Airlines Face Much Higher Fuel Prices

Russia's invasion of Ukraine has added an additional obstacle to the airlines' financial recovery from the COVID-19 pandemic. For U.S. airlines, this is not so much due to any material loss of traffic, rather these headwinds stem from the war's indirect effects, particularly the significant increase in oil (and thus jet fuel) prices. Because few U.S. airlines hedge their fuel costs, they will need to rely on raising air fares to offset their higher fuel expense.

Fuel is normally the second-largest expense for airlines after labor costs. In their 2021 annual reports, U.S. airlines disclosed estimates of how much a specified increase in jet fuel prices would raise their expenses (see table below). These disclosures used different assumptions regarding the volume of fuel consumed and fuel price increase but the overall picture was clear--their exposure is huge. For example, a $0.01 increase in the price of jet fuel per gallon would cost American Airlines Inc., the world's largest airline, an extra $40 million annually based on their forecast consumption for 2022. Translating that into barrels (there are 42 gallons in a barrel) implies that a $1.00 increase in the price of a barrel of jet fuel would add an extra $95 million in fuel costs over the course of a year.

The near-term picture is even worse. Delta Air Lines Inc. recently estimated that its would have to pay about $2.80 per gallon of jet fuel in the first quarter of 2022, which is $0.93 cents higher than during the same period last year (according to the company's March 15, 2022, investor update and 8K filing with the U.S. Securities and Exchange Commission [SEC]). Using Delta's forecast for about 750 million gallons consumed, that translates to almost a $700 million increase in its fuel expense, relative to the same period last year, for just one quarter. That said, it's risky to simply extrapolate this increase out to the full year because jet fuel prices were rising over the last year, thus any year-over-year comparisons will likely change as time goes on. Still, the increase in airline fuel costs will likely be considerable this year.

How Can Airlines Offset Rising Costs?

Some airlines hedge against price increases for a portion of their fuel consumption. While this is common among European airlines, Southwest Airlines Co. and Alaska Air Group Inc. are the only rated U.S. airlines that hedge their fuel costs. During the past decade, other U.S. airlines gradually concluded hedging was too expensive and that they could recover much of the increase in their fuel costs over time by raising their fares. Their reasoning was that fares would likely follow fuel costs in the consolidated U.S. airline industry (the four largest airlines carry more than 85% of the U.S.' total air traffic), particularly if most participants face the same risk of rising fuel prices. This view acknowledges that any such cost recovery would lag the increases in jet fuel prices, particularly if they are substantial and occur rapidly. This strategy also works best when economic conditions, and thus the demand for air travel, are strong.

The outlook for the airlines to recover most of their expected increase in fuel costs this year appears generally favorable. Based on airport passenger counts recorded by the U.S. Transportation Security Administration (TSA), passenger numbers are once again trending higher this year following a setback stemming from the spread of the omicron variant in January and the first half of February. March's numbers were at 87% of 2019 levels and rose close to 90% during the second half of the month.

What Are The Airlines Saying?

The representatives of the airlines that spoke at the JPMorgan industrials conference on March 15, 2022, uniformly reported strong bookings despite high inflation, flagging consumer confidence measures, and the Russia-Ukraine war. For example, United Airlines Holdings Inc. presented a chart as part of its presentation (filed with the SEC as an 8K; see chart below) that showed an uneven but clearly positive trend in its future bookings since the depths of the pandemic-induced downturn in spring 2020. Passenger reactions to new waves of COVID-19 infections have moderated with each successive wave and variant, which may be a function of widespread vaccination, more measured government restrictions, and consumer fatigue with limits on their activities. The booking trends United identified in its presentation provide a more forward-looking measure than the TSA's passenger counts because they measure planned future travel. For the most recent data presented, from early March, United's bookings were only 2% below its 2019 levels.

What Other Factors Will Affect Pricing?

Based on this forward-looking trend, the demand for travel appears strong. However, any potential increase in fares will also depend on how much capacity the airlines deploy and the pricing strategies of the low-cost operators. While the airlines are planning to increase their capacity, as expected given the ongoing rebound in demand, their expansion is somewhat constrained by labor shortages and pilot training requirements. After cutting back sharply on their headcount during the downturn, including implementing widespread early retirements and voluntary furloughs, the airlines have been struggling to meet their staffing needs to add capacity. COVID-related surges in employees taking sick leave, such as during the initial spread of the omicron variant, have added to their difficulties. Higher fuel prices have also prompted some smaller airlines to cut back on their planned expansions.

Southwest Airlines Co. is, by far, the largest low-cost carrier in the U.S. Although the mergers that led to the creation of the country's three large network airlines over the past two decades (Delta, American, and United) receive most of the attention during discussions about industry consolidation and pricing power, Southwest's pricing strategy is important as well. Although it continues to vigorously compete with other airlines on price, Southwest is facing cost pressures of its own, particularly from its labor expense. Therefore, while its hedged fuel portfolio could enable it to undercut its competitors, it seems more likely that Southwest will go along--at least in part--with the general increase in fares while maintaining its average discount relative to the pricing of American, Delta, and United. Smaller ultra-low-cost airlines, such as Spirit Airlines Inc. and Allegiant Travel Co., may be more aggressive with their pricing than Southwest, though they do not represent a significant proportion of the industry's total capacity (even after Spirit Airlines Inc.'s planned merger with Frontier Holdings Inc.).

How Much Could Fares Rise?

At the JPMorgan conference, Delta estimated that it would need to raise fares by $15-$20 on a typical $200 one-way domestic ticket to cover the anticipated rise in its fuel costs in the second quarter and said it is confident it will be able to do so. While this would no doubt lead to the loss of some price-sensitive passengers, the overall effect on its revenue will likely be positive considering the pent-up demand for air travel. Given the inevitable delay in reacting to the sudden run-up in fuel prices and our forecast for slowing economic growth, we expect that U.S. airlines will likely be able to recover most, but not all, of the rise in jet fuel costs this year. That said, there is currently an even-higher-than-usual level of uncertainty around the industry's outlook. Given our forecast for continued U.S. Federal Reserve rate hikes (we forecast a total of seven rate hikes this year, including the one implemented in March; see "Economic Outlook U.S. Q2 2022: Spring Chills," published March 29, 2022, on RatingsDirect), rising interest rates and high inflation could lead to a worse-than-anticipated economic slowdown during the second half of the year. The Russia-Ukraine war could also take a more dangerous turn, which would likely chill the expected boom in the demand for trans-Atlantic travel this summer. Oil prices could also rise higher and faster than we currently expect or remain elevated for longer than we anticipate.

How Will This Affect Our Ratings?

The credit implications of our base-case forecast, which assumes strong revenue and high fuel prices, suggest that the U.S. airlines will--in most cases--face a delay (but not a reversal) in their trend toward generally improving ratings.

Our outlooks on American, Delta, and United are stable and we have positive outlooks on most of the low-cost airlines we rate (or, in two cases, have already upgraded them by one-notch from their pandemic lows). We don't discount the possibility of further upgrades or outlook revisions, though it appears that most of our ratings on the U.S. airlines will likely remain at their current levels for at least the next few quarters.