You would be hard pressed to find a better example of why “timing is everything” in our quickly evolving energy markets than the Airline Armageddon that continues to unfold before our eyes. First, a quick overview of the situation with a focus on hedging of fuel prices by airlines (emphasis added):
Hedging Against $200 Oil:
Rising jet fuel prices—one of the industry’s biggest costs—have helped send seven airlines into bankruptcy this year, and more could follow. One exception to the sea of red ink so far is Southwest Airlines (LUV), which has saved billions since 2000 by successfully hedging against increases in oil prices. But with each rise in oil prices, that strategy gets more and more expensive.
…
A hedge is a financial instrument that allows investors to lock in certain prices to act as insurance against the possibility that the open-market, or spot, price of that commodity will rise. If the price then rises, the company gets a financial payoff that cushions the blow of higher prices. In this way, investors can actually make money using hedging as insurance, giving them an advantage over competitors in the marketplace.
Southwest is currently the only major airline with most of its fuel costs hedged at lower prices, largely because it is the only large carrier with the cash flow to do so. For 2008, 70% of its fuel needs are hedged at $51 a barrel. That means that while competitors have to contend with spot prices hovering around $120 a barrel, Southwest can buy oil at less than half that. Access to this discounted price means Southwest feels less pressure to pass on higher costs to customers, which could afford it more market share as competitors hike ticket prices.
…
Even an expert like Topping, who spends his days consulting with oil experts and poring over analyst reports, says he doesn’t know for certain where oil prices are headed. But for now, indications point upward, which justifies more hedging. “There doesn’t seem to be hope for a big price drop unless an unexpected dramatic event took a big chunk out of demand,” says Topping. While high prices are beginning to slow demand for oil in Western countries, developing nations like China and India have an ever-growing thirst for oil. Consider that the U.S. currently has 800 vehicles per 1,000 people, vs. fewer than 30 in China and India. As those countries’ economies ramp up—and as hundreds of millions of people seek their first cars—energy demand will also rise.
…
Indeed, many airline executives shy away from the risks involved. “I think airlines have been reluctant to hedge because corporate culture views futures as a gambling tool,” says Stephen Schork, an energy consultant in Villanova, Pa., and editor of The Schork Report, a daily energy newsletter. “But they’ve been reluctant to their own detriment. If you’re an airline without a significant hedge, you’re in a difficult spot.”
All this stuff about hedging vs. not hedging won’t matter if oil prices stay essentially where they are for years. (And just to be clear, I would consider a price retreat to, say, $100/barrel later this year before a big run up to $150 or $175 in 2009 to fall into the category of “essentially where they are”.) Eventually enough of the right people will figure out that oil isn’t going to be cheap anytime soon, and the practice of hedging will all but disappear, whether airlines consider it “gambling” or not.
Consider, by contrast, the car business. A gradual rise in gasoline prices will push people to more efficiently use oil for transportation–higher MPG cars, driving fewer miles, driving smarter, etc. The increased demand for more efficient cars pushes car companies to develop and make them, and the adoption of them and the other oil saving measures lowers the overall consumption of oil and moderates the price. Or so says conventional economic theory. If the price rise is much quicker, then we have what we’re seeing today, with a rapid shift to more efficient vehicles and the sales and prices of new and used light trucks plummeting. But even in that scenario, which we’re living through as I type this, there’s still a huge amount of low-hanging fruit for us to pick. Picking said conservation goodies isn’t always cheap or fun, but they undeniably exist, and exploiting them softens the blow of the oil price increase.
As the pressure from rising gasoline costs grows, so will the market response, in terms of the mainstream marketing of electric vehicles and plug-in hybrids, as in the plethora of such cars all set for the 2010/2011 time frame. This is the ultimate response to a high price, the wholesale demand destruction through a mix of adopting alternatives and abandoning the consumption completely.
Back to airlines. They can’t dramatically increase the fuel efficiency of their planes (equivalent to trading in a 20 MPG SUV for a 35 MPG sedan), or they would have done it years ago. So they’ve been forced to fly fewer and smaller planes in an effort to maximize seat utilization–as they say in the movie business, it’s all about putting butts in seats. They can also resort to using hypermiling techniques–flying slower, taxiing with only one engine, carrying as little excess weight as possible–but that results in a pretty small savings on a percentage basis.
Their only hope in the short run is to raise ticket prices or impose other fees and hope that not too many customers switch to train travel or skip flying altogether. Unlike cars, there really is no chance for an orderly (which is to say pleasant) transition while “the markets sort themselves out”, as economists put it, aside from the arrival of large scale alternative ways to fuel jets (lots of luck with that one) or a huge drop in world oil prices (likewise).
The bottom line: Airlines have less and less room to stand in the market, thanks to the growing use of oil for non-air-travel purposes around the world. There’s nothing to suggest that that situation will change anytime soon.
Recent posts with related articles on the discussion board (all open in a new window):
Link to original post