A welcome tailwind for Qantas

A lower oil price is good news for Qantas' international business and airline passengers, with the benefits of lower fuel costs likely to flow through to the core of its earnings base.

The continuing fall in crude oil prices to their lowest levels since the financial crisis may not be good news for energy producers, but it will provide a powerful tailwind for airlines, adding further momentum to the quite dramatic uptick in Qantas’ fortunes.

Brent crude traded at $US57.93 a barrel overnight, its lowest level since May 2009 and about 45 per cent below its level a year ago. While jet fuel trades at a premium to the oil price, it is now more than a third lower that in was a year ago.

The International Air Transport Association has estimated that jet fuel represents about 26 per cent of total industry costs but if one looks at Qantas’ most recent results it is actually a much higher proportion of its cost base.

In 2013-14 Qantas had operating costs of $9.4 billion, $520 million of aircraft leasing costs and $206m in other finance costs. Its fuel bill was a whopping $4.5bn, or about 44 per cent of its cost base excluding depreciation.

Its hedging arrangements means that lower fuel costs has had only a modest impact on the dramatic rebound in Qantas’ financial performance flagged in its market update earlier this month -- it expects to deliver an underlying first half profit of between $300 million and $350 million. But the impact of the much lower prices will flow through in the second half because Qantas’ hedging will allow it increasing participation in the lower prices.

While the full impact might be blunted by the lower Australian dollar -- with a $US1 a barrel movement in the oil prices having an impact of about $40 million on Qantas’ earnings -- the dive in the oil price and the likelihood of lower prices persisting is unquestionably very positive for the group and in particular its international business.

The market response to the earnings update and the underlying mix of cost-cutting, lower capacity growth in its markets and the lower fuel prices has helped drive Qantas’ share price up from $1.30 in October (and $1.09 a year ago) to $2.40.

Curiously, Qantas’ rival in the domestic market, Virgin, hasn’t had as positive a market experience. Its price has risen from 36 cents in October (38 cents a year ago) to about 41 cents.

That could be because it will have to absorb 100 per cent of Tiger Airways Australia’s losses this year, having bought out Singapore Airlines’ stake for $1, but another explanation might lie in its hedging strategies.

There are some analysts who believe that Virgin doesn’t have a meaningful exposure to the lower prices. It does cost more to acquire that exposure.

In the longer term, of course, if lower prices are sustained then both the domestic airlines, indeed the entire industry, will benefit significantly from lower jet fuel prices.

IATA upgraded its estimate for the industry’s profitability in 2014 from $US18bn to $US19.9bn and forecast profits of $US25bn in 2015, with the 2015 forecast driven by lower jet fuel prices and improving global economic growth. Its estimate of average jet fuel prices of just under $US100 a barrel is about $US15 a barrel above the current price, and therefore could be too conservative.

Oil prices are notoriously difficult to predict but it is obvious that OPEC, led by the Saudis, is trying to force structural change on the industry and regain its influence over prices in the face of a US shale oil-driven surplus of supply over demand.

The first casualties of its strategy have been higher cost producers like Russia and Venezuela but, overlaid by a warm winter, US domestic gas prices have also been plummeting and that could impact US shale oil and gas volumes.

The Saudis say they are indifferent to the impacts of their stance. It doesn’t matter whether the oil price falls to $US20 a barrel, they planned to maintain production and grow their market share.

That strategy wouldn’t have the desired structural effect of driving out higher-cost producers unless it were sustained for a considerable period, which suggests that oil prices and therefore jet fuel prices could remain at far lower levels than the airlines have experienced for some time and may never return to the $US100 a barrel-plus levels experienced through 2013-14.

Given the nature of the international industry, plagued by over-capacity and sub-economic behaviour, some of the benefit of the lower fuel costs will be competed away to the benefit of passengers rather than the airlines’ bottom lines. IATA expects average fares to fall by just over 5 per cent in 2015.

Qantas’ international business won’t be immune from that, although lower fuel costs should help offset the impact of the lower Australian dollar on the purchasing power of its Australian customer base.

For the two Australian domestic carriers, however, lower fuel costs could flow through to the domestic core of their earnings’ bases if their relatively new-found discipline on capacity growth is maintained.

Given their bloody experiences of a capacity war in 2013-14, and the fact that Virgin has completed its transformation program and now needs to focus on generating profits, it is improbable that the duopoly would rekindle another capacity war.

Providing common sense prevails and the lower fuel costs are sustained, 2015 should be one of steadily improving fortunes for both groups.