CAN ALL BENEFIT FROM LOWER OIL PRICES? Or TRUST ME, I AM A DOCTOR
With the substantial fall in oil prices, who are the beneficiaries in aviation? When oil prices fell I made bold predictions that traffic necessarily will go up. Some people, especially airline analysts, took this to mean that this necessarily means an end of capacity discipline which they believe transformed airlines from perennial money losers to profitable enterprises. Hence they argued strenuously against expansion of capacity. So, the question is: do capacity increases have to lead to end of an era of profitability for airlines?
Obviously, a fall in oil prices is by definition not good for everybody the same as a cessation of a plague will not be good for funeral directors. But the question here is, can lower oil prices lead to more traffic benefitting passengers and aircraft manufacturers while at the same time benefitting airlines by helping them remain profitable?
The July record passenger traffic of over 10 million flyers a month achieved by Ryanair is an indication that lower oil prices should result in higher traffic levels. Incidentally, the Irish airline’s monthly load factor was 95%, being a jump of 4% year on year. When oil prices initially fell airlines were very coy about plans of expanding capacity. One, they did not really believe me that this is most likely a permanent shift rather than an aberration which will soon go away. Two, they were afraid that expanding capacity will inevitably lead them towards the old path of financial losses.
Economic theory is quite clear. In competitive markets, prices are determined by supply and demand. When the price of a major cost component goes down (like fuel for airlines), the supply curve shifts to the right resulting in lower prices and higher quantity provided to the market. This is, as always, under the provision of ceteris paribus or other things unchanged, a magic component of all economic predictions. Other factors changing while oil prices come down could outweigh the stimulus provided by the shift of supply. As one example, in Russia demand has been increasing for the last few years with high oil prices and a booming economy. As oil prices halved the Russian economy slid into recession. Additionally, political developments caused a marked deterioration in foreign relations leading the government to ban foreign travel for all public sector employees. So, despite the fall in oil prices other factors trumped that one and resulted in a fall in traffic in Russia. Overall though it is beyond dispute that a fall in oil prices, ceteris paribus, has to lead to more traffic at lower prices. Interestingly, the same results will happen in non-competitive markets. Again, economic theory is clear. Even in the case of a pure monopoly, a significant reduction in cost will lead to lower prices and higher quantity supplied. This will happen, for those who want to know, not at the intersection of demand and supply but rather of the marginal revenue and supply curves.
I have been claiming for a long time that high oil prices do not necessarily mean low airline profits. The statements of analysts that “airlines cannot be profitable at $40/50/60 …a barrel oil” were always meaningless but repeated over the years. History shows that there is no correlation between change in oil prices and change in profits, as I have documented over the years. High oil prices obviously are not good for the airline industry. They lead to higher ticket prices, hence less flying passengers. But they also cause airlines to behave in a more rational way, not to fight for market share but rather to price in a smart way. Basically airlines have to be smart or they will not survive. Low oil prices historically sometimes led to irrational pricing and unnecessary price wars leading to large financial losses. However this does not have to happen now. Airlines may have learned to price rationally. Hence the rational behavior of increasing capacity because of substantially lower oil prices, in line with standard economic theory, may lead us to the promised land of more traffic together with continuing profitability. Airlines should not be led astray by analysts who warn of increasing capacity which, in their view, must inevitably lead to losses. With lower oil prices higher capacity will happen. Existing airlines can participate in these market developments or shrivel and let newcomers take over the market. Either way, traffic will increase, benefitting the flying public and aircraft manufacturers. Airlines can behave smarter than in the past and remain profitable at higher traffic levels or resort to the old way of price wars.