Airline industry outlook: Fuel, fares and demand shifts heading into summer

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Harry Gowers: The airline industry is heading into summer with demands still robust, but with plenty of uncertainty in the backdrop. Gas prices, geopolitics, and the cost of travel are dominating headlines, yet the human urge to get away doesn't go away. I'm Harry Gowers, part of the European Transport and Logistics Equity Research Team and lead analyst on European airlines and travel retail stocks. And on this episode of Making Sense, I'm joined by my colleague and counterpart, a man who needs no introduction, Jamie Baker, who covers the North American airline and leasing sectors. Together, we'll unpack what the summer travel season could mean for airlines on both sides of the Atlantic. Jamie, as always, thanks for joining me.

Jamie Baker: How are you doing, Harry? And thanks for having me and looking forward to it.

Harry Gowers: Jamie, perhaps, we could start with you giving your high level read on summer travel from a North American Airlines perspective.

Jamie Baker: Very robust. So when fuel prices first began to escalate in March, the industry didn't waste any time in executing fare increases. There's been six or seven broad based increases at this time. And the cautious optimism that was expressed was that with luck, continued tight domestic supply and continued economic resilience, possibly by year-end, the industry would be close to recapturing 100% of the impact of higher fuel prices. What we're hearing now is that demand trends are certainly running ahead of my internal forecasts. I get the sense that managements feel the same, and now we're hearing that 100% figure kind of pulled forward. Maybe we get there earlier in the fourth quarter or even at some time during the summer peak. So airfares are up, but consumers are happily paying the escalated prices. And industry profitability, at least, you know, for those airlines that are in the right business model, shaping up to be a decent year, let's see what happens with fuel from here. But from a demand perspective, zero complaints. And it's very rare that we ever (laughs) say that. So now, does it differ for you in Europe? Because I don't think the observations that I've made about North America should be extrapolated onto a global stage. How are you thinking about your region of the world, Harry?

Harry Gowers: Yeah. I mean, look, clearly, the narrative has been completely dominated by the Middle East and the headlines from the last few months. It's been all about steep increase in jet fuel. And then just kind of the general uncertainty that the conflict has gone for consumer confidence and passenger demand. I think before the conflict started, if you look to European capacity schedules, you'd probably be growing about mid-single digit percentage year-over-year in terms of the total piece, short haul and long haul with a pretty healthy demand backdrop opportunities to raise prices in certain markets. The Middle East has clearly disrupted that and it's been a volatile few months for the airlines and, and for the airline stocks as well. Some capacity has come out of the Middle East, partially reallocated to some other regions on long haul. So you've seen moderating trends on long haul in terms of capacity, but the short haul capacity piece has been broadly unchanged. But then if you add into that, you've actually also seen some customer hesitancy around bookings and some price stimulation needed on short haul as well relative to long haul. So I think there's just been that kind of quite clear contrast between short haul where the low cost carriers are more exposed and also long haul where, you know, that's clearly the core market for the flag carrier groups. The low cost carriers bookings have been falling behind by a few percent versus target in terms of volume trends and then they've clearly had to drop ticket prices to try and stimulate that demand and try and get back on track. I think there's a few elements at play here. I think first of all, you've had weakness in bookings to kind of those adjacent countries to the Middle East. So people have been more hesitant to book to places like Turkey or Egypt or Cyprus.

Jamie Baker: Right.

Harry Gowers: But in that general uncertainty for passengers around the war, essential impact on their wallet and consumer spending power combined with those headlines around jet fuel shortages, which have really dominated the press and the media over here. But then if I just quickly touch on, if you look at a long haul then, it does look to be more robust from a demand standpoint. So here, the European airlines have managed to raise ticket prices to partially offset higher fuel costs, and then those higher prices seem to be sticking at the moment. And if I reference kind of, if you think about direct Europe to Asia flights, there's been a huge search in demand, because you can no longer transit through the Middle East and Middle East and airline capacity has been partially grounded since the outset of the war. So in this case, you've had some capacity disruption which has actually benefited the European airlines or the European flag carriers and led to quite strong pricing on those particular routes. So it's very much been almost like a tail of two different segments to be honest with you.

Jamie Baker: So Harry, one thing I wanted to ask you, you know, the discount airline model seems to be just chugging along in Europe, very high margins, good demand set, all that kind of stuff. You pivot back to the United States though, we just had Spirit Airlines, which at one time was the most profitable franchise in the entirety of the United States, they just shut down. We've got some other sort of consumer conscious, low price airlines that haven't been able to make money since before COVID. Meanwhile, some of the full service carriers here in the US are approaching record levels of profitability. So why the dichotomy? Why do your discount airlines function and generate returns while mine here in the United States don't seem to be capable of that?

Harry Gowers: Yeah. I mean, it's a super interesting question. It's a question which we have tried to think about and tried to explain recently in terms of almost that divergence of paths geographically but also versus history as well. Look, as a starting point, it's true that the European low-cost carriers have not seen the same financial pressures that the US sector has seen. If I think about EBIT margins last year on average for the European low-cost carriers, they were about 8%, so not a bad return. But the margin performance as well have actually narrowed a little bit versus pre-pandemic compared to the European flood carriers. So it's not been perfect sailing, but the sector is profitable or healthily profitable. Now, I think there's definitely a case here that the more fragmented market structure in Europe in terms of market share favors the low-cost carriers and favors their disruptive models. I think there's also some geographical benefits which are to be had in Europe, which can explain some of the differences versus the US. You know, if you think about kind of the amount of density populated city pairs that can be accessed in Europe, if you think about the lower stage lengths, the amount of secondary airports as well that can still-

Jamie Baker: Mm.

Harry Gowers: ... serve relatively large metropolitan areas. So there's kind of the geographical and kind of network effects which are, which are at play. But crucially, I think one of the most important points here there is the cost gap. And when we've done work over the last few years, we've found that Europe's LCCs have managed to maintain better cost discipline. I think that's a fair statement compared to their US counterparts. And so Europe's [inaudible 00:15:27] unit costs for the low cost carriers have not converged with the flag carriers or the network carriers on average versus 2019 to the same extent that you've probably seen in the US market. So keeping low unit-

Jamie Baker: Interesting.

Harry Gowers: ... you know, cost clearly enables this business model and then you can offer low airfares and the ability to stimulate that growth and take market share. But you mentioned Ryanair, that's an average. When you dig deeper, really the driver is Ryanair in the European low cost sector.

Jamie Baker: Interesting.

Harry Gowers: They've seen one of the lowest increases in extra unit costs in the whole sector versus 2019. So both EasyJet and Wizz have seen increases that have actually outstripped the European flag carriers. So when you ask that question around the low cost model in Europe, why is it so successful, really the answer to that is, is why is Ryanair's model continue to be so successful? And the answer there is effectively cost leadership, right? And that's driven by management focus on efficiency, lead capital allocation, network strategy. Anyway, I was maybe, Jamie, just gonna bring it back to fuel prices and the energy shock, because clearly you have a slightly different way US versus Europe on the hedging structure-

Jamie Baker: Mm-hmm.

Harry Gowers: ... how these airlines think about fuel. So maybe you could give kind of your latest fuel on fuel sensitivities for your airlines and hedging as well.

Jamie Baker: So given the escalation in fuel, paid yields are now up about 15 to 20% year-on-year across the board, which is offsetting much but not the entirety of higher fuel. That simply takes more time because bookings are done in advance. So, you know, fares started to go up in the month of March, but that month was already booked. So that was really summertime bookings where we started to see it. You're correct to point out that US carriers don't hedge. It's expensive and it's difficult to get right in the long run. But at this point, yeah, they're... All of the managements are bullish on recapture rates. Now, as you might imagine, airlines that cater to business travelers, J.P. Morgan's not gonna flinch if my next ticket to an event in London is a $100 more than it was this time last year. So-

Harry Gowers: Yeah, but we hope not. We hope not.

Jamie Baker: Yeah. Yeah. Well, yeah (laughs). Knock on wood. You know, I think airlines that cater to business travelers that cater to premium travelers are certainly gonna get to that 100% recapture mark sooner than airlines that really cater towards that low-

Jamie Baker: ... sooner than airlines that really cater towards that lower arm of the K-shaped economy. The one thing we are not worried about here in the United States, just given refining capacity, are jet fuel shortages. That, that's just not even on the table here in the US, but I get the sense that, you know, certain areas of Southeast Asia and also some European airports, that could be a problem. What, what, what's your house view on that at the moment?

Harry Gowers: Yeah, I mean, it's been a massive talking point for the last few months in terms of fuel scarcity or fuel availability for the European airlines. Approximately half of Europe's jet fuel imports came from the Middle East, the majority of which transited through the Strait of Hormuz. So there saw you had around 20 to 30% of its, of Europe's kind of total jet fuel exposure, shall we say, impacted by the closure of the Strait. So there have been concerns, valid concerns that Europe might effectively start running out of fuel kind of into late May, early June, which is where we are now when we're recording this. And then you'd have to start cutting back on some profitable summer flying. Now, this was a totally unprecedented situation, right? We've seen the fuel price go up before. I can't remember there ever being a conversation about airlines running out of fuel to put in the, in the aircraft, so totally unprecedented. Positively though, in the last few weeks, what we've seen is all of the European airlines have come out and [inaudible 00:19:32] much more positive on the outlook for jet fuel availability. Now, from our perspective, these structures and these supply chains are quite opaque, but all of the airlines now have come out and said, you know, summer should be largely unaffected. And that's because either A, Europe has managed to ramp up domestic production quicker than anticipated, or B, they've managed to source alternative fuel supplies. But it's also fair to say if the Strait remains shut permanently, then this is an issue which could come back. But for now, sentiment has clearly improved. I did want to say as well, you mentioned the, the US airlines don't hedge. That is a different story in, in Europe. Europe does tend to have the highest amount of hedging in place in terms of protection. But again, there are smaller unlisted or private airlines in Europe who don't hedge at all and clearly have, it would have far less protection in place versus the larger listed airlines that I cover.

Jamie Baker: Well, and the challenge here in the US is, is less about the price of crude than it is crack spreads.

Harry Gowers: Yeah.

Jamie Baker: The refining expense, because there's no real way to hedge against that component. Is that the same for the European airlines?

Harry Gowers: Yeah. And the, the hedging structures actually differ quite a lot between the airlines that I cover.

Jamie Baker: Oh, okay.

Harry Gowers: The crack spread has been an issue for those who haven't hedged jet fuel directly. So generally the low cost carriers have actually hedged jet directly. So there hasn't been, there hasn't been much issue per se in terms of the crack spread widening. But the flag carriers actually, you could argue their hedging has been less effective because they will hedge a combination of, um, rents, gas oil, in some way, but also the crack spread as well. So you've got a mixture there, which depending on the combination or the proportion of that hedging, has been that some airlines might have been more exposed to the crack spread widening versus, versus others.

Jamie Baker: Hmm, interesting.

Harry Gowers: So it's, it's a, it's an airline by airline basis.

Jamie Baker: Yeah. All right.

Harry Gowers: Jamie, I wanted to just follow up on that one very quickly. Now we're talking about bottlenecks in some way. This is the energy bottleneck. Anything you would highlight in terms of very airline specific operational bottlenecks in the US, crew, ground handling?

Jamie Baker: I think the OEM delays also added to the impairment of discounted airlines because airlines with low ex-fuel costs tend to keep them low by growing very, very quickly. And when growth is forced to cease, sometimes what we learn is that these low cost carriers weren't really as low cost as we were kind of mathematically led to believe. So, you know, the OEM challenges are still very much there. One very large debate is as fuel prices recede, do airfares begin to soften a little bit? And of course, there's no direct correlation between fuel and ticket pricing, but as input costs fall, the profit maximizing level of output, of capacity obviously is gonna change and it's that restoration of capacity that could put downward pressure on yields. We are long-term, still very much agree with that, but in the short to medium term, I just don't know where the excess capacity would come from. Spirit's fleet is grounded and is leaving the United States. JetBlue has pushed out deliveries. Frontier has pushed out deliveries. Even aircraft that are being delivered are being delivered quite late and less frequently than what we had planned. So I do fall into the camp of believing that we're gonna hold onto a lot of this stronger revenue that we're seeing this summer, even if peace in the Middle East is right around the corner and we can count on, on fuel prices receding. But that's probably one of the central debates right now. If, if we are gonna embrace lower fuel in our 2027 models, should we also step on revenue a little bit? It's a work in progress.

Harry Gowers: Yeah, as always.

Jamie Baker: But the OEM bottlenecks are, are still driving very tight domestic capacity here in the United States and that's obviously ha- had a positive attendant impact on, uh, ticket pricing.

Harry Gowers: Right, Jamie, [Start making Sense music here] that was super insightful. As always, absolute pleasure to talk to you and I think that's a great place to wrap up. So thank you so much for taking the time to chat. And to anyone listening, have a great rest of your day.

Jamie Baker: Always great to, uh, catch up with the area. Thanks so much for posting this. Take care.

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