Fuelling losses in the aviation industry

This yearÆs biggest talking points, the high cost of oil and the credit crunch, have pushed airlines into a painful position.
This isnÆt a good year for the aviation industry. Airlines, like everyone else, have been caught off guard by the massive increase in oil prices. While Asian airlines had hoped to be cashing in on a growing number of passengers, they are instead concentrating on how to keep themselves in the air.

There have already been two Asian casualties this year: the low-cost carrier Adam Air Indonesia and Oasis Hong Kong Airlines, which tried û and failed û to pioneer the budget model on long-haul flights. Even airlines that havenÆt been dealt a fatal blow are hurting. In July, Cathay Pacific Airways issued a profit warning, predicting that the financial results for the first half of the year are expected to be ôdisappointingö. The airline paid 60% more for its jet fuel in the first half of this year than it did in the same period last year. It reported that the most recent spot price for fuel was 93% higher than the average price in 2007.

ôAirlines have been more badly hit by high energy costs than possibly any other industry,ö says Anup Mysoor, head of CitiÆs industrial and aviation corporate banking team in Asia-Pacific.

One reason for this is that aviation fuel is one of the more expensive kinds of fuel. Before it can be put in a plane, the oil has to be refined, and the cost of refining has also risen due to a shortage of capacity. The expense of turning oil into aviation fuel has increased to around $30 a barrel from $3.50 in 2002, meaning airlines are now paying roughly $175 per barrel of fuel.

The situation is so bad that the cost of fuel has gone from being 20% of an average airlineÆs costs, to between 30% to 40%, and in the case of low-cost carriers, it can be as much as 50%. To counteract this, airlines have been cutting other costs, but that can only go so far, especially for the low-cost carriers whose business model was lean even before fuel prices went up. There is also the option of adding a fuel surcharge to the ticket price û raise that too high though and passengers will become discouraged from flying.

Airlines can also save money by cutting back on fleet sizes. Nicolas Parrot, BNP ParibasÆs head of aviation finance group Asia-Pacific, says that this is more common in the US, where most major carriers have announced cuts in the fleet size by 5% to 10%. But itÆs beginning to happen in Asia too. ôIt was very interesting to see that up until the end of May, most of the action that airlines have taken was to increase the fuel surcharge, but since early June, they have acted on the size of their fleet with capacity reduction and decreases in frequencies. At least five or six Asian carriers have announced fleet reduction or disposal of some aircraft.ö

One way in which banks can help airlines handle the high cost of fuel is through hedging. A smart airline might have hedged 50% of its expected fuel costs, but CitiÆs Mysoor thinks that this is probably not enough. What he recommends to some clients is hedge 90% of fuel costs in the first year, 50% in the second year, and 25% in the third year.

But what if the cost of fuel collapses and the airline is lumbered with paying for fuel at a higher price later? ôHigh levels of near-term hedging provide the airlines with control of their fuel costs and the focus can then be on revenue management to ensure the business is profitable,ö he says. ôA lower level of hedging in later years provides some cushion against fuel prices decreasing in the future.ö Furthermore, by not hedging, an airline is transferring the fuel risk to its investors, who are more interested in being exposed to the aviation industry than to the fuel markets.

The only problem with hedging is that it could be beyond the means of a low-cost carrier. ôItÆs not a cost-free business. Banks and commodity derivatives houses will want to see some collateral. If youÆre an airline with a low capital base and you go to the bank saying that you want to hedge against fuel prices, it can be difficult,ö says John Duffy, head of transport Asia, HSH Nordbank.

And cash to spend on hedging might be better used on something else û survival. Parrot of BNP Paribas recommends keeping money in the bank. ôWhen times become tough, the most important thing is cash, cash and cash. What you want is to have enough cash to go through the down cycle and wait for the better times. A lot of airlines could potentially be in a cash-burn situation right now, so the higher their cash balance, the longer they can stay alive,ö he says.

With a spate of US airlines already bankrupt, Asian airlines hope that Adam Air and Oasis have not started a similar trend in the region. NordbankÆs Duffy points out two ways in which Asian airlines might be more resilient to a downturn than their US counterparts. The first is that many Asian airlines are at least partially owned by the government, which means that they have an extra source of capital, combined with a desire to protect the national carrier. The other key point is that while there are some bilateral open skies agreements in Asia, there is no pan-Asian system. So the number of routes and their accessibility is quite restricted, which means that airlines are more sheltered against the effects of competition.

One more thing, Asian airlines might just be made of tougher stuff. It is not as if this is the first rough ride for Asian airlines in recent memory. They survived the 1997 Asian financial crisis and Sars. Using a cricket metaphor Duffy says: ôItÆs hard to bat against them when theyÆve seen these previous events.ö

A longer version of this story was initially published in the August issue of FinanceAsia magazine.
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