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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Are Airlines The Real Losers Of The OPEC Deal?

OPEC

The Saudis have managed to come through with a double win. Following the production cuts agreed to by OPEC members, the Saudis were able to work with Russia and other non-OPEC producers to get further cuts in production pushed through. These cuts are likely to pump up oil prices even higher. That’s going to be good for oil companies of course, but it threatens to upend a resurgent sector; the airlines.

The 558,000 bpd in cuts by non-OPEC members are only going to exacerbate the recent 30 percent surge in jet fuel costs. For the U.S. airline sector, these price increases will dampen a recent bout of increased profitability. U.S. airlines should be able to handle the turmoil though – the sector has consolidated, updated their fleets, crammed more seats into each plane, and generally improved operations. The result of all this is stronger profitability and greater capacity utilization. That’s not to say that U.S. airlines won’t be hurt by rising jet fuel prices – they will – but the price increases will not be a body blow.

Another group of less disciplined airlines is likely to have more trouble though – the Asian airlines. Asian airlines have been buoyed for 30 years by strong increases in economic growth across the continent, and more recently by the oil price downturn. As a result, companies like Singapore Airlines offer unheard of perks to flyers such as free alcohol on planes, free bag checking, free entertainment in-flight, and frequent flights even to unprofitable smaller locations. Those perks make face new pressure now.

Related: Which Oil Majors Are Most Exposed To The OPEC Deal?

A key part of the Asian carriers problems echoes past issues in the U.S. space – ruinous competition pushed down fares across the continent, and with growth in many Asian countries now slowing, it will be difficult to raise those fares unilaterally. Excess capacity and declining premium traffic for Asian carriers like Cathay Pacific are only making things more difficult. Asian airlines have margins that are roughly half the level of US peers – about 8 percent versus 15 percent in the U.S.

The trouble could be particularly acute for Cathay which is Asia’s biggest international airline. The company is already conducting a “critical review” of its business following a drop of more than 80% in net income for the first six months of the year. Reinforcing the view that things won’t be getting better anytime soon, Cathay said 2017 will be “challenging.”

For Asian airlines the troubles may be more persistent than many investors hope. As energy investors found out a few years ago, commodity cycles do not turn on a dime – the slow boil up of oil prices (and by extension jet fuel), is likely to continue sporadically for a while yet. Airlines betting on oil prices to go back down to the $30 a barrel level and stay there are probably going to be disappointed. Related: Stormy Seas Ahead For Oil Markets

These changes will undoubtedly make airline travel even more unpleasant both in the U.S. and abroad. Airlines have come up with new and innovative ideas in their continuing quest to make customers feel like sardines in a can. New research has shown airlines that as long as they give passengers a thinner and less comfortable seat, they can squeeze a few more people onto each plane. This will let airlines add about 5% more seats in most planes. Passengers on airlines may desperately need the free booze to forget how closely packed they are with strangers.

We haven’t quite reached the level proposed by Ryanair’s CEO a few years ago of charging customers to use the bathroom, but that day is clearly getting closer. For all the benefits of rising oil prices for investors and companies in the space, there are clearly some downsides too.

By Michael McDonald of Oilprice.com

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