Jet Fuel Premium Set to Fall

A bit of cheery news for beleagured airlines: jet fuel, which of late had traded at a considerable premium to heating oil, is set to have that margin fall considerably, perhaps as much as 90%, due to aggressive moves by the industry to cut capacity in the face of skyrocketing (no pun intended) costs and slackening demand.

The bad news is that the fall in the spread would be only 2 to 8 cents on fuel that currently costs $4.26 a gallon. But the article also suggests that sharp falls in jet fuel demand, as in the Gulf War or immediately after September 11, have also led to drops in oil prices.

Although the Bloomberg story cites some encouraging examples of demand destruction, unless and until oil prices break (the price of oil is leading emerging economies to reduce fuel subsidies, and higher prices will cut into their purchases), not-very-profitable-even-in-the-best of-times US airlines will be on the ropes. If things don’t change soon, expect to see a lot of consumers priced out of Christmas flights and calls for bailouts in the new year (although they may need to move faster to make sure the banks don’t get all the money).

From Bloomberg:

Jet fuel’s 100 percent rise over the past year to a record $4.36 a gallon is setting the stage for its decline in the next six months….

The U.S. airline industry plans to ground 413 aircraft, eliminating 8.8 percent of seating capacity, as increasing fuel costs spur losses of as much as $13 billion, the Air Transport Association says.

Fuel demand will fall 7.5 percent this year, or 95,000 barrels a day, and 104,000 barrels a day in 2009, according to the U.S. Energy Department. That will spur as much as a 90 percent decline in the fuel’s premium to heating oil futures, said Mike Busby, manager of oil and refined-products trading for Northville Industries Corp. in Melville, New York.

“People are responding to a doubling of prices and the airline industry is one industry that is responding,” said Edward Morse, chief energy economist at Lehman Brothers Holdings Inc. “The markets will weaken significantly after the third quarter.”

The decline in airline fuel consumption parallels the drop in gasoline sales to a five-year low as drivers take vacations closer to home and use mass transit. Crude oil declined 35 percent in the three months after Sept. 11, 2001, a time when airline traffic plummeted 30 percent.

Jet fuel, along with diesel, is traded at a differential to heating oil futures because the fuels are made from similar components of crude oil at the refinery…

In 1991, when U.S. jet fuel consumption slid 8.2 percent, crude oil fell 40 percent from a high of $32 a barrel in January to $19.12 by the end of the year. Jet fuel traded at a 1.55 cent discount to heating oil by Dec. 11 of that year, down from a 3.85 cent premium six months earlier.

Lehman Brothers expects crude oil to average about $90 in the first quarter of next year….Demand for oil will be less than half of initial forecasts, increasing by 616,000 barrels a day, because of the slide in transportation use, Merrill Lynch said…

“There is definitely demand destruction going on,” Sung Yoo, an oil analyst at JPMorgan Chase & Co., said in a telephone interview. “We could see a bit of a pullback of the entire oil complex after the summer.”….

The reduction in U.S. fuel consumption may not be sufficient to reverse oil’s climb toward $200, said Adam Sieminski, chief energy economist at Deutsche Bank AG. “The difficulty is that demand is still rising in China and the Middle East and the rest of the world” while oil production may be leveling off, he said. “What price does it take to have demand growth go to zero to match zero supply growth? That’s very scary because it might take a really high price.”…

While U.S. airlines cut back, some carriers overseas are expanding, “soaking up demand reductions achieved in the United States,” Merrill Lynch said in a July 4 report…

The narrowing of jet fuel’s premium to heating oil may be limited if refiners don’t increase crude processing rates, Beutel, the energy consultant, said.

“One of the biggest factors here is the simple inability of refiners to bring up their runs,” he said. “We are still below 90 percent and that is unheard of.”

Note that there are signs that shipping, another big use of fuel, is falling, although the Baltic Dry Index is still higher than it was at year end.