By Tony Webber
Recent reports indicate that Qantas is increasing the price of air travel through both fare and surcharge increases, with the extent of those increases varying by both route and cabin.
They also claim that higher costs caused by a significantly higher jet fuel price is the culprit, and for the first time singling out the weaker Australian dollar as a causal driver of higher jet fuel costs.
I don't think anyone could begrudge Australian airlines putting up prices given that they have been so low for so long, particularly over the past 12 months, but to put the blame on the jet fuel price and currency movements doesn't seem to align with the facts.
Fuel price facts
So, here are the facts. The spot price of Singapore jet kerosene, which is the jet fuel benchmark that Qantas and other airlines in Asia use to determine their unhedged fuel costs, averaged $US123 per barrel from May 1, 2012 to July 30, 2013.
Over the 12 months to April 30, 2012 the price of Singapore jet kerosene averaged just under $US128 per barrel. The price of jet fuel has therefore declined by around $US5 per barrel or 2.7 per cent over these two periods.
The average value of the Australian dollar has fallen from around US104.3¢ to US101.6¢ over the same time period, which is a decline of 2.6 per cent.
Taken together, this would suggest that the Australian dollar price of jet fuel has actually declined by around 1 per cent. In terms of using backward-looking fuel cost movements to justify forward-looking fare increases the argument just doesn't stack up.
Currency
The airline could have used forward looking cost arguments that depend on the weaker Australian dollar to justify their price increases.
The Australian dollar has fallen from US106¢ in mid April 2013 down to US90.5¢ recently, which is a drop of more than 14 per cent. It is this very recent drop, and the prospects that it could drop further, that will be hurting both the flying kangaroo and Virgin Australia Australian dollar cost base at the moment.
Qantas could certainly have mounted a case that the significant recent drop in the Australian dollar and the likelihood of a further decline has put upward pressure on costs which must be recouped.
That they didn't use this forward-looking justification perhaps reflects the fact that Allan Joyce has on several occasions publicly claimed that a weaker Australian dollar is good for the Qantas group, when it quite clearly isn't.
Decoupling
The main problem that Australian airlines have at the moment, including the Qantas group, is the decoupling of the Australian/US dollar exchange rate from the oil price.
For many years, the Australian dollar has risen with the price of oil, allowing the airline a natural hedge against higher fuel prices because a stronger Australian dollar provides an offset against higher US dollar fuel costs. That natural hedge has been missing in action for the past few months.
This problem is exacerbated by the fact that Australian airlines are about to enter a weakening cycle in the Australian economy (which is, of course, linked to the currency movement). They are therefore faced with elevated fuel prices in US dollars, a weakening currency, and a floundering economy.
Add the uncertainty of an election year on top of that and you have the ingredients for a perfect profitability storm.
Capacity response
The first response to this perfect storm is not to raise prices, but to reduce capacity. In the short term this means cutting back on fleet utilisation. This will reduce variable costs at the same time as enabling higher average airfares.
Over a medium to long horizon the airline must delay the arrival of new aircraft by requesting that new aircraft arrivals be pushed back in time, by not taking up options to purchase aircraft, and by cancelling aircraft.
The problem Qantas has is that it has no control over its aggregate capacity in the domestic and regional markets. By rigidly sticking to a 65 per cent market share target in these markets, this in turn means that its aggregate capacity decisions in this market are entirely determined by its competitors.
Specifically, the market share target means that Qantas capacity must be exactly 1.9 times the capacity of its competitors. For Qantas to reduce capacity it must hope that its competitors do the same.
This loss of control of the capacity lever in a volatile economic and aviation demand environment would certainly be keeping Qantas executives awake at night – or it should be.
Tony Webber was Qantas Group chief economist between 2007 and 2011. He is now managing director of Webber Quantitative Consulting and Associate Professor at the University of Sydney Business School.