Aviation - Airlines Rejoice as Jet Fuel Gets Cheaper

By OSK Research26 June 2012

Jet fuel price has been on a downtrend since early May, plunging by 20% to an 18-month low of USD106.5/barrel this week. As jet fuel is the biggest cost component at up to 70% of total costs, an airline with the least hedging exposure and a low earnings base will see the most meaningful impact on earnings. THAI and SIA will have the highest earnings sensitivity to receding crude oil prices due to their slim margins and conservative hedging position respectively. The share prices of the airline stocks under our coverage are currently at an attractive below mid-cycle valuations. We maintain our OVERWEIGHT call on the sector, with AirAsia (FV: RM4.57) and Thai Airways (THB35.4) as our top BUYS.

Dynamics of oil prices. Jet fuel price has been on a downward trend since early May, plunging by 20% to an 18-month low of USD106.5/barrel. YTD, the jet fuel price has averaged USD127/barrel (YTD 2011: USD126/barrel). The price drop is in tandem with the fall in crude oil prices due to high oil inventories amid weaker demand arising from renewed concerns over the protracted European debt crisis and the slower than expected economic growth in China and the US. The decline in crude oil price is also linked to the oversupply of oil from both Saudi Arabia and Iran, which is facing trade sanctions. Nevertheless, China and India continue to import oil from Iran despite the sanctions, while Saudi Arabia continues to supply more oil to fill the gap created by the anticipated shortage due to the sanctions.

Spreads get slimmer. The spread between WTI and Brent crude has been narrowing significantly of late due to a pipe reversal between the hub at Cushing in Oklahoma and the refineries in the Gulf of Mexico. This has allowed the previous glut of oil extracted from domestic oil production from shale deposits stored in Cushing (benchmarked by the WTI) to be transported by pipe (instead of rail) to the Gulf of Mexico for refining. As the supply glut eases, the spread between WTI and Brent has accordingly narrowed. In the US, the demand for oil imports is dropping as the country is extracting oil from shale deposits and becoming more energy independent, which in turn has put further downward pressure on Brent oil price. As the US is one of the key major oil importers, the lower oil imports into the country essentially leads to surging inventory globally amid weak demand, which is in turn favorable for jet fuel price. 

THAI, SIA reap the benefits of low jet fuel prices. Jet fuel is the biggest cost component, making up about 70% of an airline’s total costs. The downtrend in jet fuel price means that airlines with the least hedging exposure and a low earnings base would see the most earnings upside. Figure 1 overleaf suggests that THAI and SIA have the highest earnings sensitivity to the recent drop in crude oil due to their low earnings base and hedging positions respectively. AirAsia’s earnings, however, are the least sensitive to jet fuel price movement given its high hedging position (at 40% in 2Q and 20%-25% in 2H), as well as high-margin low cost model, which fetches a net profit margin of 20% vs the less than 5% among its peers under our coverage.

Best time to hedge. In a matter of a few weeks, the shape of the forward curve for jet fuel has shifted from a state of backwardation to that of a contango, meaning that future prices are anticipated to be higher than the current spot price in the longer term. This means that airlines will be in a favorable position to lock in hedging positions from 2H onwards.

Global headlines shake confidence. Recent global news headlines on Europe’s lingering debt crisis, a weakening US economy and the slowing manufacturing activities globally may have been cause for worry. Generally, things are worse than anticipated and central banks and policy makers globally are expected to do whatever it takes to spur growth.  As all eyes are now on Europe’s debt crisis, the region’s failure to support a bailout will negatively affect the global economy.

Passenger demand seems encouraging. Recent statistics from SIA and Thai Airways show that demand for air travel has been resilient across the board, including traffic from/to Europe. In the immediate term, we see passenger travel possibly picking up during the summer holidays as well as due to the on-going Euro football championship and upcoming Olympics. For instance, Thai Airways’ advance bookings indicate that as much as 75% of its seats may be filled in June, well above last year’s 65.7% and 72% in May 2012, while AirAsia’s advance bookings are 3ppt higher than last year’s load factor, suggesting that demand is very encouraging. Furthermore, a weaker Euro will draw long haul travellers to the European region. As such, we think that in the immediate to medium term, air travel demand will remain encouraging and continue to see growth. However, due to intense competition, notably from carriers from the Middle East, the upside on yields may be somewhat limited. All in, given the sharp drop in jet fuel price, we expect breakeven load factors across the airline industry to improve. 

But cargo may disappoint. The weaker than expected global manufacturing data is a source of worry for the air freight market. A recovery can only be expected as towards end-2012, provided that the European debt crisis is contained. SIA has the highest exposure in the cargo segment among the airlines we cover. Despite these concerns, yesterday’s announcement that SIA will commence joint freighter services with China Cargo Airlines between Shanghai and Singapore from 26 June 2012 will stimulate tonnage carried and load factor. These two cities will essentially function as hubs for SIA’s vast global network.  

OVERWEIGHT. We are of the view that the prices of the airline stocks under our coverage are currently at attractive levels. As such, this is an opportune time to accumulate as these counters are trading below their mid-cycle valuations. However, investors should take heed of the cautious global outlook as all eyes are now on how Europe will tackle its debt crisis. We have BUY calls on the stocks across our coverage, with AirAsia being our top pick at a FV of RM4.57, followed by THAI Airways, at a FV of THB35.40.

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