London, 29 Feb 2016
Volatility in oil markets poses a risk for airlines. An increase in crude oil prices lifts the industry’s largest input cost. But a price decrease, such as that experienced in the past 18 months, can also cause problems.
Brent prices fell in December 2015 below $US40 a barrel for the first time since 2009, down from $US115 in 2014.
While weakening crude oil prices enhance profits, they can also lead to lower airfares, spurring demand for travel and pushing airlines to increase capacity.
Macquarie Securities aviation analyst Douglas McNeill says if airlines add too many routes or expand their fleet, it can erode their profitability when oil prices recover.
However, he says management is taking a disciplined approach in the latest price downturn.
"So far, the rate of capacity addition does not strike us as being high enough to presage trouble," he says.
"Airlines are tending to strike the right balance between adding capacity, banking the benefit of cheaper fuel, and holding the line on passenger yields."
Euro depreciation may help
Low oil costs may still hold good news for European airlines.
Hedging tools mitigate the initial price decline in jet fuel, while the Euro’s 20 per cent depreciation against the US dollar since the start of 2014 has diluted the fall in oil prices, which are benchmarked in dollars.
Should the exchange rate stabilise, the benefits of cheaper fuel will be evident in coming months.
Airlines are tending to strike the right balance between adding capacity, banking the benefit of cheaper fuel, and holding the line on passenger yields.
The International Air Transport Association has forecast European carriers will boost profits by 23 per cent in 2016, helped by lower fuel costs, a recovery in the region’s economy and strong business travel on North Atlantic routes.
One development to watch in coming years is the emergence and growth of "in-house" low-cost carriers within established airline groups and their ability to gain market share without incurring losses.
New research model
Macquarie initiated coverage of the European airlines sector in August 2015, based on its ProbabilityMap proprietary research, which marries the principles of value investing with studies of behavioural finance.
According to McNeill, the airline industry needs a valuation approach that is sensitive to the cyclicality and volatility of the sector’s earnings.
The analysts assess a company’s valuation by:
- establishing its earnings power, based on what the business has demonstrated it can achieve over a period of several years, rather than forecasts, and
- considering future developments that may alter shareholder value; as these are uncertain, determining the probability of events occurring.
This technique helps identify the anomalies and assumptions from which future share price movements may result.
Decreasing fuel prices, fare competition and the emergence of the low-cost carriers within established airlines will all be key factors in shaping the future outlook for Europe's airline industry.
For more information on the report "Industry Initiation: European airlines" (14 August 2015) contact Macquarie Research.
To find out more about Macquarie’s European airline crude and jet trading & hedging expertise please contact Benjamin Davis, Energy Markets Division, Commodities & Financial Markets.