity as the remainder of costs are predominately fixed – aircraft rental, flight crew salaries, and overheads so an additional flight does not lead to significantly higher cost.

In the past higher fuel prices has led to a more disciplined capacity deployment e.g. 2010 and 2012 – jet fuel prices 70% higher than 2003-2005 but operating margin much higher in 2010 to 2012 – see below.

With higher fuel prices, the marginal cost of operating increases, which in the past has led to more disciplined capacity deployment. Better discipline restores profitability.

Source: Why rising fuel prices might not be as bad for the airline sector as it seems. McKinsey and Company – 15th July 2022

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