Lower fuel costs could be Qantas' ticket to profitability

While Qantas' decision to emulate Virgin Australia and cut fuel surcharges is largely (albeit not entirely) cosmetic, there was an unusual underlying tinge of optimism to the context in which Qantas presented its decision.

Once Virgin announced it would get rid of its surcharges on flights to the US, Qantas really had no option but to follow suit, even though it is a decision that will actually have more immediate impact on Qantas than its rival.

That's because Virgin has never imposed a fuel surcharge on its Velocity loyalty program, whereas Qantas' frequent flyers have had to pay the surcharge when redeeming points for flights.

From tomorrow Qantas will cut the fuel-related charges for frequent flyers on both Qantas and Jetstar redemptions by up to $110 in economy class return flights and up to $130 for premium economy flights. There will, therefore, be a real reduction in Qantas' revenue that can't be offset by base fare increases.

While Qantas also said it would "gradually" absorb fuel charges into its base fares for international flights as part of a restructuring of its international tariffs, the overall fares won't change. The reduction in fuel surcharges will be offset by increases in the base fares as the surcharges are absorbed. (Virgin, in withdrawing its surcharges, cut a modest $40 from its economy class fares and $50 from its business class fares.)

There may be a cost to the decisions to phase out surcharges on international flights too, given that higher base fares could lead to higher commissions for travel agents, but no material change from the customers' perspective.

The big question, for both Qantas and its international passengers, is the impact of competition in an environment where fuel costs are plummeting.

While it will take time for those lower costs to work their way through to airlines' bottom lines because of their hedging arrangements, and there will be some offsetting impact from the now material devaluation of the Australian dollar, there is potentially a major benefit from fuel costs that have more than halved since their peak last year.

With the International Air Transport Association estimating that fuel accounted for about 26 per cent of the industry's cost base, and a Qantas jet fuel bill of about $4.5 billion last year, the impact could be significant if it were allowed to fall through to airlines' bottom lines.

In a rational industry most of it would, given that as an industry, airlines don't come close to recovering their cost of capital. As Qantas said today, even in a more positive environment, IATA only expects airlines to lift their profit per customer by $1 to a meagre $7.

The industry has, however, never been rational. It has been irrationally competitive and plagued by over-capacity and falling fares and margins. As Alan Joyce said today, yields today are significantly below their pre-financial crisis levels.

The US industry perhaps offers a glimmer of hope. After massive consolidation and restructuring (including regular visits by all the major carriers to Chapter 11) the US industry has recently showed far more discipline and has competed rationally, enabling it to generate more than twice the profit per customer of the average international airline.

Qantas, whose international business has racked up massive losses in recent years (about $500 million last financial year) appears hopeful that rationality might spread. Its strategy, "like the rest of the industry", is to keep strengthening yields.

‘'In a highly competitive environment where customers are already paying less than they were several years ago, lower oil prices can help put the industry on a more sustainable footing,'' Joyce said.

Maybe that's a forlorn hope, but Qantas has indicated that its international business was profitable on an underlying basis in the December half. Given that it does have a significant international network, as the lower fuel costs flow through the business should be increasingly profitable, unless the benefits are competed away.

If the behaviour of Qantas competitors is even reasonably rational, its international business, which has been heavily restructured, would be able to make reasonable profits. And, for the first time in several years, Qantas would be in a position to invest in new aircraft and potentially new routes.

The outbreak of commonsense in the domestic market last year, when Qantas and Virgin ended their destructive capacity war, should have transformed the profitability of the domestic market. However, it might take longer to show through at Virgin, which has to absorb 100 per cent of Tiger Australia's losses as it restructures that business, than at Qantas.

Joyce is clearly hoping for something similar within the international market, with the lower cost base of his international business meaning that Qantas is now far more leveraged to any improvement in yields.

He's right that the plunge in fuel costs and the likelihood that they will remain at current or even lower levels for some years could enable the industry to be re-based on more sustainable footings. History would suggest however, that, even if that were to occur momentarily, it would be unlikely to be sustained.