Case 060Macro and commodity sensitivityCore

Crude falls from USD 90 to USD 60 a barrel. Fuel is 38% of Skyvela Airlines' costs and the rupee is flat. What happens to costs and EBITDAR if fares hold, and if half the saving goes into fares?

The situation

Skyvela Airlines has annual revenue of Rs 10,000 crore and operating costs before aircraft lease rentals of Rs 9,000 crore, so EBITDAR, earnings before interest, tax, depreciation, amortisation and rent, is Rs 1,000 crore. Fuel is 38% of those costs, Rs 3,420 crore.

Crude falls from USD 90 to USD 60 a barrel and the rupee does not move. Assume, as a first pass, that the airline's fuel cost moves in proportion to crude and that Skyvela carries no fuel hedges.

Your task

Work out the new cost base and EBITDAR with fares unchanged and with half the saving passed to passengers, and say what decides which case you get.

Quick check

With fares held, roughly what happens to EBITDAR?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Costs fall 12.7%, from Rs 9,000 crore to Rs 7,860 crore, and EBITDAR more than doubles to Rs 2,140 crore if fares hold. If half the Rs 1,140 crore saving goes into lower fares, EBITDAR is Rs 1,570 crore, up 57%. Which case happens depends on competition on Skyvela's routes, not on the size of the saving.

Step 1How big is the saving, and why does profit move so much more than cost?

A crude fall from 90 to 60 is a third. If fuel cost moves with it, fuel drops from Rs 3,420 crore to Rs 2,280 crore, a saving of Rs 1,140 crore, and total costs fall 12.7%. That saving lands on an EBITDAR of only Rs 1,000 crore, a 10% margin, so a cost cut in the low teens becomes a 114% profit rise. The thinner the margin, the larger the operating leverageHow much more profit moves than revenue or cost does, because the profit left over is a small number. on any cost change.

The fuel slice shrinks; who keeps it depends on fares, Rs croreother 5,580fuel 3,4201,000Crude USD 90other 5,580fuel 2,2802,140USD 60, fares heldother 5,580fuel 2,2801,570USD 60, half passed on-570to faresEBITDAR in lime
Skyvela's fuel bill shrinks from Rs 3,420 crore to Rs 2,280 crore when crude falls to USD 60, taking EBITDAR from Rs 1,000 crore to Rs 2,140 crore with fares held, or to Rs 1,570 crore if Rs 570 crore is handed back to passengers in lower fares.
Step 2Who keeps the saving?

Think of every bus operator on one highway when diesel gets cheaper. If one cuts fares to fill seats, the others must follow, and within a season the saving belongs to passengers. Who keeps a cost saving depends on competition, not on the saving: an airline on crowded routes with spare seats passes most of it on, while one with full planes on routes with few rivals keeps it. So the question to ask is about capacity growth in the industry, not about oil.

Every rupee passed to fares comes out of EBITDAR, Rs crore1,0001,5002,000Fares held: 2,140Half passed on: 1,570All passed on: 1,0000%25%50%75%100%Share of the Rs 1,140 crore saving passed to passengers
Each 10% of the Rs 1,140 crore fuel saving passed into fares takes Rs 114 crore off Skyvela's EBITDAR, which falls from Rs 2,140 crore with fares held to Rs 1,570 crore at half and back to Rs 1,000 crore if all of it is passed on.
Rs croreCrude USD 90USD 60, fares heldUSD 60, half passed on
Revenue10,00010,0009,430
Fuel3,4202,2802,280
Other operating costs5,5805,5805,580
EBITDAR1,0002,1401,570
EBITDAR margin10.0%21.4%16.6%
With crude at USD 60, Skyvela's EBITDAR margin rises from 10.0% to 21.4% if fares hold and to 16.6% if half the fuel saving goes into lower fares.
Step 3What would you refine before publishing the number?

Three things. Jet fuel is crude plus a refining margin plus taxes and airport charges, so it does not fall a full third when crude does; if only 80% of the fuel bill tracks crude, the saving is Rs 912 crore, not Rs 1,140 crore. Fuel hedges delay the saving by however many months are hedged. And a flat rupee is an assumption worth stating, because airlines buy fuel and lease aircraft in dollars, so a weaker rupee can eat a large part of a crude fall. Fuel taxes differ by state and change over time; confirm the current structure before using it.

Where candidates lose it

The usual loss is saying costs fall a third because crude fell a third. Fuel is 38% of costs, so the cost base falls about 13%, and the interesting number is what that does to a thin margin.

The second is assuming the airline keeps the whole saving. In a competitive market fares follow fuel within a season or two, and the interviewer is testing whether you ask about competition.

What the interviewer asks next

  • Skyvela has hedged 50% of next year's fuel at USD 85. What is the saving in the first year?
  • The rupee weakens 10% at the same time as crude falls. What is left of the saving?
  • Which kind of airline benefits most from cheap fuel: a full-service carrier or a low-cost carrier?

Company names and figures are illustrative.