Will airlines suffer due to Saudi Arabia’s latest oil production cuts?

The Saudi Arabian Ministry of Energy announced on April 2, 2023, that it will introduce voluntary cuts to oil production resulting in an immediate spike in fuel prices.

The government ministry stated that together with other Organization of the Petroleum Exporting Countries (OPEC) and non-OPEC Participating Countries, the country will cut oil production by up to 500,000 barrels per day from May 2023 until the end of the year.

“The Ministry of Energy official emphasized that this is a precautionary measure aimed at supporting the stability of the oil market,” the ministry said in an announcement.

This will be the second production cut in a span of five months. In October 2022, OPEC and non-OPEC ministers agreed to slash production by two million barrels from November 2022 until December 2023.

As a result of the latest announcement, Crude Oil (CL=F) prices on the New York Mercantile Exchange (NYMEX) went from $75.67 per barrel to a peak of $81.43 on April 2, 2023. It is currently trading at $79.92 per barrel as of April 3, 2023, 11:41 AM (UTC +3). In recent weeks, oil prices have fallen from their peak on January 23, 2023, when the material closed the day of trading at $81.62 per barrel, dropping to as little as $66.74 per barrel on March 17, 2023.

Fuel-related cost volatility
During the past few years, oil markets have experienced a turbulent period. Perhaps the best example of this is the day when oil traded for less than $0 during the first lockdown in April 2020.

It reached its recent peak first on February 27, 2022 ($115.68 per barrel) after Russia’s invasion of Ukraine and reached the summit on May 6, 2022, trading at $120.67 on the NYMEX. Since then, it has been going down, allowing major fuel users, including airlines, to reduce costs on a short-term basis.

In December 2022, the International Air Transport Association (IATA), an organization that represents more than 300 airlines across the globe, stated that the aviation industry’s fuel bill increased to $222 billion and was likely to rise to $229 billion by the end of 2023. “IATA’s forecast is based on Brent crude at $92.3/barrel (down from an average of $103.2/barrel in 2022),” the organization noted. When IATA issued the forecast on December 6, 2022, Brent Crude (BZW00) traded at $78.36 per barrel on the NYMEX. The commodity opened the day at a price of $81.23 per barrel on April 3, 2023.

According to the United States (US) Bureau of Transportation Statistics (BTS), which is part of the Department of Transportation (DOT), airlines in the country consumed 1.413 billion gallons (5.3 billion liters) of fuel in January 2023, 4% less than in December 2022. “The cost per gallon of fuel in January 2023 ($3.28) was up 14 cents (4.3%) from December 2022 ($3.14) and up $1.37 (71.7%) from January 2019,” the BTS said, adding that the total fuel bill was $4.63 billion in January 2023, 0.2% more than in December 2022 and 70.6% more than in January 2019.

In its 2022 annual report published on February 23, 2023, American Airlines stated that while it earned $48.9 billion in revenue throughout the year, its operating expenses were $47.3 billion. One of the largest airlines in the world in terms of fleet size, it earned a $127 net profit in 2022, compared to a $1.9 billion loss in 2021.

The airline noted that fuel-related costs were 29% of total expenses in 2022, compared to 22% the previous year. Naturally, as more capacity was deployed throughout its network, American Airlines’ aircraft consumed more fuel, yet the average price per gallon rose from $2.04 to $3.54 between 2021 and 2022. “Based on our 2023 forecasted mainline and regional fuel consumption, we estimate that a one cent per gallon increase in the price of aircraft fuel would increase our 2023 annual fuel expense by approximately $40 million,” the airline noted in the report. Furthermore, as of December 31, 2022, the carrier did not have any fuel hedging contracts due to its policy to “not to enter into transactions to hedge our fuel consumption,” adding that it did “review that policy from time to time based on market conditions and other factors”.

The airline concluded: “As such, and assuming we do not enter into any future transactions to hedge our fuel consumption, we will continue to be fully exposed to fluctuations in aircraft fuel prices.”

Fuel hedging
In layman’s terms, fuel hedging is a bet against a certain event occurring that would swing the price of oil one way or another, such as the announcement of Saudi Arabia’s production cut resulting in an immediate price jump.

If a hypothetical airline were to hedge forward-looking fuel contracts at $78 per barrel, for example, the hedging contract would provide a huge advantage versus the direct competition, which did not hedge the price. The difference in fuel bill would allow the hedging airline to underscore its competition on the same and/or similar route by offering cheaper tickets.

Comparing American Airlines’ average price of jet fuel per gallon, which was $2.04 in 2021 and $3.54 in 2022, to Delta Air Lines’ results in 2021 ($2.02) and 2022 ($3.36) it could be said that not hedging might not always pay off, such as in the case of 2022. However, in its 2022 annual report, Delta Air Lines said it “recognized losses of $394 million, $146 million and gains of $85 million on our fuel hedge contracts in aircraft fuel and related taxes on our income statement for the years ended December 31, 2022, 2021 and 2020, respectively.”

Like American Airlines, United Airlines’ current strategy, according to its 2022 annual report, is to “not enter into financial transactions to hedge the market price exposure of its expected fuel consumption”.

However, according to its own 2022 annual report, Southwest Airlines had “approximately $179 million in unrealized gains, net of taxes, which are expected to be realized in earnings during the twelve months subsequent to December 31, 2022” from fuel hedges. At the same time, between Q2 and Q4 2020 and throughout 2021, due to the reduced demand for air travel, Southwest Airlines was “over-hedged”, which is why it “reclassified approximately $39 million and $6 million in losses from Accumulated Other Comprehensive Income (AOCI) into Other (gains) losses, net, during 2020 and 2021, respectively”.

While the impact of the recent production cuts would need to be studied on a case-by-case basis, airlines that have hedged fuel below the upcoming market price will undoubtedly win if fuel were to become more expensive.