Fuel cost is an easy scapegoat

 - October 18, 2006, 11:14 AM

European regional airlines don’t need to be told that fuel prices could stunt their growth. But one industry official believes that operators must start to view high fuel costs in the broader context of all expenses, and resist the temptation to blame them for all losses. Speaking at the ERA gathering, Professor Judith Patterson reminded operators of commercial aviation’s fundamental dependence on petroleum, “unlike other transport modes.”

Patterson warned that growth predictions often assume no future price or fuel constraints, despite the industry’s voracious appetite compared with 40-year worldwide trends. “Global oil consumption has increased in linear fashion since 1965; fuel use by aviation has increased [exponentially]–and is predicted to continue [so doing],” she said.

With increasing constraints on petroleum production, fuel will likely become airlines’ single largest cost item, said Patterson, who pointed out that the International Air Transport Association acknowledges “the seriousness of this situation” in its fuel and environmental management guidance to airlines.

Ratios of current oil reserves to production rates, commonly used to predict future supply availability, suggest a potential supply of 41 years from an “ultimately recoverable reserve” of 2,200 billion to 3,000 billion barrels of conventional oil, which requires no upgrading before refining. The world consumes about 84 million barrels a day. Given that trends show declining size and number of oil discoveries since 1965, the question arises of whether production is approaching the point after which rates fall because of depleted volume, said Patterson.

Steadily on the rise since 1998, fuel prices depend upon supply and demand, as well as geopolitical factors and the cost of exploration and extraction. Patterson noted that price has become increasingly sensitive. “Anything that might have had a minor impact in the past will have a major impact today,” she said.

“OPEC has the taps wide open and is just meeting demand…” and major player Royal Dutch Shell has revised downward its reserves estimates by 20 percent, she added.

Analysts in the 1950s projected peak production in 2000, while much more recent predictions show maximum output occurring not much later, only into this decade. “If we are at the peak of production of conventional oil, then remaining reserves will be more costly to extract,” said the McGill University professor.

Nor can airlines turn to engine technology for a remedy. “Between 1950 and 1997 there has been a 70-percent improvement in aircraft fuel efficiency,” said Patterson. With a five- to 10-year gestation period for innovation, technology will not offer a quick fix to help airlines cope with today’s high fuel prices.

“Airports could become intermodal transportation hubs, integrating air and surface modes,” she concluded. “Oil prices will remain high. It is unlikely that present aviation growth trends can be sustained. Carriers will have to develop a new civil aviation paradigm to survive.”

While acknowledging that fuel supply and demand stand as crucial issues, Air France head of subsidiaries and investments Marc Verspyck nevertheless encourages airline managers not to forget other risks they must manage. He also does not share Patterson’s rather pessimistic view of potential technological solutions. “Lots of long-term answers are in the hands of the engine suppliers, not to speak of the oil producers,” said Verspyck.

In an attempt to put fuel costs into perspective, the Air France executive said that for a medium-size European airline a 5-percent rise in labor costs would inflict as much financial damage as a 13-percent increase in fuel prices, while a 10-percent change in the euro/dollar exchange rate could prove five times worse.

One month’s turnover has become the industry standard requirement for liquidity and cash, but reserves cover forward demand for fuel for 54 days, two days longer than a year ago. Verspyck identified myriad risks challenging airlines apart from fuel: high fixed costs, yield deterioration, dependence on airport capacity, capital requirements and international “events.” He also cited operational, accounting and third-party risks, as well as environmental, insurance, pension and credit considerations.

Accordingly, fuel prices can make a convenient explanation for poor financial performance, said Verspyck, but high fixed costs and needs for capital also require concentrated focus and management control.