New Zealand Professional Investment Services Firm

Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>Transport Titbits — Oil Prices Pumping</h2>
Oil prices have been on an upwards trajectory since early December last year. Since Russia invaded Ukraine on 24 February 2022, the&nbsp;Brent crude price increased to a peak of US139/bbl&nbsp;(on 7 March 2022) but has since back-tracked to US$112/bbl (today). We’re not oil price experts and recognise there are a number of drivers in play at any one time, but simplistically we view the Russia/Ukraine situation as the global oil market’s critical influence currently.
Russia currently produces around 11m bbls of crude oil per day,&nbsp;of which it exports around 7m bbls per day. Around 2/3rds of these exports have until now gone to countries backing sanctions. These countries will need new sources of oil, potentially from producers like Saudi Arabia, UAE, Iran, Venezuela or the US. At the same time, China, India and other&nbsp;countries not backing Russian sanctions may now opt to purchase discounted-Russian oil&nbsp;altering their existing supply status quo and having a calming influence on the oil price. This appears to have been the case at least over the past week. Nonetheless, despite this calming influence fuel prices remain substantially higher than they were at the start of 2022. The knock-on impact on the transport sector is significant, though differs by mode, and the nature of industry pricing mechanisms that allow cost pass-through of fuel price changes.
Aviation most exposed &nbsp;
The&nbsp;financial exposure to fuel for different transport providers varies widely. Computing an analysis of historic costs for companies/industries provides different answers given the historic variability in fuel rates but for comparison purposes, the following is indicative of the typical fuel component of operating costs attached to different transport modes:
<ul>
<li>20%-35% Airlines</li>
<li>15%-25% Road transport</li>
<li>10%-20% Container shipping</li>
<li>10%-20% Rail</li>
</ul>
Pass-through mechanisms are helpful, with Mainfreight and Freightways largely protected
Inflationary pressures, and not just fuel, are impacting most industries currently. We expect margins to decline across many companies as a result. For the transport industry, landside sectors are more likely to deploy pass-through mechanisms for fuel costs in customer contracts. Sea freight contracts will also employ similar mechanisms. In contrast, airlines are most exposed to changing fuel prices given that ticket prices are more linked to supply and demand, than costs. Costs (or profitability) will ultimately influence supply, which will drive pricing and then demand, but the linkage isn’t direct and is lagged.
<ul>
<li>Airlines – Many airlines do not hedge their forward fuel costs (although Air New Zealand typically hedges ~75% of its volume for the next 6-12 months) therefore any changes in oil prices, or jet fuel prices, have an immediate impact on profitability as customer ticket prices don’t change once they’re issued. While hedging may remove the peaks and troughs of jet fuel, and provide certainty for a period of time, any sustained change in oil prices ultimately have an impact on industry and company profitability. Higher oil prices invariably mean lower profits and less capacity, ultimately driving ticket prices higher. Cargo customers that are subject to block space agreements (BSAs) will likely have some fuel adjustment factor tied into their agreements.</li>
<li>Container shipping – Shipping lines refer to fuel used as bunker fuel. The industry typically applies a bunker adjustment factor to assist with passing on changes in bunker cost to shippers, however these may not always be variable, as at times they may be a fixed amount for the duration of the contract. In the spot market shipping lines may attempt to pass on the soaring bunker prices by applying emergency bunker surcharges, albeit these tend to quickly get folded into headline rates. If fuel prices increase shipping lines may deploy slow steaming to mitigate the financial impact.</li>
<li>Landside freight from parcels, to pallets, to containers – Many road and rail companies deploy variable fuel adjustments to their pricing mechanisms&nbsp;to ensure that changes in fuel costs are passed directly through to customers. Both Mainfreight and Freightways are largely immune to fuel price movements.</li>
</ul>
In summary,&nbsp;we like those companies that use fuel pass-through mechanisms&nbsp;to&nbsp;de-risk the impact on profitability, thereby allowing&nbsp;their&nbsp;management teams to drive strategic and operational value irrespective of the oil price cycle. &nbsp;&nbsp;
Figure 1: Fuel prices have soared in recent months (weekly data, excludes last week’s peak of US$139/bbl)
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/262/741/original/image_47963925121647220276084.png?1647220277" class="editor-image img-responsive" data-smartkarma-image-id="262741"></figure>
Source:&nbsp;Bloomberg,&nbsp;Forsyth Barr analysis

Transport Titbits — Oil Prices Pumping
Oil prices have been on an upwards trajectory since early December last year. Since Russia invaded Ukraine on 24 February 2022, the&nbsp;Brent crude price increased to a peak of US139/bbl&nbsp;(on 7 March 2022) but has since back-tracked to US$112/bbl (today). We’re not oil price experts and recognise there are a number of drivers in play at any one time, but simplistically we view the Russia/Ukraine situation as the global oil market’s critical influence currently.
Russia currently produces around 11m bbls of crude oil per day,&nbsp;of which it exports around 7m bbls per day. Around 2/3rds of these exports have until now gone to countries backing sanctions. These countries will need new sources of oil, potentially from producers like Saudi Arabia, UAE, Iran, Venezuela or the US. At the same time, China, India and other&nbsp;countries not backing Russian sanctions may now opt to purchase discounted-Russian oil&nbsp;altering their existing supply status quo and having a calming influence on the oil price. This appears to have been the case at least over the past week. Nonetheless, despite this calming influence fuel prices remain substantially higher than they were at the start of 2022. The knock-on impact on the transport sector is significant, though differs by mode, and the nature of industry pricing mechanisms that allow cost pass-through of fuel price changes.
Aviation most exposed &nbsp;
The&nbsp;financial exposure to fuel for different transport providers varies widely. Computing an analysis of historic costs for companies/industries provides different answers given the historic variability in fuel rates but for comparison purposes, the following is indicative of the typical fuel component of operating costs attached to different transport modes:

20%-35% Airlines
15%-25% Road transport
10%-20% Container shipping
10%-20% Rail

Pass-through mechanisms are helpful, with Mainfreight and Freightways largely protected
Inflationary pressures, and not just fuel, are impacting most industries currently. We expect margins to decline across many companies as a result. For the transport industry, landside sectors are more likely to deploy pass-through mechanisms for fuel costs in customer contracts. Sea freight contracts will also employ similar mechanisms. In contrast, airlines are most exposed to changing fuel prices given that ticket prices are more linked to supply and demand, than costs. Costs (or profitability) will ultimately influence supply, which will drive pricing and then demand, but the linkage isn’t direct and is lagged.

Airlines – Many airlines do not hedge their forward fuel costs (although Air New Zealand typically hedges ~75% of its volume for the next 6-12 months) therefore any changes in oil prices, or jet fuel prices, have an immediate impact on profitability as customer ticket prices don’t change once they’re issued. While hedging may remove the peaks and troughs of jet fuel, and provide certainty for a period of time, any sustained change in oil prices ultimately have an impact on industry and company profitability. Higher oil prices invariably mean lower profits and less capacity, ultimately driving ticket prices higher. Cargo customers that are subject to block space agreements (BSAs) will likely have some fuel adjustment factor tied into their agreements.
Container shipping – Shipping lines refer to fuel used as bunker fuel. The industry typically applies a bunker adjustment factor to assist with passing on changes in bunker cost to shippers, however these may not always be variable, as at times they may be a fixed amount for the duration of the contract. In the spot market shipping lines may attempt to pass on the soaring bunker prices by applying emergency bunker surcharges, albeit these tend to quickly get folded into headline rates. If fuel prices increase shipping lines may deploy slow steaming to mitigate the financial impact.
Landside freight from parcels, to pallets, to containers – Many road and rail companies deploy variable fuel adjustments to their pricing mechanisms&nbsp;to ensure that changes in fuel costs are passed directly through to customers. Both Mainfreight and Freightways are largely immune to fuel price movements.

In summary,&nbsp;we like those companies that use fuel pass-through mechanisms&nbsp;to&nbsp;de-risk the impact on profitability, thereby allowing&nbsp;their&nbsp;management teams to drive strategic and operational value irrespective of the oil price cycle. &nbsp;&nbsp;
Figure 1: Fuel prices have soared in recent months (weekly data, excludes last week’s peak of US$139/bbl)

Source:&nbsp;Bloomberg,&nbsp;Forsyth Barr analysis

Mainfreight Ltd

Transport Titbits — Oil Prices Pumping