Skift Take

If fuel prices rise considerably, airfares will need to increase as well, so this would be bad for consumers. But investors might cheer.

If U.S. airlines know what’s good for them, they’ll hope fuel prices go up, one prominent investment analyst said Thursday at an industry conference in New York.

The conventional wisdom is the opposite. A considerable chunk of an airline’s cost is typically fuel, and if the prices fall, an airline that otherwise makes no changes almost immediately becomes more profitable. But over time, if fuel prices stay relatively low, as is the case today, airlines tend to use extra profits to expand into new markets and add routes and frequencies. Analysts sometimes fear that could lead to a supply-and-demand imbalance, with carriers dropping prices to fill unsold seats.

“These airline management teams come out and they say they don’t want higher fuel prices,” Hunter Keay, an analyst with Wolfe Research, said at Aviation Day USA, sponsored by the ​IATA, a trade group, and The Wings Club. “They don’t know what’s good for them, because they’re just going to compete away any benefit over the long term.”

In recent weeks, a barrel of oil mostly has been trading at $60 to $65 per barrel. That’s considerably more expensive than about two years ago, when it dropped below $30, but a lot less pricey than in early 2012, when it was above $120 a barrel.

Keay was joined on a panel by another investment analyst and two airline industry consultants, who generally agreed with his argument. But Mark Drusch, a vice president at ICF, an aviation consulting firm, said there’s a “goldilocks” conundrum — because while cheap fuel is potentially an issue as it may spur unnecessary skirmishes for market share, expensive fuel is also problematic. That’s because airlines may be unable to recoup the added costs fast enough by raising ticket prices.

Drusch said anything higher than $100 a barrel might force airlines to raise ticket prices by so much that it could stifle demand, which would ultimately hurt revenues. But Keay said he suspects airlines can withstand fuel as high as $105, with the sweet spot at $85 to $105 per barrel.

“I believe, over time, airlines can pass through fuel on a one-to-one basis up to like $105 a barrel in its current structure,” Keay said. “Beyond that it gets a little bit dicey.”

The panelists spoke wistfully about a period several years ago, when fuel costs were considerably higher than today and airlines were reluctant to add too many new flights. Through 2015, airline executives often would speak about “capacity discipline,” promising analysts they would be prudent with their growth.

The carriers might not have gone with that strategy had fuel not unexpectedly increased above $147 per barrel in 2008. But they did, and over time, especially as fuel costs started to decrease and airlines emerged from bankruptcy and consolidating, they ended up with a successful business model.

“It was weight loss through diet and exercise,” Keay said.

One panelist, though, expressed mild skepticism with the argument that high fuel costs are good for the industry. Michael B. Cox, managing director at Seabury Consulting, said the economics of the industry have changed since 2011, noting labor costs have risen at larger U.S. carriers, as employees got their piece of airline profits.

“Labor has gone up 11 percent, compounded annually, since 2010,” he said. “That’s not going away. I’m not saying there are going to be any more bankruptcies or anything like that, but that’s going to be a problem, particularly if there’s rising oil prices and if the economic cycle that were are in right now [ends].”

While low fuel prices may have led airlines to add more new capacity than they might have otherwise — United plans to grow by 4 to 6 percent in 2018 and 2019 — the panelists said they commended carriers for being mostly rational with their growth. For the most part, carriers are not building new hubs or trying to push each other out of markets.

“It used to be, who is the biggest in the market, and therefore you would win,” Drusch said.

In the current climate, J.P. Morgan analyst Jamie Baker said, airlines still compete vigorously, but in a slightly different way.

“Back then it was bigger is better,” he said. “Who can open new hubs, who can order more aircraft? Now the competition is, who is going to be first to be included as a component in the S&P. Or whose dividend has more heft and consistency?”

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Tags: airline innovation, iata, jet fuel, U.S. airlines

Photo credit: Southwest, like all U.S. airlines, is paying more money for jet fuel than a year ago. Some analysts think higher fuel prices make airlines act more rationally. Bloomberg

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