As fuel costs have come down we have seen the US airline industry report record profits. But how is the impact playing out? We created the following chart to illustrate this using the Boeing 737-700 and a few airlines as an example.
There are numerous inputs airlines report to the DoT via Form 41. As we have reported before, these numbers are sometimes odd and not easy to explain. But staying at the highest levels we should be able to eliminate as many oddities as possible.
Looking at overall flight operations costs per flight hour for one aircraft shows how costs rose through 2013. Delta saw its costs peak in 2014. However in the first half of 2015 we see that Alaska reduced its costs per flight hour by nearly 20%, Delta by about 10% and Southwest by over 30%. The biggest driver in cost reductions has been driven by lower fuel costs.
In the following chart we illustrate the impact fuel prices have on flying operations among US airlines. Note the variance over the period – oil prices have been volatile as well as generally at high levels.
It is clear a sharp, unexpected, increase in the cost of fuel can significantly throw off budgets. If planners get their fuel cost projections wrong the damage can be immense. Which is why airlines were hedging their fuel costs a few years ago, despite the costs. With falling fuel costs hedging is no longer seen as vital.
Southwest Airlines was a major beneficiary of well executed fuel hedging years ago, and its consequent lower costs of production enabled it to make competitors bleed. Just as many US airlines are now forgoing fuel hedges, with expectations of low fuel prices going forward, Southwest is taking the industry’s most conservative view on fuel. What do Southwest’s planners know that nobody else does?
“What do Southwest’s planners know that nobody else does?”
It’s not so much about secret knowledge, as it is about reacting rationally to the market instead of emotionally. Buy low, sell high is really hard for most people. All the airlines have been burned by hedges. It’s not easy to lose almost $2 billion on an investing strategy like Delta did and still have any confidence in it, especially knowing that hedging should be a net-loss making investment strategy on average (unfortunately, most investors will accept lower overall returns to avoid looking at occasional negative numbers on an earnings statement). It’s also very easy to get sucked into to buying during a big run-up in prices when you feel like you’re missing the boat.
Southwest seems to try to run counter to the market trends, which is one of the main ways people try to beat the averages in the stock market, too – again, Buy low, sell high. That’s not risk free, but the downside risks are more limited when you buy after a big decline, and the upside benefits are larger.
When oil is $50/barrel and an extropolation of the long term price trends points to $70/barrel prices, it’s much more likely there will be a significant increase in prices than a decrease. Conversely, when oil is at $110/barrel, it’s more likely there will be a decrease than an increase. But when oil is at $110/barrel and your stockholders are screaming at you for not having protected yourself against volatile prices, that’s when hedges tend to look most compelling, even though it’s when they make the most sense.