Fuel costs are going to slash airline revenues

The International Air Transport Association has once again revised its forecast of global airline revenues downwards, this time because of rising fuel costs. 

Cloudy skies ahead for airlines

The global governing body for the industry lowered its forecast from revenues of $3.5 billion to $3 billion. This number is substantially lower than its initial forecast of $4.9 billion, which the group had already lowered on fears of a European debt-related economic slowdown.

High fuel costs will have disparate effects on individual airlines, with some carriers more adversely affected than others. Entrenched European carriers like Alitalia and Air France-KLM (AFLYY, quote) are already struggling as the result of increased competition from European budget carriers like Ryanair (RYAAY, quote) and Middle Eastern full-service carriers like Emirates.

The resulting lower yields and thin profit margins have challenged the traditional business models of the old guard of European airlines: Malev and Spanair have both gone under in the past few months. Combined with increasing fuel costs, the IATA predicts that European airlines will lose $600 million this year.

Hedging strategies will also determine which airlines struggle most during this period of elevated fuel prices. Airlines such as US Airways (LCC, quote) that have abandoned fuel hedging strategies will see severe margin pressure.

Latin American carriers have embraced hedging strategies to differing degrees. According to their most recent quarterly filings, Gol Linhas Aéreas Inteligentes (GOL, quote) has hedged 40% of their 2012 fuel consumption. LAN (LFL, quote) indicated in its annual filing that it has hedged 34% of its fuel consumption for the first three quarters of 2012.

On the other hand, COPA (CPA, quote) has hedged only 20% of its 2012 fuel. While these carriers will see some paper profits from these hedges, if Brent crude continues to trade above $120, profit margins in Latin American carriers may suffer.

Chinese airlines like China Southern (ZNH, quote) and China Eastern (CEA, quote) face different problems, as well as different solutions, as the result of rising oil prices. Chinese carriers are required to purchase the majority of their fuel domestically at spot prices set by the PRC. However, during times of sustained high fuel costs, the Chinese government allows domestic airlines to charge a predetermined fuel surcharge. In the past, sources have claimed that these additional charges are not enough to offset the rising cost of fuel. As a result, Chinese carriers are also likely to be adversely affected by higher fuel costs.

While emerging market air carriers may serve as a direct play on fast-growing middle classes, until fuel costs decrease markedly, it is difficult to make a bullish case for the sector.

LCC and CPA are trading higher on the day; AFLYY, GOL, LFL, ZNH, and CEA are all lower.

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