We know prices are rising now, but we think this is a temporary condition due to unrest in Middle East. If speculators step in, prices can spike even further. But in the long term we think the trend will be in the opposite direction.
This is chart typical of one sees when doing any research on oil prices and aviation. It’s always a line running sharply to the right hand top corner. Just the kind of curve to make every airline manager (and analyst) cringe. How does one square this chart with the ever reducing real cost of air travel? How can airlines ever become profitable? Yet many airlines are profitable and, of late, more so than in many years.
IATA’s data demonstrates how quickly airline profits bounce back when fuel prices fall. In 2008 the world had a short reprieve from oil price shocks. But it did not last long.
In fact when one looks at the impact of fuel costs on total airline costs, we get the same picture, as illustrated here by IATA data.
It is really quite depressing isn’t it? Yet traffic keeps growing and, despite losses, airlines keep flying. Even the OEMs are seeing signs of continued confidence by way of massive backlogs in orders. The general hypothesis is that these orders are for the newest most fuel efficient airplanes money can buy. In the EU, taxes on fuel certainly encourage airlines to go for the lowest fuel burn possible. IATA points out in their Economics Briefing No 10, “Since 1970 air travel demand, measured by revenue Passenger Kilometers flown (rpks) has risen 10-fold, compared to a 3-4-fold expansion of the world economy. Air cargo demand, both reflecting and facilitating the globalization of business supply chains and economies generally, rose 14-fold.” Yet IATA found that the typical passenger only generated $2.56 in net profits for the industry. This razor thin margin simply cannot withstand shocks – and the cost of fuel has been impacted by a series of shocks. Airlines are, simply, too risky for many investors. The margin of profit is insufficient to offset the risk of an industry that regularly is impacted by exogenous factors, like oil, politics and health issues.
To this point this article reads like a brief on reasons not to be involved in the aviation industry. However, there is some very good news on the horizon and it is quite likely to be transformative for air travel. The good news can be summed up in two words “Shale Oil”.
Changing the Supply-Demand Balance
The Supply Side
Leonardo Maugeri at Harvard University provides an excellent analysis of the US shale oil boom. The numbers involved are eye popping: “Continental Resources now estimates that Bakken may hold 900 billion barrels OOP, a two-fold increase in the 2012 assessment. That would make Bakken’s endowment alone larger than Saudi Arabia.“ Bakken is one of three major oil shale areas in the US. In addition to finding so much “new” oil, drilling technology has also improved. Using a steerable rotary drill bit means that wells that took two weeks to complete now take ten days or less. In addition to improved technology, production productivity has improved as well – average production per well has doubled between 2007 and 2012. Texas’ oil production is now larger than some OPEC members. .
With all this extra oil production, traditional sources like OPEC can be expected to react. It did not take long for this to happen. But OPEC is not a monolithic body – some members simply don’t have the flexibility to handle sharply lower US demand. US crude production was up 20% to 7.37 million barrels a day in the week ended May 3, making it the highest level since February 1992, according to data from the U.S. Energy Department. If US production keeps growing at its current rate, there are estimates the country will have no need for foreign oil by the decade’s end.
Mr. Maugeri calculates that at $85 a barrel most shale oil wells repay capital costs within a year. He estimates that if oil prices fall steadily to $65 in five years, shale oil production will treble in the US because of increasing productivity per well and the easing of transport bottlenecks. By 2017, Mr. Maugeri thinks, the US will be producing nearly 11 million barrels a day which is equal to its previous production peak in 1970. Crucially, US oil imports peaked at 60% in 2005 and will probably below 40%. An amazing impact.
However the reason we have so much interest in shale oil is the current high oil price. Shale producers, just like OPEC, do not want to see prices fall below $100 per barrel. So it should be clear that all producers are goal congruent with respect to pricing. However it will be tough to stop the drillers now because they are getting better at their work, and US wells are likely to see profitability at even lower prices. OPEC will be stressed because of the disrupted Middle East. Whereas Saudi Arabia has throttled back production to keep prices high, they may less inclined going forward. To prevent any “Arab Spring” in that country, the royal family can be expected to continue to throw huge amounts of money at its restive population. As the link points out, the House of Saud has been doing this for a long time. If the choice was between selling its oil to garner cash to buy domestic calm or protect OPEC, we are betting on pacifying Saudi citizens before anything else.
The Demand Side
At the same time, the demand side of the Supply-Demand balance is also trending towards a model that requires less oil. Automobiles, the largest users of oil, will have mandated CAFE increases in 2016 and 2025 that will significantly cut fuel consumption. Those standards are documented in a presentation by an MIT Professor and show that on-road mileage will increase from 22 mpg in 2012 to 26 mpg in 2016 (an 18% improvement) with an additional increase to 35 mpg, (a further 34.6% improvement) in 2025. From 2012 to 2025, automobiles will reduce average consumption by 63.6%. That’s a meaningful reduction.
Aviation itself is seeing significant improvements in fuel economy, as the 727s and DC-9s have been phased out, and early model 737s and A320s will soon be replaced by A320neos and 737MAX models that are 15% more fuel efficient than current model aircraft, and are 20-30% more efficient than older generation aircraft. The net result is that demand, even with moderate economic growth, will fall significantly as new technologies enable higher fuel efficiency.
What Will Happen to Prices?
As economic history has shown, lower demand leads to lower prices, and increased supply also leads to lower prices. Logic suggests we are headed for a much lower oil price. This is the view of Mr. John Llewellyn in a report for Puma Oil. In Mr. Llewellyn’s report he details two schools of thought:
- The ‘peak-oil’ school which anticipates the price of oil in real terms will rise over time, perhaps to $200 per barrel
- The ‘technology-driven’ school which anticipates the price of oil in real terms will fall over time, perhaps to significantly below $100 per barrel
Mr. Llewellyn’s report concludes: “We judge that a sub-$100 per barrel price (Brent, in real terms) will eventuate by 2020 as a result of a number of economic and policy-driven factors.
Economic factor – A high oil price of around $100-120/barrel has driven, and will continue to drive, technological innovation, both in finding new reserves, and more efficient extraction. This contrasts sharply with the 1990s, where a price between $20-30/barrel effectively destroyed the incentive for development of new technologies. There is also much potential to switch to abundant low-cost substitutes, such as natural gas: global reserves held by the majors have risen by more than a third since the early 1990s.
Policy measures – To the extent that a carbon price is introduced more widely, this will raise the oil price in the short-term, reducing elastic demand. But in the medium-term it will also induce substitutes i.e. low-carbon alternatives, further lowering the demand for oil. To the extent that subsidies for fossil-fuels – which are important in a number of developing countries, including India – are removed or reduced, this will tend to reduce demand, and lower the oil price.”
In summary, we expect to see oil prices start to decline as production in the US impacts markets.This should be a major boost to the transportation sector, especially the airline industry. Among the US airlines, Delta Air Line’s decision to bet on keeping older aircraft in service looks like it could become a winning strategy. Its capital has been preserved by not ordering new aircraft to the same extent as its competitors. However the impact on OEMs and engine makers could be harsh. If oil prices do fall, possibly back to $65-$70 per barrel levels, there is likely to be sharp reduction in the new orders and huge backlogs for re-engined narrow-body aircraft. Delta will then be in a very compelling position to get very good pricing as it replaces old airplanes.
The question today is whether the OPEC cartel can be broken, or whether market forces take over and enable the supply-demand balance to reach an appropriate equilibrium. We’re betting on the latter.
Supply and demand have nothing to do with oil prices. As for the claim that unrest in the middle east is the cause for the latest spike, nonsense, those crazies have been at each others throats for years and its never going to change. Oil as a commodity has been played to the like a violin to the benefit of oil producers and oil companies. They raise prices by 50 cents then lower them by 25 cents and the gullible public is happy. Its been this type of pricing mind games that has led to what we have today, oil prices strangling the worlds economy. Oil, got to have it and it has done more to ruin businesses all over the world. Food prices, heating of homes, soaring electrical bills, high prices at the pumps are affecting billions by lost jobs and even interest rates at near zero cannot stop the downward spiral.
It costs no more to extract oil that it did a few years ago. Have oil producing workers seen their wages go up by 20 to 50 percent in the last 5 years?
No one in any of the worlds governments wants that to change as they are all making millions by the constant rise of oil prices.
Oil will drop by a few cents and the masses will breath a sigh of relief and go about their lives getting ready for the next hike in prices which without fail will come, but this is the new normal, a few profiting while the majority suffer as the quality of life deteriorates and nothing will ever stop this greed called capitalism.
Oil below 80$? Probably not, because the oil market is global. On a global scale the demand will not rise as fast but it will not fall. The number of planes will rise significantly on a global scale till 2020 and these highly efficient planes will need more fuel. The number of cars will rise also on a global scale look at china and india. China now the biggest market in the world and india growing strong. The slowdown in global growth will not stop these trends. So will the US import less oil? Yes but the rest of the oil will soon find new customers. The new technologies to drill for oil like deepwater, shale oil are more of a replacement for depleting older fields. In the end the supply of oil will be sufficient but there will be no oversupply. Oil between 80-120$ is here to stay.
Supply and demand is supposed to explain prices when the market is NOT being manipulated. In the end, I dont care if it’s being manipulated because high prices will only force us stupid humans to conserve more and pollute less. The only drawback of high prices is fracking and tar sands which would otherwise not be profitable… I think high prices are probably a net positive for our continued existence on this planet.
Stupid humans are still buying SUV’s, large pick ups and many fuel guzzling autos. People will continue to pay high prices and the oil companies know they have a monopoly, Shell, B.P. all know people need oil for cars, heating and its the price of oil that is driving up prices on all commodities and products.
Its all about raising the stock price for the shareholders, capitalism at its ugliest finest.
Addison, Your remarks on Delta’s older fleet remind me that Delta chose not so long ago to invest their capital not in aircraft but in a refinery in NJ …yes, they have older less fuel efficient fleet– but they’ve hedged that by owning their own fuel production. Any increase in fuel prices also increases revenue from the refinery for non-JP product (for which, I recall, they have a guaranteed purchasing agreement). Not too shabby!
Now I’m really curious to know which management consulting firm they used!
More broadly, do you think there could be a perfect storm for legacy carriers? I imagine that low fuel prices plus massive over-capacity in narrow bodied market could entice low price carriers to enter the market and attack the legacy carriers burdened with higher fixed cost, higher labor costs, and higher capital costs for fancy new fuel efficient narrow bodies. Ouch. Inexpensive airplanes plus Inexpensive fuel = big legacy pains.