Fuel prices have a direct and significant impact on the airline industry. The recent trend of rising fuel prices has adversely affected the industry in several ways. The paper discusses the effect of rising fuel prices on the airline industry. The paper is divided into three sections. The first section highlights the impact of fuel prices on profitability of the industry. The second section covers the measures taken by the airlines to combat the adverse effects of rise in fuel prices. The third section concludes the paper.
Impact of Fuel Prices of Airline Industry
Rise in fuel price undercuts the bottom line of an airline. Fuel is an important element adding to overhead cost of flying airplanes. With recent trend of rise in fuel prices, fuel is becoming more significant in total cost structures of airlines. Fuel accounted for 13% of airlines’ operating cost in 2002 that increased to 28% in 2013 (GAO 7). This has been on account of increase in aviation fuel prices. Airline for America is the main association of airlines in the aviation industry. It has stated that rise in oil prices led to significant losses in the industry. In 2005 and 2008, the extent of loss was $5.7 billion and $9.5 billion respectively (GAO 9).
Response of Airlines to Combat Fuel Price Rise
The airlines have borne major losses due to sharp rises in fuel prices. Learning from these lessons, airlines are becoming more cautious and prepared for sudden fuel price rises. The two main measures taken by airline industry to combat fuel prices is fuel hedging and backward integration, which is covered in detail in this section. Apart from this, airlines also beat fuel price increases by reducing investment activity, raising their fares (with strong demand in the industry) and consolidation.
Airlines have learnt that fuel prices are volatile and cannot be relied upon. The oil prices depend upon a variety of factors, both national and international. For instance, recent tensions, including in the Ukraine, have sparked an upward trend (IATA n.pag.). To reduce the risk of losses due to fuel price rises, the airlines are relying on fuel hedging. Most airline companies try to reduce the effect of fluctuating crude prices by hedging their fuel risks using derivatives instruments (Chandrappa n.pag.).
Commodity derivative markets have become more mature these days and provide options that not only protect against price rises, but also provide option to draw away from the contract if prices are unfavourable. These options, however, come with extra cost and act as a discouragement for airlines to fully hedge prices of their fuel requirement.
Backward integration is another way to hedge fuel cost by having own refineries. Delta Air Lines (DAL.N) bought its own refinery in 2012 to address the risks from fuel prices (Hackett n.pag.). There are three main reasons why most airlines do not opt for this option. First, buying own refinery cost intensive. Second, there exists a risk of diversion of focus from the core business. Third, generating profits from refining business is a difficult task.
Rising fuel prices have a direct and adverse impact on the bottom line of airlines. It increases overheads of firms and undercuts their profits. Firms in aviation industry have faced severe losses due to sharp increases in fuel prices. To combat this situation, airlines are relying on fuel hedging and buying of refineries. While the latter is a cost intensive option, hedging is a more feasible and easy option to keep to control fuel price risk.
Chandrappa Tejeshwari. “Southwest’s Fuel Hedging Overview as on June 2014”. Finance.yahoo.com, 22. Aug. 2014. 2 Nov. 2014.
GAO, Government Accountability Office. “Aviation: Impact of Fuel Price Increases on the Aviation Industry”. Gao.gov, Sep 2014. Web. 2 Nov. 2014.
IATA, International Air Transport Association. “Industry on Track for Second Year of Improving Profits”. Iata.org, 12. Mar. 2014. Web. 2 Nov. 2014.
Hackett Paul. “Air Industry Mulls Jet Fuel Hedging Options”. Reuters.com, 20. Jan. 2014. Web. 2 Nov. 2014.