There will be blood: oil prices beyond imagination

But on 21 May, 2008 in the US, there appeared to be a tipping point. As if investors and consumers had been holding their breath for as long as they could – then let them out with a collective rush, as they realised oil prices were not in fact going to fall back soon.

That rush saw American Airlines’ shares fall 24% to USD6.22; United Airlines’ shares fell 30% to USD8.15 and Continental Airlines lost 13% to USD14.20. Only Southwest Airlines, with its fuel hedge buffer escaped the savagery, falling a mere 4.4% to USD12.43. The Dow Jones Industrial Index meanwhile fell 1.8%, after a drop of 1.5% the previous day and the Transportation Index lost 2.1% yesterday.

American Airlines also announced schedule reductions and a capacity cutback of 12% by the fourth quarter, as it fought to reduce costs at USD130-plus oil prices. It will only be a matter of days before other similar announcements are made, as US airlines ground some of their geriatric fleets.

It would be unwise to expect that European airlines will be immune from these forces today when markets open, even where Air France-KLM reports a strong result. If in fact 21 May does represent one of those points in time when overall situations are re-evaluated, then the US’ pain will not be contained geographically.

When Ryanair, an airline with among the best margins in Europe, predicts it will no longer be profitable at oil prices beyond USD135, it is time to start implementing Plan B. It is not only the higher cost base, but the compression of demand caused by higher transport prices and the slowing economy that creates the pressure.

Faced with this situation, hoping for a price fall is not a strategy. Airlines with thin margins have two options: lose money, or reduce flying. The first aircraft to be grounded will be the oldest. The first routes to go will be the lowest yielding. The logic and the mathematics are simple.

Airline boardrooms worldwide will now be forced to give serious consideration to capacity cuts, even where they are not yet in financial danger territory. Shareholders will now demand that.

Average fleet ages: Selected European airlines, May-08 (LCCs light shade)

Source: Centre for Asia Pacific Aviation & airfleets.net

Average fleet ages: Selected US airlines, May-08 (LCCs light shade)

Source: Centre for Asia Pacific Aviation & airfleets.net

Some companies are better placed than others in these stakes. The pressure is most intense now for US and European airlines, where fleet ages tend to be higher. Margins in Asia and the Middle East are still solid. But as demand slips, the wave will spread.

Average fleet ages give a rough indication of where the cuts are most likely to come. And, on another scale, where widebody aircraft (generally older than the single-aisle aircraft, at least outside the US) constitute a large part of an airline’s fleet, there will probably be a tendency to withdraw from the lower yielding long haul routes, as demand slackens.

There are many variations of this, particular to each airline, as for example British Airways’ CEO, Willie Walsh, looking to long haul for refuge, where premium markets remain strong.

There are other ramifications. A United-US Airways merger under these conditions becomes complex. Indeed any merger transaction, amid this level of volatility, requires an extremely high level of risk tolerance – above what would generally be considered prudent corporate behaviour. In any event, mergers cannot provide a short-term fix. And white knights will be outnumbered by willing sellers.

But it is an ill wind that blows no good at all. For some, this time will offer real opportunities: airlines sitting on strong cash reserves; short haul carriers like Ryanair and others with young fleets and reasonably resilient markets; Southwest, remarkably well hedged, cashed up and with aggressive intent, domestically and internationally; Emirates and other Middle East airlines, where yields remain strong and sixth freedom traffic flows continue; and some of the Asia Pacific carriers.

It is not in everyone’s interests that oil prices fall. But if they don’t, the changing of the guard will arrive earlier than expected.

*This is the Perspective from today's edition of Europe Airline Daily - the comprehensive new pre-digested daily update on strategic news from Europe, saving you time and keeping you right up to date. Complimentary subscriptions to this report are currently available. Register now !