Vaughn Cordle, CFA / February 13, 2015
- $15 billion in full year earnings is double 2014's.
- 35% lower fuel costs and 80% higher industry concentration.
- Higher employee wages and profit sharing offset fuel savings.
- Lower energy costs boost GDP and air travel demand.
Average fares are expected to fall by as much as 4% this year due to lower fuel costs and then increase by about 6% in 2016 as oil prices and fuel expense move higher (Fig. 1). How do I know this? Well, it's all about the math and airline economics, albeit with the caveat that fuel costs are impossible to forecast. The best anyone can do is have a reasonable set of assumptions and update whenever new information is presented.
Let's start with a simple regression of jet fuel prices (spot) to average airfares in order to determine the relationship. Airfares always follows fuel prices but with a lag. Airlines buy fuel months in advance and have hedge costs that drove up the economic cost of fuel, especially where there are very large drops in oil/crack/jet prices. The crack spread is the cost of refining the crude oil into jet fuel.
A regression of spot prices of jet fuel to average airfares over the last 285 months produces the following r2s:
- one month: 0.02
- three months: 0.09
- six months: 0.23
- one year: 0.33
What this means is that over the period of three months, the variability of jet fuel only explains 9% of the variability of airfares. Over one year, it's 33%. Fuel costs averaged 30% of the industry's costs last year, so if jet fuel costs fall by 35% for the full year, which is what I'm modeling, industry operating costs fall by about 10%. I'm rounding the numbers so that the math will be easy to follow; however, operating costs cover a lot of costs that are not associated with flying a passenger from point A to point B.
The market [spot] price of jet fuel is estimated to be about $1.6/gal in the 1Q15, which is is about 45% lower than the average for 1Q14; however, the airlines will pay about $2/gal, which is 40 cents more. Most airlines use futures to estimate fuel costs, and the February 11, 2015 future curve has jet fuel averaging about $1.82/gal or $77/bl for the full year of 2015 (Fig.2). I use a wide variety of sources (IMF, World Bank, WSJ surveys, EIA) and update every month. The futures curve is too volatile and is more of a sentiment indicator. I prefer the more stable monthly forecasts that are based on fundamentals, but even the best oil experts can't forecast oil or jet, at least not very accurately. Due to this uncertainty, I have a $10/barrel swing built into earnings estimates for this year. The ten major airlines will burn 388 million barrels of jet collectively, so a $10 swing in the price of a barrel of oil or jet fuel is a $3.9 billion swing in fuel costs. This swing in costs does not include hedge benefits or costs which would be added to determine economic fuel costs. 388 million barrels = 16,310 million gallons.
The difference between spot prices and airline fuel costs include hedge and [into aircraft] handling costs and taxes. The ten major airlines will burn 16.3 billion gallons this year, so $2 X 16.3 = $32 billion. The airlines paid $3.05 on average in 2014 and burned 15.76 billion gallons for a cost of $48 billion. Hence, the implication is that airlines will save $17 billion in fuel costs.
I'm estimating that the ten major airlines will generate $164 billion in total revenue and $122 in passenger revenue. If we divide $17 billion in fuel savings into passenger revenue, the implication is that airlines could lower fares by 14%, if fuel expense falls by 35% as expected, and if they wanted to be generous. If airlines lowered fares by this amount, the price elasticity of demand would kick in and traffic would increase by about 9%, which is 3x faster than current estimates of seat capacity growth. The industry can't gear up that fast, and there are other costs in the pipeline that must be considered. Higher TSA fees and passenger facility charges (PFC) as well as other taxes/fees imposed by the government could be in the range of $3.8 billion (Obama's new budget proposal). The airlines have to account for costs, and this is the equivalent of a 3% increase in airfares. So, it's not prudent for the airlines to pass along too much of the fuel savings given these new costs, in addition to the fact that oil prices and jet fuel costs are expected to be higher in 2016. Moreover, the airlines will pay about 40 cents more than market prices of jet because of hedge and other costs. $0.40 X 16.3 billion gallons = $6.5 billion, which is equivalent to 5% of passenger revenue. As the math suggests, hedge costs and higher fees/taxes is the equivalent of 8% in passenger revenue. So, the 14% fuel savings now is reduced by 8%, which implies that 6% of the fuel savings is available for other uses, including lower fares. However, there is one more cost to consider - labor.
Labor costs are rising because of new agreements, and when airlines earn profits above a certain threshold, profit-sharing checks can be quite large. Delta, for example, will pay out $1.1 billion in profit-sharing for earnings generated in 2014. Delta's profit sharing program pays 10% of the company's adjusted annual profit up to $2.5 billion and 20% above that. Employees will get a profit-sharing check that is about 16% of their salary. A senior wide-body captain will get an additional $40,000, and a senior flight attendant about $9,000. United has a somewhat similar plan where the company pays out 10% of pre-tax profits when earnings are below 6.8%, but will pay out 14% if profits exceed this threshold. United will pay out 10% of pre-tax earnings for 2014 and 14% this year because margins are estimated to be about 10%. Southwest and other airlines are also paying out profit-share checks, and lots of new labor agreements are being negotiated. American Airlines is the exception to the profit-sharing rule, but just agreed to give large pay raises to its employees. This includes 23% pay hikes for its pilots and the new rates put American's pilots and flight attendants 7% above industry leader Delta, which is fighting a unionization drive and is negotiating with its pilots. The new agreements will increase American's labor costs $850 million. Bottom line: labor costs are moving up, and this will offset the savings from lower fuel costs. Labor + fuel = 55 cents out of every $1 in revenue, so when fuel prices fall and airlines profit, labor costs go up.
The airlines reported $64 billion in losses between 2001 through 2009. Balance sheets are highly leveraged, and average assets have gotten older than optimal. In other words, the airlines will use some of the fuel savings to pay down debt and invest in competitive resources. Mergers and consolidation have increased domestic concentration [ASM share in HHI terms] by 80% since 2007, and the corollary to concentration is pricing power. This is why the airlines will keep the bulk of the savings from lower fuel and pass along much of the savings to shareholders and employees, but also pay down debt and invest in in competitive resources, which improves the product. Hence, a 35% decrease in jet fuel costs this year will only result in a 2% to 4% decrease in average fares.
Industry earnings are estimated to be in the $12 to $18 billion range with a midpoint estimate of $15 billion, a 10% profit margin (Fig. 3). The wild card is fuel costs - a $10 wing in the price of a barrel of oil or jet fuel results in a 24% swing in earnings, when all else is held constant. And, there is weakness in foreign markets that have slow economic growth and too many airlines.
Passenger headcount, yields and load factors have been falling in the Pacific and Latin America regions (Fig. 4), and headcount and load factors are falling in the Atlantic. This trend is troubling and suggests that there will be seat capacity adjustments if the trend doesn't improve. Passenger revenue in these regions represent $37 billion (28%) of the system-wide revenue so continued weakness would impact current earnings estimates. Example, a one percent reduction in this non- U.S. revenue would reduce earnings by about 3% or $470 million.