The impact of higher fuel and emissions costs on air fares and demand
Will higher fuel and emissions costs be passed on to customers in higher fares? What will be the consequences for demand, capacity and market share?
Airline planners and commercial teams are a bit busy dealing with the current operational issues at airports across Europe. But in a world of high fuel prices and rising emissions costs, one of the biggest topics of debate will be the extent to which such increased industry costs can be passed on to customers.
We know that in the US domestic market, the big players have been very confident of their ability to fully pass on fuel cost increases. With 84% of the capacity in the hands of five players, all of whom seem to be taking the same approach, it seems likely they will succeed. The main question is what impact higher industry prices will have on demand, but airlines are also saying they will adjust capacity down if necessary.
This same thinking is likely to apply to the big long-haul markets, such as Europe - North America. The capacity and pricing decisions there are in the hands of the big joint ventures, where the same US majors sit around the table and will undoubtedly be arguing for the same approach.
However, the situation in European short-haul is much less clear. This market is much more fragmented than the US domestic market, with the top five accounting for only 49% of capacity. There are better surface transport alternatives within Europe than in the US, and of course there are no such alternatives for long-haul journeys. That makes the potential demand destruction from raising prices a bigger consideration when it comes to intra-European air travel.
The centrality of Ryanair to intra-European pricing
Ryanair accounts for around 16% of intra-European capacity these days, almost twice the size of the next biggest competitor, easyJet. When it comes to the significance of Ryanair for intra-European pricing, you need to remember that a lot of the short-haul capacity of the network players is actually devoted to long-haul connections and is not available for intra-European travel. Conservatively, I think Ryanair accounts for around 20% of the capacity available for meeting intra-European demand. In some markets, such as Italy, that rises to around a third.
Some airlines have pricing power in their local markets, notably Lufthansa in Germany. But as the lowest cost and largest player by far, Ryanair is a price setter in a way that no other airline is on European short-haul markets. To understand the likely path of industry pricing on European short-haul flights in the medium and long-term, you therefore need to look carefully at how Ryanair is likely to behave if fuel prices remain high.
Being a data-oriented kind of person, I decided to look back at history, to see what we could learn about how Ryanair has actually behaved in the past when fuel costs rose or fell.
The data
Trying to do quantitative analysis on the relationship between prices and costs relies on having as much data as possible. It is also important to look at periods of low as well as high fuel costs, to try to tease out the relationship. So I went back and assembled a data set of quarterly Ryanair figures going back to the start of 2002. It took a bit of ingenuity and even the use of the wonderful WayBackMachine to find some of the early data, but there was something quite nostalgic to looking back at quite how awful Ryanair’s website was back in the early 2000s.
Anyway, here is a chart of the raw data. I’ve truncated the scale on the chart since the “per seat” metrics went pretty crazy during the pandemic. I went with quarterly data to maximise the number of data points. The dotted lines show the four quarter moving averages, which give you a better idea of the trends excluding seasonality.
Source: Company reports, GridPoint analysis
Before I move on to the numerical analysis, I’ll make a few general observations on the trends these data show.
The yellow line shows PBT per seat. I went with PBT rather than Operating Profit, since accounting changes during the period will have moved some costs from above to below the operating cost line. PBT should not have been materially affected. Ryanair has never had much by way of debt or interest costs, so the difference is not that great anyway.
You can see that Ryanair was very profitable in the early years in terms of profit per seat, but that took a step down in 2008 and 2009, as the company was hit by a spike in fuel prices, followed by the demand hit that came with the Global Financial Crisis. Profitability continued at a lower level than historically for some years, a period during which Ryanair’s fuel costs were rising steadily. When fuel prices stabilised in the mid 2010s and then started to fall, profitability picked up and remained strong until the second half of 2018. Profitability started to fall as fuel prices rose, although profits were undoubtedly also impacted by disputes with its pilots and operational issues.
On the face of it then, there is some evidence that Ryanair’s profitability does do better when fuel prices are falling and worse when they are rising, but this seems to be more of an adjustment process than a linkage with the level of fuel costs per se.
Non-fuel costs per seat have been remarkably stable over the period, reducing in the early years as the company grew strongly, then trending gradually upwards for the rest of the period. The most recent quarterly figures show unit costs back down to pre-pandemic levels, although unit revenues still have some way to go.
Cleaning up the data
Before I attempt to answer the question about the relationship between unit revenues and unit fuel costs, we need to clean up the data a bit. The first adjustment I am going to make is to adjust for stage length, since Ryanair’s stage length did change somewhat over the period. For revenue per seat, I adjusted using the “square root” method, where a flight of double the distance should have fares which are 41% higher (√2 - 1), all other things being equal. It might sound a bit weird, but it is a relationship that has a good fit to data if you look at a cross-section of routes of different distances. For fuel cost per seat, I’m using a fuel consumption formula based on real-world aircraft fuel burn data for European routes of different stage lengths.
I’ve then removed the seasonal and constant trend components of the revenue data. For anyone who is interested, on average Ryanair’s revenue per seat grew by 0.3% per annum over this period. Relative to calendar Q4, unit revenues for Q1 are 4% worse, Q2 is 12% better and Q3 is a whopping 43% better.
This gives us the following chart, showing a time series of de-seasonalised, de-trended and stage length adjusted unit revenues against stage length adjusted fuel cost per seat. I didn’t include any of the crazy pandemic period figures after the end of 2019.
Source: Company reports, GridPoint analysis
Correlations
You can tell by “visual inspection” of the above chart that there isn’t much correlation if you do a statistical analysis using the entire period. Back in the early 2000s, fuel costs were low but unit revenues were high. The spike in fuel prices in the September quarter of 2008, followed by its subsequent collapse, doesn’t seem to have caused any response in unit revenues. A regression of these two parameters against each other unsurprisingly shows no statistically significant relationship. The estimate for the fuel cost coefficient, which is the same thing as the estimated pass-through rate, is 1.4%. No evidence for any pass-through at all.
However, if you use the period from June 2009 onwards, you get a very different story. This was a period when Ryanair wasn’t growing super fast and changes to fuel prices in either direction were sustained for several quarters, allowing pricing time to adjust. The R-squared value for a regression run on this period is 38%, meaning that fuel costs explain 38% of the variance in unit revenues. This time the relationship is highly statistically significant (a t-stat of 5 and a P-value of 0.001% for the statistically inclined). The central estimate for the % pass-through rate this time is 118%.
What does this mean? Surely we can’t have a pass-through rate of more than 100%? Well, first there is statistical uncertainty. There is a 20% chance based on this regression that the true pass-through rate could be 87% or lower.
It is also not impossible that the pass-through rate for Ryanair could be more than 100%. With relatively efficient aircraft types, high seating density and less congested airports, Ryanair’s fuel cost per seat may well be lower than their average competitor. If competitors were passing through their increases in unit fuel cost and Ryanair matched their increases, that would “over-recover” Ryanair’s actual cost increase.
Hedged fuel costs versus spot prices
As a quick aside, I wanted to address the issue of whether flight pricing is driven by fuel costs after hedging, or by marginal / spot prices. You will have seen that in my correlation work, I used hedged fuel cost. But there is a strong economic argument that marginal fuel prices should drive both capacity and pricing decisions. The profit or loss from fuel hedging contracts is a sunk item at the point that any such decision is being made. I did look at the correlation of Ryanair’s pricing to spot prices and found much lower correlations. Part of that is the “smoothing effect” that hedging provides. Airlines don’t want to be constantly adjusting prices and capacity up and down in response to volatile movements in oil prices. They only respond to sustained changes and use hedging to “smooth out the bumps”. In the case of Ryanair, we know there is a strategic element too. The company uses its high levels of hedging to allow it to be slower than competitors when it comes to raising prices. The flip side of that is that other carriers could undercut it in a falling fuel price environment. Ryanair seems understandably confident that this is unlikely to happen in practice.
Ryanair will have to pass on sustained fuel cost increases eventually
The historical analysis suggests that Ryanair does fully pass through fuel cost increases in ticket prices. A lot of that has historically been done through ancillary charges, but in the end it is all revenue to Ryanair and cost to the passenger. In reality, it is hard for Ryanair to avoid passing on the cost, as its other costs are already very low, with limited scope to reduce them to offset fuel cost increases. The company’s margins don’t have a lot of room in them to absorb significant cost increases. In 2018/19 and 2019/20, it made pre-tax profit margins of about 13% and with fuel costs making up almost 40% of revenue in 2021/22, even a small rise in fuel costs could quickly wipe out its profit if pricing is not adjusted.
They have even acknowledged the inevitable in recent public statements (Ryanair chief warns fares will rise for 5 years because flying is ‘too cheap’)
However, this is only part of the story. We know that Ryanair is likely to delay raising prices whilst its hedging protection remains in place, preferring to put pressure on competitors and gain share at their expense. With 80% of fuel costs hedged for its financial year ending March 2023, it could take many months for the impact of higher fuel prices to become fully reflected in Ryanair’s prices.
The second issue is the impact on demand. Higher industry prices will impact on volumes, which will require a capacity adjustment somewhere in the industry if higher prices are to stick. Ryanair’s strategy of delaying its own price rises as long as possible is designed to ensure that any capacity adjustment comes from competitors.
How big does the capacity reduction need to be, given likely demand destruction?
Average fuel prices in 2019 were around $650/MT, or €580/MT at 2019 exchange rates. The current spot price is around $1,200 in Europe and that’s pretty much the same figure in euros these days. So that’s more than a doubling of price. Of course, the forward curve in the oil market is lower than the spot price, so that might come down. But emissions costs for intra-European travel are becoming quite significant too and are growing fast. I’m going to stick with a doubling of the effective fuel price as a scenario to explore.
With fuel costs accounting for about 25% of revenue in 2019, a doubling of costs would need a 25% increase in unit revenues to maintain profits in absolute terms. Maintaining margins expressed as a percentage of revenue would require an even bigger increase, of course. But it should be return on capital that really matters. If prices go up by 25%, asset turn goes up by the same amount (same assets, 25% higher revenue). Investors and finance directors who are paying attention should be adjusting down any profit margin targets expressed as a percentage of revenue accordingly.
What would a 25% increase in fares do to volume? IATA estimates a -0.924 price elasticity for “whole market” changes in prices for the intra-Europe market. So 25% higher fares might reduce demand by 23%. If Ryanair doesn’t adjust its capacity down and goes for market share gains, it needs the other 80% of the market to cut capacity by something like 29% for the sums to add up. As Ryanair gets bigger, repeating the trick of forcing the capacity adjustment on everyone else is getting harder to bring off.
Before making allowances for recent operationally driven capacity cuts, intra-European capacity in the peak summer this year was running about 3% below 2019 levels. Passenger volumes have been strong, driven by pent up demand. In the short-term, resource shortages at airports have forced airlines to reduce capacity, creating an even stronger pricing environment. That is allowing airlines to raise prices and offset their fuel cost increases, which in most cases are still mitigated by fuel hedging protection.
But if fuel prices remain inflated going into the winter season and into 2023, the industry is going to need to reduce capacity compared to their original plans. I don’t get the impression that airlines are planning to do that. Some are hoping that fuel prices will have subsided by then. Other airlines that have already reduced capacity compared to 2019 do not want to make a further round of downsizing. Some of the weakest players have already disappeared completely and can’t do so again. The reborn AliItalia / ITA and Norwegian could I guess “die another day”, but they are much smaller entities than they were.
So what does all this mean for pricing and fuel cost pass-through?
In conclusion, I do think it is safe to assume that if fuel prices remain inflated without falling back, ticket prices will eventually rise to offset the increase. But with Ryanair seemingly determined to use its strong hedging position to pile pressure on competitors, carriers like Wizz reluctant to cut capacity as it would destroy their growth story, and carriers who have downsized being unwilling to do so again, it could be a rough ride in the next 12-18 months unless fuel prices drop back or underlying demand somehow comes to the rescue.
In the short-term, that’s exactly what is happening of course. I think that everyone would agree that demand has surprised to the upside. Long-haul demand is also very strong and that is eating up short-haul capacity at network airlines. The problems at airports this summer might have the effect of prolonging the period of pent-up demand as customers once again defer their travel plans. On the other hand, with cost of living squeezes and forecasts of recession ahead, the downside risks are also piling up.
The only reason that planned S22 capacity was close to 2019 levels overall is because some players have grown capacity, with Ryanair (up 18%) and Wizz (up 35%) by far the biggest contributors. If those two decide to stick to their guns and try and force the rest of the industry to “take the strain”, we have the mother of all market share battles ahead of us, which will make passing on fuel cost increases in the next year or so much more of a struggle than I think many are assuming.
Let the battle commence.
