A leading airline industry fuel expert has warned that pouring money into research and development into new fuels, while ignoring the crisis in current resources is a recipe for future disaster. Speaking at the recent AAG Executive Jet Fuel conference in London, John Armbrust said: “There is a lot of money and attention spent on the promise of biofuels, which will account for 20% of future barrels, but what about other 80%? G8 should give priority to efforts to trigger a step change on renewable energy markets today.”

While applauding new environmental initiatives, Armbrust is concerned that the lack of infrastructure development in today’s refineries and pipelines will hurt airlines in future. Because oil is priced in dollars, prices remain high, and airline profits have slumped, or they are operating at a loss. Add in to the mix that OPEC predicts that jet fuel demand will be 25% higher in 2020 than it is today, despite more efficient airframes and practices. Armburst warned that although there is a great deal spent on alternative fuel research, traditional oil infrastructure capital investments are being ignored in many places. He said: “The lion’s share of R&D money goes to biofuels, but production of the other 80% of Jet A is in global crisis, with fewer refineries producing less aviation fuel.”

The aviation fuel industry is on shaky ground. The international monetary fund has predicted that the overall global economy is expected to contact by half a percent to one percent in 2009, the first time this has happened in 60 years. Energy demand has fallen roughly by seven percent worldwide. Refinery margins have fallen dramatically and the fuel industry as a whole has seen cconsolidation in world markets. The emergence of new refineries in Brazil, India, Russia, and China are leading to longer supply chains. Marry these factors to a continuing weak dollar, and global refining could permanently drop below 80% capacity.

In the developed world refineries in North America and Europe have also been hit by environmental legislation, leading to an estimated drop of 25% in US refining capacity, partly due to the cost of compliance with new regulations.

Another concern is the new emergent group of “pure play” independent refiners, which produce aviation fuel for short periods of time, according to market fluctuations. Companies such as Petroplus, the leading independent supplier of unbranded petroleum products in Europe have no obligation to supply retail outlets or support a retail brand. Armbrust said: “Independents can’t be counted on to produce fuel on a ratable basis every month. For example, one may offer 75,000 barrels one month, then the next month make something different than jet fuel.” A small buyer has no storage facility for 75,000 barrels, so is forced to turn to the majors, who sell at a higher price. Indeed, the majors may well buy from the independent refiner, since they have the capacity to store the surplus oil.

Robert Brijl who buys fuel for KLM and Air France said: “Due to the closure of refineries continental Europe is now short and has increased its imports from the Middle East, India and the Far East.” Last year Europe saw record refinery run rates at more than 90% capacity. Today refiners are cutting back in line with the recession and capacity is down to 80% or below. Larger airlines are now forced to manage their own storage and supply as major oil companies withdraw from the continent, which is expected to see a contracting jet fuel production market over the next 40 years.

Helmut Fredrich VP of corporate fuel management for Lufthansa said that fuel prices are not the major problem affecting his airline. He said: “Greater issues are the lack of refineries, cutbacks at existing refineries because of small margins and a fall in demand for gasoline. Oil companies are withdrawing from airports.” Chevron has withdrawn from continental Europe; Conoco has removed itself from Germany and the UK, while both Exxon and BP have also withdrawn from bases in Finland and the UK. Shell, too, is shutting down smaller refineries.

Lufthansa is managing its own fuel supply in many areas, using barges, trucks, trains, and pipelines into Zurich, Munich, and Vienna. Fredrich said: “It is not so easy to put the product through. We don’t like to do that as it is not our core business, but we are increasingly forced to do so.” He added that pure play refiners do not have the commitment to invest in logistical and airport infrastructure.

Five years ago United Airlines’ Robert Sturtz experienced similar issues in the US. He outlined the deal he and his team had brokered with Morgan Stanley in the US, enabling United to keep flying. Morgan Stanley now manages the logistics systems for UAL’s fuel and storage, which has saved the airline some $850 million in infrastructure development costs. United prepays Morgan Stanley one day in advance before it lifts its fuel, which helps the airline conserve cash flow and cuts its credit exposure. The bank is now making inroads into Europe, but problems with complex pipeline ownership means that it will not be so easy to replicate its US investments there.

Canada, too, is in dire straits in terms of its fuel supply landscape. There is a shortage of distillate and only eleven Jet A producing refineries in the entire country. One airline actually trucks fuel from Washington to Calgary because there is so much shortage on the airfield. James Fee and Wade Morrell of the FSM Management Group are looking at potential solutions and have created non-profit airline consortiums, which help airlines obtain credit and leverage their purchasing power. A key component of the work FSM does is to assist in developing new infrastructure. The company helps consortiums raise credit in the form of bonds – vital in today’s economic climate. ”If the structure is put in place and lenders educated – there is financing available,” said Morrell.

Hedging
While infrastructure development is a key issue, balancing the books is also critical. Keith Carter of the Star Alliance group of airlines said: “Cash flow is major problem. From the airline perspective, one day you can be in profit, but price volatility can kill you. Risk management programs help members offset 25% of their operating costs, even up to 30-40% for some smaller airlines.”

Risk management programs have taken a battering over the last few months, although many airlines would still like to hedge sensibly. The drop in fuel production has a knock on effect of lack of liquidity in the European oil sector. After last year’s turbulent markets, most airlines want to see an increase in trading transparency, but fear that over regulation could damage their ability to hedge. Virgin Atlantic’s head of fuel management Jonathan Pardoe said: “We need people in the market to provide liquidity. We need transparency and we need to see who is doing excessive deals.”

Deutsche Bank’s Jamie Trillow pointed out that hedging would always incur some risk. He said:  There is a cost associated with any type of hedge and credit appetite it is all about the right risk for the right reward." He admitted that the number of counterparties in the market had shrunk this year and that airlines are opting for "vanilla" or safer instruments. "Hedging is about cash flow management, not making profit."

Airlines are keen to see new legislation, but it must be useful to industry. Lufthansa’s Helmut Fredrich cautioned: “We have got to get the legislation right. It will have a massive effect on the industry.” Pardoe added: “Everyone is trying to force a change through, we have to be careful. Knee-jerk reactions, if not thought through, could hamper an airline’s ability to hedge their risks.”