Doing the math with oil prices

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As China’s economic boom levels off, consumers are beginning to expect more reasonable oil prices. The cost of both raw oil and jet fuel is highly susceptible to economic shifts.

In recent months, European car owners have been shaking their heads at record-high gasoline and diesel fuel prices. The cost of crude oil has gone up, and the euro has weakened in relation to the US dollar, which is the currency of international oil trade. Small reliefs are in the horizon, however, estimates Paavo Suni of the Research Institute of the Finnish Economy.

"Prices are expected to decline slightly from here," he says, adding that the institute estimated for the per-barrel cost of Brent-quality oil to sink to 105 dollars in 2012, maybe even further. After experiencing price swings last year, the cost of Brent crude settled at roughly 110 per barrel. Suni says that considering the current economic situation, this is an expensive price point.

"Demand for oil is lukewarm in traditional industrial economies due to slow economic growth and the high cost of petroleum products. China’s growth is currently the single largest thing impacting oil prices," he says.

Prices reflect politics

The price of crude oil peaked before the financial crisis of 2008, when it cost nearly 150 dollars per barrel. The high price of oil has resulted in new investments to locate and produce new oil. These initiatives can, with a slight delay, increase the availability of oil and thus lower its cost. 

New investments also change the internal hierarchy of oil-producing countries. Especially North America is seeing an increase in oil and gas production from so-called unconventional sources, among which are, for example, oil shale and oil sands. The international energy association (IEA) thus predicts that the US will become the world’s largest producer of crude oil and natural gas within the next five years.

The lowering of oil prices requires, however, that geopolitical risks be kept under control. Political unrest and scuffles in major oil-producing regions have an immediate effect on global market prices. In the event of a conflict in the Middle East, for example, production in the Persian Gulf and deliveries through the Strait of Hormuz could be threatened.

Jet fuel – crude oil correlation

Jet fuel, used in air traffic, is a so-called middle distillate refined from crude oil. Its price correlates with the cost of crude oil relatively strongly, says Pasi Keski-Karhu, director of treasury operations at Finnair.

"Of course this correlation is constantly shifting; it’s also influenced by the stock situation of both crude oil and middle distillates. Service outages at refineries also have a direct connection to the price of jet fuel," he says.

Jet fuel prices are quoted daily in the world’s central oil trading hubs together with crude oil and other oil products, for instance Rotterdam in Europe and Singapore in Asia. Finnair’s head of fuels Ilpo Juhola says that in December of 2012, jet fuel in Rotterdam cost roughly 1050 dollars per tonne.

"The average cost of jet fuel for an agreed period is roughly 95 per cent of its final price. The remaining five per cent consists of the transportation of fuel from ports to airports, as well as of airport, intermediate storage and refuelling fees," he adds. Jet fuel makes up about 25 per cent of the operating costs of European airlines.

Airlines regularly issue tenders to fuel suppliers. Finnair, for example, generally negotiates one-year base contracts.

"Finnair currently has fuel supply contracts with nearly 50 oil companies at 150 airports around the world," Juhola says.

Balancing price swings

Airlines can employ various protective measures to reduce the impact that shifting fuel prices can have on company results.

"Airlines usually have risk management policies approved by their boards of directors. The goals and limits of fuel-hedging programs are determined in these policies," says Keski-Karhu.

Hedging programs allow airlines to create a base for planning long-term strategies. In managing fuel price risks, Finnair utilises primarily jet fuel swaps and options.

Hedging horizon is set at two years. Hedging level, meanwhile, is set at a minimum of 60 per cent for the first two quarters of the year, and is reduced gradually each quarter thereafter.

"Without hedging programmes, price changes would reflect immediately in a company’s financial performance. Oil prices sometimes shift very strongly, and long-term business planning from this standpoint would be difficult," Keski-Karhu explains.

Airlines can cut down on fuel costs in many different ways. Modern aircraft consume significantly less fuel than older planes. In addition, reducing aircraft weight with lighter seats and containers, for example, reduces consumption. Employing strategic flying techniques can have similar results; one of these is landing with a gradual "continuous descent approach."
 

Text by Matti Remes

Published January 8, 2013

Category: Market updates, Finnair Cargo

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