Airlines Confront Jet Fuel Uncertainty Amidst Conflicts And Environmental Push

Airlines operate as extremely low-margin firms, with even the most successful carriers being lucky to turn a profit margin of 20%, with the industry as a whole managing a gross margin of around 3% last year. With such razor-thin margins, it is important for airlines to reduce operational costs as much as possible.

For carriers, the largest cost, and often the one that they are the least able to control, is jet fuel, a non-negotiable product for which the number of suppliers is relatively limited. In recent years, airlines have faced even more cost pressure from rising fuel prices, something that is not inherently surprising amid a tightening of demand in energy markets on account of conflicts in the Middle East and Europe.

However, the recent environment of rising fuel prices is unlike any that carriers have seen before, as its origins actually differ from most traditional periods of tightening within the energy sector. In this article, we will take a deeper look at the newer pressure airlines have been placed under on account of rising jet fuel prices.

The factors that determine jet fuel prices

Jet fuel prices are naturally directly tied to crude oil prices as crude oil is the primary raw material required for the refinement process that creates aviation-grade fuel. Therefore, airlines have traditionally been able to use trends in oil prices to predict how their fuel costs would change, hedging their bets by stocking up on fuel when prices are low and avoiding buying when prices are high.

The price of jet fuel is not identical to the price of crude oil since the refinement process adds an extra layer of costs that are factored into the market price. The difference between the price of Brent Crude Oil and jet fuel is known as the crack spread, a number that has become increasingly important since the COVID-19 pandemic.

In the years before the pandemic and for decades before that, the crack spread had been kept to under $20 a barrel, an amount that fluctuated during different periods of economic growth and stagnation, according to the International Air Transport Association (IATA). However, across the board, carriers could expect the crack spread to have a rough value of $10, a factor that was far less important when predicting fuel prices than the price of crude oil, which was almost always more than five times that amount.

Shifting market conditions

The nature of the jet fuel market has changed drastically over the past two years, specifically leaving airlines more uncertain about fuel prices in the medium term. The outbreak of war in Ukraine in 2022 naturally led to a steep rise in crude oil prices, which peaked at over $140 per barrel in that year's spring.

Jet fuel prices, however, continued to rise and did not peak until reaching a price of over $180 in the summer of 2022, a rise that demonstrated an interesting phenomenon. The crack spread, which typically remains under $20, had spiked, even reaching a peak of $60 per barrel during this time period.

The industry's challenges continued in 2023, according to IATA data, where tensions in the Middle East and OPEC-backed production cuts drove rising crude oil prices. Prices rose sharply, and while the cost of jet fuel remained below its 2022 levels, the crack spread averaged a higher 30.6 per barrel.

Crude oil prices are forecast to remain roughly the same throughout 2024, but the crack spread, more problematically, is predicted to remain at an excessively high $26 per barrel. The crack spread's current unpredictability has left airlines without many of their most reliable tools for estimating and anticipating their future fuel costs.

What gives?

All of this statistical analysis yields a rather fascinating question: what exactly has led to such a rapid increase in the crack spread? The answer, as one would naturally expect, is nuanced and comes as a result of several different factors converging to drastically increase the price difference between a barrel of crude oil and one of refined jet fuel.

Crack spreads often increase when demand for a given commodity decreases, as refineries will be forced to raise prices to maintain profits. Furthermore, the opportunity costs of not producing complementary goods, which may be far more in demand, suddenly become a far more important factor for consideration.

The years that saw a rapid rise in the crack spread also came along with hefty increases in gasoline prices, demonstrating the prospect of refining crude oil into gasoline and motor diesel to be far more lucrative. According to the US Energy Information Administration, both gasoline and oil production in the United States reached record highs in 2023.

The elephant in the room

As one would expect, environmental regulations have undoubtedly been a major factor in the increase in crack spread and the high cost of jet fuel in aviation worldwide. This holds true across the entire energy sector, as increasingly strict environmental regulations take their toll on refineries and drilling companies' bottom lines.

According to an extensive analysis of the correlation between environmental regulations and rising fuel prices published in Energy & Environment by Brian Simpson, extensive regulations have undoubtedly led to higher costs throughout the refinement process. In the United States and especially in Europe, where most of the world's jet fuel refineries are located, almost every stage of production is subject to onerous environmental taxes.

Despite accounting for around 8% of all refinery output, jet fuel is extremely regulated and heavily taxed by nations seeking to reduce the environmental impact of the aviation industry. As a result, companies are forced to raise prices, and demand weakens as companies have an incentive to refine petroleum into other commodities that are less subject to environmental regulations.

The advent of Sustainable Aviation Fuels (SAF) has also led companies that refine petroleum to rethink their operating cost structures. Notably, with new fuel blending mandates in Europe, large-scale refineries are being forced to raise their prices higher, increasing the crack spread and putting airlines in an increasingly difficult position.