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Essay: The effect of a rise in the price of oil on an airline   

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Abstract

This report will analyse the implications for the airline industry if the rising trend in oil prices continues.

Introduction

On June 20th 2014, price of oil per barrel was $114.55, yet this did not last and was the beginning of what was to be a steep decline in the price of Brent crude oil. Oil prices continued to descend for almost two years until a low peak of $27.88 on January 20th 2016. However, since then, despite fluctuations, the price of oil overall has risen. See figure 1.

Looking more closely at the past three months starting in August 1st 2017 – $51.78, we can see a steady increase with minor fluctuations. Monthly, the price seems to progressively increase with the jump from October 2nd 2017 – $56.12 to November 2nd 2017 – $60.62 being $4.50. Today the price stands at $63.90 per barrel. See figure 2.

Reasons for which oil prices have remained low in previous years

There is not one sole reason that explains why oil prices have remained consistently low in previous years, rather a few contributing factors. One of which is the low demand of oil from economies that are struggling, possibly in recession (Bowler, 2015). Economies that are becoming more efficient and trying to use other more environmentally friendly and renewable sources of energy also have a lower demand for oil (E.L., 2014). See figure 3.

Another reason for the low oil prices is that production in the United States is the highest it has been in years and there are no signs of it slowing. Furthermore, oil production in Saudi Arabia and nearby gulf countries were not reducing their production at all either, (E.L., 2014) argues that if they were to cut production, that countries, such as Russia, which they are not allies with may enjoy the benefits. In addition to this, the oil cartel ‘OPEC’ had the power to slow production in order to raise prices yet decided against this (Bowler, 2015). Together these contributed to an excess of supply of oil, which pushed the price lower. High supply causes a price decrease due to there being an excess of supply and not enough demand. In result there is less quantity sold and at a lower price. New equilibrium is now at P2Q2. This together with falling demand would drastically decrease the market price of oil. See figures 4 and 5. – S shifts right. 5. That and D shift left.

Reasons for which oil prices have recently risen

Despite the falling trend in the past three years, we have seen a steady rise in the price of oil since January 20th 2016. Reasons for this include the fact that the OPEC cartel did decide to crop production with the aim of both increasing the price and also decreasing the global excess of supply (Goldsmith, 2017). Another reason that (Reid, 2017) discusses is that demand is growing, hurricane Harvey and other storms have a need for more oil at this time, thus shifting demand to the right. Shifting demand to the right are also emerging economies, (Inman, 2017) states that these countries, particularly in the Eurozone which are not yet seeking sustainable energy in fact have a growing demand for oil. See figure 6. D shifts right.

Implications on airlines

This section will be an analysis, using economic theory and diagrams, of the possible implications for an airline if the rise in the oil price is sustained.

Costs

The price of oil has a direct impact on the cost of running an airline and thus profits. For the past three years, airlines have been benefitting from low oil prices, this means they could lower their prices to be more competitive, yet also earn more profit. This has come to an end and the oil industry is now seeing an upward trend in prices. Oil is the airline industry’s main input cost and a rise in the price will cause a huge increase in costs (Macquarie, 2016). Some airlines, after adapting to lower costs by adding long haul routes or investing in more aircrafts may not be able to accommodate these higher costs and have to be bought out or merge. The continued rise in oil prices will not only affect the flying of aircrafts, but more generally any sort of transportation and some production processes. Airlines may have to cut costs elsewhere such as cutting employees, unprofitable air routes or decrease the number of flights to a certain place. See figure 7.

Pricing decisions

To counter the negative effect on costs, airlines will have to put together strategies on pricing. Higher prices will have to accommodate higher costs, yet still include a profit, albeit a smaller one than before. With that being said, the prices must not be so high to become uncompetitive. Smaller airlines struggling with the increase of costs should be wary of bigger airlines that can withstand the higher prices, using this to undercut and kill off competition. Airlines should consider elasticities when making pricing decisions. Due to the fact that travel for work purposes will not change much with a change in price of flight tickets as demand for this purpose has inelastic tendencies, meaning the percentage change in demand will be less that the percentage change in price. See figure 8. This means that airlines can push up the price to maximise profit on these known business routes, or even on business and first class flights on long haul flights.

Contrary to this, flights to holiday destinations or ‘party towns’ may have more elastic tendencies, meaning if prices were raised slightly, one would see a larger decrease in quantity of flights sold. A good strategy might be to keep the price low whilst still gaining profit in order to maximise sales. See figure 9.

Profits

The profitability of airlines will also be impacted, some more drastically than others depending on how permanently they put adaptations towards the low prices of the past three years. Airlines must increase their prices on tickets, which may cause a decrease in the demand at this higher price, contributing to lower profits. The decrease in demand of air travel will mainly be unnecessary travel or where there are cheaper substitutes (John Hansman, 2014). Alternatively, airlines could stop flights that are not being filled to a profitable standard to save on costs and keep profits. This kind of effect on profit may also affect share prices. See figure 10.

Conclusion

In conclusion, the sustained increase in oil prices will have a more drastic impact on smaller airlines and airlines that have planned for lower oil prices. Airlines will have to increase prices to accommodate for higher and unavoidable costs, risking less profit. Some airlines will have to decrease costs elsewhere such as firing workers or decreasing the number of flights. Profit will likely decrease for all airlines, some airlines may have to shut down or merge in order to decrease losses. Bigger airlines may benefit in long run due to this and having less competition. Due to higher prices, demand will decrease; this will contribute to lower profits.

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