Military fuel needs hit airlines - Rising demand boosts prices, adds to carriers' woes

www.chicagotribune.com By Melita Marie Garza Tribune staff reporter Published February 13, 2003

As the nation prepares to go to war with Iraq, the U.S. military and the domestic airline industry are vying for the same increasingly expensive commodity--jet fuel.

The competing demands for jet fuel have bid up the prices, adding to the woes of hard-hit U.S. air carriers that can ill afford to absorb higher fuel prices, their second-biggest expense behind labor.

To be sure, major military mobilizations have always required large amounts of fuel.

But jet fuel now is the core of the military's fuel strategy. In the aftermath of the Persian Gulf war in 1991, the U.S. military adopted NATO's one-fuel policy in an effort to simplify logistics and save money. These days, jet fuel powers every fighting vehicle in the air and on the land, including Army tanks and jeeps.

"The U.S. military is the largest single buyer of jet fuel in the world," said Cristina Haus, editor of Jet Fuel Intelligence. "Prices will rise even if the military has enough fuel. This is a war that can impact jet fuel more than any other crude oil product."

Before the Persian Gulf war, Kuwait was the main supplier of fuel for U.S. military aircraft. When Iraq invaded its oil-rich neighbor, Saudi Arabia stepped in to supply the U.S.-led coalition forces. This time around, however, the U.S. military has signed supply contracts with virtually every Middle East oil refiner, Haus said.

Still, supply demand tied to the U.S. military's preparation for an incursion into Iraq is but one factor contributing to the tighter market and higher prices for jet fuel.

Even though airlines have curbed flights as demand has fallen, the oil strike in Venezuela, which began Dec. 2, has intensified the problem by taking a major U.S. supplier offline for more than two months.

"Clearly, the Venezuelan situation has put upward pressure on distillate prices," Guy Caruso, administrator of the U.S. Energy Information Administration, said in an interview. "It's a combination of the Venezuelan reduction in output, coming at a time when winter demand for home heating oil, exacerbated by cold weather, is at its peak."

Shifts in production

Jet fuel, heating oil and diesel fuel all are so-called middle distillates. When demand for heating oil rises, it can shift production of jet and diesel fuel as refiners rush to capture higher prices.

Most of the demand for heating oil is generated in the Northeast, from New England through the Middle Atlantic states.

Historically, in times of tight supply, Europe provides additional shipments of heating oil to the East Coast. But colder weather in Europe has made supplies tighter there, with little left over to be shipped to the U.S., Caruso said.

Phil Flynn, vice president and senior market analyst with Alaron Trading Corp. in Chicago, said Venezuela is producing only 1.5 million barrels of oil a day.

That's still a far cry from the 3 million barrels a day it was producing, Flynn said. "The cumulative total of what we've been losing is just beginning to be felt."

Some nations stockpiling

Flynn also believes that some countries are stowing oil away in the event of war, hoping to bolster supplies.

"Anybody who can afford to put away a barrel of crude oil is doing so," Flynn said.

The higher jet fuel prices have come at a particularly critical time for the airline industry.

"The problem is that in this weak revenue environment, airlines can't pass along their increased fuel costs as they could when the economy and business traffic were booming," said Ray Neidl, an airline industry analyst. "And, even on a reduced schedule, they still have to fly airplanes."

Perhaps no airline is more vulnerable than Elk Grove Township-based United Airlines, whose precarious financial position landed it in bankruptcy court late last year and left it without recourse to financial safeguards such as fuel hedging.

Oil companies that participate in the fuel hedging process are reluctant to work with companies that may be in financial distress, the airline told employees recently. Because of United's financial situation, it was unable in 2002 to secure hedges for 2003.

In contrast, Houston-based Continental Airlines has hedged about 95 percent of its fuel at a crude oil price of $33 a barrel for the first quarter. Airlines' fuel hedging is based on the price of crude oil.

In relation to historical prices it's still very high; in relation to current market prices of about $35 a barrel, it's a little bit less, said David Messing, a Continental spokesman.

Messing warned that hedging wasn't a magic bullet. "It's a gamble," Messing said.

In general, a $1 increase in the cost of a barrel of crude oil equates to a $40 million increase in operating costs for the airline, Messing said.

It's easy to see how a relatively small swing in the price of crude oil rolls into a rather large change in the bottom line, Messing said, noting that fuel costs last year accounted for 12 percent of the airline's operating expenses.

Fuel consumption in 2002 was down 9 percent from 2001, principally because Continental is flying a reduced schedule and has moved to more fuel efficient airplanes, he said.

Still, jet fuel is a significant expense, Messing said. "If oil prices were at historically normal levels, our profitability outlook would be substantially different."