Falling oil price won’t bring much cheaper travel fares

Falling oil prices benefit the bottom line of fuel-heavy industries such as airlines and cruise travel. This could spell good news for Cayman’s tourism sector. More disposable income for Cayman’s predominantly American tourist visitors should be a boost for the sector.  

However, whether lower oil prices will also translate into cheaper air and cruise fares for passengers is far from clear.  

By the end of January, crude oil prices had more than halved from their peak in June 2014, mainly because oil production in the U.S., in combination with the boom of shale oil, has surged. Worldwide, oversupply has pushed oil prices to their lowest level in five-and-a half years. 

For consumers, lower prices at the pumps mean more disposable income, and to the extent that this windfall is not used as savings or to pay down debt, several industries are expected to benefit. Retailers, leisure companies and restaurants are set to receive revenue from the increase in the discretionary spending power of consumers.  

Fuel-dependent travel companies, such as airlines or cruise companies, see a positive impact from lower oil prices, not only because their target customers have more money available, but also because the cost base for these businesses is coming down significantly. 

Fuel accounts for 20 percent of the operating expenses of cruise lines and for 30 percent of the operating costs of airlines. Any fuel cost reduction will therefore translate into larger profit margins, lower fares or both. 

 

Lower ticket prices?  

However, lower airline ticket prices may not necessarily be in the cards.  

Compared to the crude oil price drop of 55 percent, the global trade association for airlines, the International Air Transport Association (IATA) expects air fares to fall only 5.1 percent this year, after declines of 3 percent in 2014 and 6.2 percent in 2013. 

The main argument against lower air fares is that the price is market-driven and not cost-driven. As long as demand is very strong, airlines have less of an incentive to cut ticket prices and are more inclined to use profits to pay down debt or for reinvestment in the business. 

While some airlines have indicated they are considering changes to their price structure, others have gone on record stating that the competitive situation does not allow them to drop prices for their customers. 

Tim Clarke, president of Emirates airline company, told the World Economic Forum that the oil price fall prompted his airline to review its pricing structure in November 2014.  

“We’ve been trying to get a better handle on what’s good for us and good for the passengers,” he said. 

“We’re asking what we can pass on to the consumer, but at the same time maintain the margins we need for investment in expansion. We want to pass value through to the passenger, but we have to balance that with the need to meet our own key performance indicators, our profit and return levels.” 

Clarke also noted that many airlines have not been all that profitable and will see their improving cost base as a temporary relief. 

“Some airlines, in the U.S. for example, are making money for the first time in a decade, so it’s hard for them to say they’re going to drop prices immediately,” he said. 

One issue in the pricing structure is the level of the fuel surcharge, but it is not the only element. Australia’s Qantas Airways eliminated the surcharge in January and at the same time bumped up base fares to maintain its margins. 

The company said that oil cost reductions were not sufficient to offset the effect of competition on international routes. Meanwhile, Singapore Airlines refused to cut the fuel surcharge because it represented only partial relief against the company’s high operating costs. 

Cayman Airways said for its fiscal year-to-date, the fuel expense for the airline is within 8 percent of last year’s while operating a similar flight schedule.  

However, current average fuel prices paid by Cayman Airways are now considerably below those in late summer, so the airline is expecting lower fuel costs going forward. “This reduction, assuming it continues, and assuming that the international economy remains generally strong, will allow Cayman Airways to consider the possible reduction or elimination of existing fuel surcharges in the short term,” the airline said in a statement. 

While the airline continues to monitor the oil market with “cautious optimism,” its management notes that oil prices “are notoriously volatile” and a sudden surge of oil prices is as easily conceivable as the recent drop. 

The practice of selling tickets for flights as far as a year into the future “creates a tremendous amount of risk which must be managed carefully,” Cayman Airways said. 

 

Margins  

Globally, margins in the aviation industry have been as low as $6 per passenger, and although the industry is expected to increase profits by $5 billion this year to $25 billion, the margin per passenger is expected to increase only by $1, to $7. 

Traditionally, airlines have used cheaper fuel to increase capacity in order to win market share.  

Lower fuel costs tempt airlines to add more flights in off-peak periods because added flights bring down the unit costs for airlines, as capital intensive planes, ground infrastructure and staff are becoming more productive. Marginal routes suddenly become profitable and can boost revenues at comparatively lower cost.  

The danger of this approach is that when oil price surges again, this additional capacity can be difficult to reduce in time and can lead to quickly deteriorating profit margins. 

 

Cruise travel  

Cruise lines, which brought 1.6 million tourists to Cayman last year, will also see a massive reduction in costs from falling oil prices. 

Carnival Corp. could save about $500 million in 2015 as its fuel costs are reduced from $2 billion in 2014 to less than $1.5 billion, Morningstar analysts said in January.  

Carnival reported a 13 percent decrease in its fuel costs for its fourth fiscal quarter as the company paid on average $584 per metric ton, compared to $671 per metric ton during the same period in 2013. 

The Miami-based cruise line said that based on December pricing, it could save $475 million net of derivatives hedging.  

 

Hedging, currencies and emissions  

Fuel price hedging complicates the potential savings for both cruise lines and airlines.  

Carnival uses so-called zero-cost collars on Brent crude oil to cover a portion of its estimated fuel consumption through 2018 to mitigate the risk that oil price hikes will dent profits and to increase operational flexibility and price certainty.  

The collar hedges set a cap and floor price for the price of oil, which keeps the effective fuel cost within this price range.  

Carnival’s collars cover 8.48 million barrels or about 45 percent of the company’s expected fuel consumption in 2015 at various price ranges between $74 and $110 and $80 and $125. 

These paper transactions dictate that when the oil price exceeds the cap price, the cruise line is compensated the difference by its counterparty, and when the price drops below the floor price, Carnival has to pay the difference to its counterparty.  

In effect, Carnival is therefore unable to benefit from any oil price declines below $74 and $80 for the portion of its fuel needs that are hedged as it will suffer losses in its hedging portfolio. However, the company still benefits from lower than floor prices, which for crude Brent stood at $49 at the end of January, for the 55 percent of its fuel needs that remain un-hedged. 

Carnival rival Royal Caribbean uses more traditional fuel-price hedges with a combination of fixed-price swaps and forward purchasing from suppliers, which cover 52 percent of projected fuel purchases in 2015. The average cost of the 2015 hedge portfolio is approximately $636 per metric ton. In 2014, Royal Caribbean paid an average bunker price net of hedging of $693 per metric ton for its total consumption of 1,367,000 metric tons. 

“Our strategy is not to speculate on market movements,” the group’s associate vice president of global fuel supply Michael McNamara told World Cruise Industry Review in September 2014. “We do not attempt to either beat or time the markets with our strategies. Instead, we try and maintain a disciplined approach to reducing fuel price risk over time. We typically start hedging our fuel exposure three to four years out.” 

The company said in its fourth-quarter earnings release that even though the worldwide price of crude oil dropped precipitously during the quarter, there was a lag between sharp movements in crude prices and the cost of fuel at the pump and bunker inventory on board its ships. 

 

Complicated by the US dollar  

Matters are further complicated by the U.S. dollar. The dollar strengthened late in 2014, whereas the cost of fuel, priced in U.S. dollars, declined more dramatically. 

While the impact of the U.S. dollar appreciation was immediate, there was a lag before the change in the price of fuel took effect for the company, resulting in a negative net effect of currency and fuel on earnings, Royal Caribbean said.  

For 2015, Royal Caribbean predicts that a 10 percent change in fuel prices will impact the company’s bottom line by $25 million. 

Another reason why cruise lines will not benefit fully from lower oil prices is the raft of emission regulations worldwide that require ships to use low-sulphur distillate instead of the traditional bunker fuels.  

These greener, low emission fuels are about 60 percent more expensive. They are now prescribed for vessels traveling to the U.S. and Europe, but not to the Mediterranean.  

As an alternative, and to avoid having to purchase the more costly fuel, many cruise lines invested in retrofitting their vessels with scrubbing technology.  

Despite these investments, the cruise lines are going to be a major beneficiary of falling oil prices. The cost of cruise fares is unlikely to go down. However, related costs such as travel to the cruise ports will fall and improve the net revenue yield.  

More consumer spending power, as a result of falling oil prices, is even more important for cruise companies than for airlines, since cruise travel is entirely discretionary.  

This could lead to an increase in demand and make 2015 another record-breaking year for Cayman tourism, following up on 2014’s record 1.96 million visitors. 

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Lower oil prices can make marginal routes for airlines profitable.

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Cruise lines are set to benefit from lower fuel bills.

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