If you are in a bad business, you generally can't help it, or help yourself. Well, if you are in airline business, we wonder who can help you.
There are too many variables which are likely to outsmart this business and its owners. For one, it requires a large amount of capital expenditure just to be where it is. Then are operating costs which are beyond management's control.
Take for example, fuel costs of airlines. If there is no fuel, the fleet can't fly. Common sense. If they don't fly, there is no revenue; no cash to settle obligations. The circle is generally vicious. Aviation fuel is the single most important component of operating costs of an airline business. And Alas, you cannot manage it. The fuel costs are beyond the control of management. The prices fluctuate at random. The steeper they go, the higher the airlines suffer.
Take a look at the historical oil prices:
And the aviation fuel prices in the past year:
Now, have a look at the airlines' income statements:
At current prices, fuel costs are about 50% of revenue generated. That means, to achieve an operating profit, all other costs will have to be below 50% of revenue. There are employee costs, lease costs, aircraft maintenance costs, airport costs, depreciation, and many other costs. To bring them down to make way for operating profit is a challenge. High interest costs (as the business requires huge capital investment usually there is high debt) can turn operating profit, if any, into much lower net profit or even loss.That's why airline business is such a pathetic business. Too much cash inside, too little or no cash outside.
Getting back to fuel costs, is there anything management can do to tackle it? Some do; they manage their fuel costs. What are the options available? You cannot fiddle with the volume of fuel. Then it's the price we are talking about.
1) Some airlines do nothing about their fuel costs. It is a good choice if you see falling prices. If oil prices keep rising, you can see the pictures above.
2) Some enter into forward contracts for oil. The price of purchase is locked in for the agreed period. It is a good strategy if you see increasing prices. But if the prices fall, airlines take the hit.
3) Instead of forward contracts, some airlines buy call options for oil. The airlines can choose to exercise the option (if prices go up) or buy market (if prices go down). This is a good choice if you don't know what is going to happen to the prices. The cost of the call is the premium paid. The prices have to be good enough to give you a better total cost including the premium.
4) The airlines have another choice, selling put options for oil. Letting someone else have the option to sell, that is. Airlines get the premium upfront. If the prices fall, the buyer (of the put) will exercise the option to sell at the agreed higher price to the airline. If the prices go up, the buyer will not exercise the option; but the airline will have to purchase fuel at higher prices from market. Its total cost is net of premium received. This is the least preferred strategy.
We can see that in one way or the other, the airline is exposed to the fuel price risk.
Let us once again conclude that airline business is such a lousy business to be in. Look elsewhere in the pond, or in another pond, shall we?
There are too many variables which are likely to outsmart this business and its owners. For one, it requires a large amount of capital expenditure just to be where it is. Then are operating costs which are beyond management's control.
Take for example, fuel costs of airlines. If there is no fuel, the fleet can't fly. Common sense. If they don't fly, there is no revenue; no cash to settle obligations. The circle is generally vicious. Aviation fuel is the single most important component of operating costs of an airline business. And Alas, you cannot manage it. The fuel costs are beyond the control of management. The prices fluctuate at random. The steeper they go, the higher the airlines suffer.
Take a look at the historical oil prices:
And the aviation fuel prices in the past year:
Now, have a look at the airlines' income statements:
At current prices, fuel costs are about 50% of revenue generated. That means, to achieve an operating profit, all other costs will have to be below 50% of revenue. There are employee costs, lease costs, aircraft maintenance costs, airport costs, depreciation, and many other costs. To bring them down to make way for operating profit is a challenge. High interest costs (as the business requires huge capital investment usually there is high debt) can turn operating profit, if any, into much lower net profit or even loss.That's why airline business is such a pathetic business. Too much cash inside, too little or no cash outside.
Getting back to fuel costs, is there anything management can do to tackle it? Some do; they manage their fuel costs. What are the options available? You cannot fiddle with the volume of fuel. Then it's the price we are talking about.
1) Some airlines do nothing about their fuel costs. It is a good choice if you see falling prices. If oil prices keep rising, you can see the pictures above.
2) Some enter into forward contracts for oil. The price of purchase is locked in for the agreed period. It is a good strategy if you see increasing prices. But if the prices fall, airlines take the hit.
3) Instead of forward contracts, some airlines buy call options for oil. The airlines can choose to exercise the option (if prices go up) or buy market (if prices go down). This is a good choice if you don't know what is going to happen to the prices. The cost of the call is the premium paid. The prices have to be good enough to give you a better total cost including the premium.
4) The airlines have another choice, selling put options for oil. Letting someone else have the option to sell, that is. Airlines get the premium upfront. If the prices fall, the buyer (of the put) will exercise the option to sell at the agreed higher price to the airline. If the prices go up, the buyer will not exercise the option; but the airline will have to purchase fuel at higher prices from market. Its total cost is net of premium received. This is the least preferred strategy.
We can see that in one way or the other, the airline is exposed to the fuel price risk.
Let us once again conclude that airline business is such a lousy business to be in. Look elsewhere in the pond, or in another pond, shall we?
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