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Striking Oil - Understanding Oil Price Volatility

The price of oil continues to play a leading role in airline strategy. Unfortunately, its increasing volatility may not be a simple case of supply and demand

Oil prices seem to have a life of their own.

In summer 2008, the price of oil came close to $150 a barrel (Brent), representing up to 40% of airline costs. Some opined that $200 a barrel was feasible given little spare capacity in production, the booming economies of China and India, and concerns over sources such as Iraq, Nigeria and Venezuela.

Then came the credit crunch, triggered by the US housing crisis. As the US is by far the biggest consumer of oil, the downturn in the country’s economy led to a sharp fall in the oil price (for example, petrol consumption in the US dropped by 5% in 2008). The credit crunch soon developed into a fully-fledged global recession, affecting even the tiger economies of Asia, and oil dropped to around $40 a barrel.

It seems like a simple equation. When demand was high and supply was low, the price soared. Then demand dropped just as supply issues were being resolved, causing the price to fall.

But while such fundamentals are certainly the single largest determinant of the oil price, some argue its volatility is due to other factors. Even now, as hints of a reviving economy finally surface, the oil price is increasing beyond what might be deemed as reasonable.

Brian Wilson, former British Energy Minister under Tony Blair, believes there is a huge speculative element in the oil price. “The actual connection between the paper trading price of oil and anything that is happening in the physical world is now extremely remote,” he says.

US Airways President Scott Kirby would seem to agree. “Of course, I’m nervous all the time about what could happen to oil,” he told an investor conference. “We saw it run last year, for no fundamental reasons that I could see, up to $147 a barrel. The fundamental supply and demand just doesn’t seem to justify where it is today.”

Guessing games

Currently, the world consumes about 85 million barrels a day whereas oil trading is thought to involve more than one billion barrels a day.

There are a number of guessing games going on. For a start, it is unclear how much oil is left in the ground. Easily accessible fields have been tapped and the question now is whether the price justifies the search for, and utilization of, more difficult sources.

In any case, there are no truly reliable figures on the capacity of existing oil fields just as it is unknown how much countries are storing should a fuel crisis, 1970s-style, hit again. Add in hurricanes in the Gulf of Mexico, oil tanker hijackings and the geopolitical situation in the Middle East and it soon becomes clear why speculators love the oil industry.                                  

All for one

Speculation thrives in an uncertain market and the oil industry makes for rich pickings. The Organisation of Petroleum Exporting Countries (OPEC) accounts for around 55% of oil exports. The countries in this cartel should, in theory, act in unison; increasing or decreasing production together with all the consequences for price this implies. In practice, some countries produce above their quota to garner extra cash, although this is less evident as volatility takes hold.

OPEC supports an end to speculation too. It comes under intense scrutiny when the price jumps wildly but complains the finger should more often be pointed at speculators.

“The speculators are still there,” OPEC Secretary General Abdalla el-Badri said before January’s World Economic Forum. “Before, they were playing a supply shortage, now they are playing too much supply. They are delaying a recovery in prices.”

Brian Pearce, IATA Chief Economist, agrees speculation is playing its part but says there are deeper causes for the market’s capricious nature. He believes OPEC has more control over the price than they might admit. “The fundamental problem with oil prices is one of supply,” he suggests. “Simply, OPEC controls such a large share of the market it can easily affect prices. For any degree of stability, the oil market needs greater variety in supply. Other sources are not as reliable as they could be.”

Pearce cites the example of iron ore to underline his point. Its price jumped 100% last year, rising sharply alongside oil. Yet it has no exchange-based market and, as such, there is no scope for speculation. “It shows similar volatility to oil and also has supply-side concerns. When demand is low this isn’t such an issue, but when demand is high, it will become very costly.”

Understanding costs

With fuel such a significant element in an airline’s cost base, understanding the price of oil is crucial to future strategy. Most airlines hedge to a degree—a form of speculation in itself—and there have been both winners and losers in recent times as the price went on its rollercoaster ride.

But hedging is not about making money, rather bringing stability to the cost base. This is becoming increasingly difficult, however. Not only is the market so volatile as to make hedging extremely uncertain, but the current climate means airlines have little resources left to invest in such an activity anyway.

It explains why airlines are becoming hesitant about hedging for 2010, even with prices currently hovering around $70 a barrel.

“The increasing volatility would argue for more hedging but airlines have become very wary,” concludes Pearce. “Airlines need to manage their fuel price risk by hedging. But ultimately reducing price volatility will require investment in new and alternative fuel supplies, including aviation biofuels.”

Hedge Health Check

Airlines traditionally hedge a proportion of their fuel costs. It is reported that Malaysia Airlines has hedged 47% of its fuel requirement this year, and 63% of its needs for 2010. In the second quarter the carrier reported an operating loss of $119 million (MYR420 million) but exceptional gains of $380 million (MYR1.34 billion) on fuel hedging.

Meanwhile, the Cathay Pacific Group reported a profit of $105 million (HKD812 million) for the first six months of 2009, primarily as a result of a $271 million (HKD2.1 billion) fuel hedging gain.

Brazil’s TAM guessed that prices would top $100 a barrel and lost about $33 million (BRL62 million) in the first quarter 2009 although the strong currency helped cut the dollar-denominated debt.

In North America, the most recent fuel price analysis shows that Delta Air Lines lost $390 million on fuel hedges while JetBlue waved goodbye to $42 million. United’s bottom line was $249 million worse because of its hedging positions. Southwest and Alaska Airlines are now the only carriers in the region reported to have a sizable hedging position.

 

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