Airlines Association Cuts Profit Outlook by Half

The favorite way for International Air Transport Association (IATA) president Giovanni Bisignani to describe airline profits is with the word “pathetic”. In his first forecast for 2011, Bisignani noted that profits for the industry would total $9.1 billion in 2011, down from $16 billion in 2010. Net margin was forecast at a “pathetic” 2.7% for 2011.

Now Bisignani is cutting his forecast for 2011 to $8.1 billion, nearly 50% lower than 2010 profits. The net margin forecast has been revised downward, to 1.4%. “Pathetic” doesn’t do the situation justice.

IATA’s first estimate of profits was based on a crude oil price of $84/barrel. With crude prices for WTI within pennies of $100/barrel and North Sea Brent prices hovering around $115/barrel, IATA has now raised its estimated annual average price to $96/barrel. That figure includes the impact of hedging, and IATA expects the fuel bill for the entire industry to rise to $166 billion in 2011, about 29% of operating costs.

Expected growth in the global economy moderates the effect of higher fuel prices because the airlines can raise fares and fees to cover the higher price for fuel. The IATA notes that since early in 2009, fuel prices have added 25% to costs while fares, excluding fees, rose 20%.

On a positive note, IATA has raised its forecast for demand growth from 5.2% year-over-year to 5.6% for passenger traffic and from 5.5% to 6.1% for freight traffic.

The airline industry can deal with higher fuel costs if the economy is strong and growing because airlines can raise prices to offset the higher fuel costs. The danger is that rising crude oil prices will choke off global economic growth, causing fewer passengers to fly and less freight to be hauled.

The increased risk to airline profits comes from events in North Africa and the Middle East. The International Energy Agency (IEA) reports that between 850,000 and 1 million barrels/day of Libyan production is shut-in. Libya normally produces about 1.6 million barrels/day.

The IEA notes that European refiners have “ample” supplies to last through March, and the European market is “not perceived as constrained”, mainly due to scheduled maintenance at European refineries.

The IEA believes that from a fundamental supply/demand approach, there’s plenty of oil. The IATA forecasts a $12/barrel price hike that will cut industry profits in half. The price rise, and the overall risk to crude prices going forward, is not fundamentally supply and demand, but political.

Libya produces less than 1% of global crude, but Iran produces more than twice as much, and Saudi Arabia produces more than 8.5 million barrels/day, as well as controlling the largest portion of the world’s spare capacity. Political unrest in the countries of North Africa and the Middle East is adding about $15-$20/barrel to the price of WTI crude, and probably more to the price of North Sea Brent, which is seen as a replacement in Europe for the lack of supply from Libya.

In the US, the WTI price curve has bent to higher current prices than forward prices, a condition known as backwardation. The long streak of market contango, where futures prices are higher than current spot prices, has been broken, due both to geopolitical fears and to a very high level of inventory.

Until the turmoil in the oil-producing countries ends, the geopolitical risk premium on a barrel of oil will continue to be high. If serious unrest comes to Iran or Saudi Arabia, the risk premium will skyrocket. And very likely it will never again fall below $90/barrel.

Paul Ausick