Jeremy Warner's Outlook: Fuelling problems for the airline industry

Carry trade nemesis; GlaxoSmithKline

It is unfair, says Ryanair's Michael O'Leary, for British Airways passengers who have already bought and paid for their tickets, to find themselves suddenly saddled with a £2.50 surcharge to cover the rising cost of the fuel taking them to their destination. The same charge of unfairness might be levelled at Ryanair and its infuriating penchant for closing down routes without notice. But let's allow that one to pass.

It is unfair, says Ryanair's Michael O'Leary, for British Airways passengers who have already bought and paid for their tickets, to find themselves suddenly saddled with a £2.50 surcharge to cover the rising cost of the fuel taking them to their destination. The same charge of unfairness might be levelled at Ryanair and its infuriating penchant for closing down routes without notice. But let's allow that one to pass.

BA's knee-jerk reaction to the rise in world oil prices demonstrates once again that, when faced with a rise in costs, the instinct of the flag carrier is to pass it on rather than to absorb it. It is no accident that all the airlines which have either announced fuel surcharges or are contemplating them are full-service national carriers.

BA says this is because they are all long-haul airlines and so spend more of their time in the air guzzling kerosene. A fully laden jumbo burns a Kyoto-busting 19,600 gallons of fuel flying from London to New York. Yet on closer inspection, the argument does not stack up. Fuel, as a proportion of total operating costs, is twice as high at Ryanair as it is at BA, because Ryanair manages to keep its other costs so low. An increase in the price of aviation fuel, therefore, ought to hit low-cost carriers harder.

Still, there are at least some advantages in charging more. One is that it enables BA to pass on cost increases more easily because the impact on ticket prices is smaller. In the case of Ryanair, a £5 fuel surcharge on a round trip might be more than the cost of the ticket. Even so, BA is bound to be damaged by the move. If only at the margin, BA and its fellow flag carriers are likely to lose at least some passengers. This they can ill afford to do with the airline industry still in such a tender state.

Rod Eddington, BA's chief executive, calculates that he can just about get away with it this time around. Yet if the price of oil keeps rising, then even Mr O'Leary will be having to eat his words. The effect of $50 a barrel for an industry still struggling with all manner of other problems would be catastrophic.

Carry trade nemesis

Just recently it was reported that the amount invested by hedge funds has grown to more than a trillion dollars. Whatever number you care to pick, it's almost certainly bigger, for hedge funds (I'm including in this category the proprietary trading desks of the big investment banks) continue to be the investment phenomenon of our times. Yet, successful though they have been in protecting and growing capital, their growth poses risks.

Whenever the interest rate cycle changes, as it has over the past month, these risks are highlighted anew by the rapid unwinding of a myriad of different carry trades. Largely unnoticed by the outside world, these have been wrecking merry havoc in financial markets for some weeks now, and there's talk of worse to come.

There is nothing new about carry trades: they are as old as money itself. The simplest form of them has been practiced by the banks since time immemorial. Indeed the whole business of banking - which is to borrow short and cheaply and lend it long and more expensively - is based around them. When money is cheap and plentiful, as it has been for some years now, the banks make hay by borrowing from the Federal Reserve and other central bankers for next to nothing and lending it for more to others. If short-term interest rates start to rise, the banks become correspondingly less profitable.

The hedge funds have developed this basic form of carry trade into a whole new industry. First it was the interest rate spread between short and long money they took advantage of. As that narrowed, the speculators started to chase more high risk assets - emerging market and corporate bonds.

As those those spreads narrowed too, the hedge funds moved on to currencies, commodities, Japanese equities and just about anything else that was going. In a process Wall Street practitioners sometimes call "reaching for yield", caution was thrown to the wind. The beauty of hedge funds is that they also offer "leverage". Thus if you expect to make a 5 per cent rate of return on your money - not bad, but hardly spectacular - you can improve it to 50 per cent by gearing the capital 10 times with borrowed money. In an era of cheap credit, the temptation is that much greater.

When the liquidity is withdrawn, and policy makers begin to tighten again, the problems begin. Over the past month there has been a mad scramble to unwind overstretched positions. Up until recently, the general assumption, encouraged by Alan Greenspan, was that the Fed would keep policy unchanged at least until the end of the year.

That perception changed with the March payroll figures, which were much more buoyant than expected. The Fed has been hinting at higher rates ever since. As a result bond markets across the world have fallen. So have commodities and the Japanese stock market, big targets over the last year for hedge fund speculation. The repatriation of money to the US as carry trades are unwound has caused the dollar to strengthen, which was again contrary to expectations and has compounded the dash to unwind positions.

The damage to the real economy has so far been limited, though many traders are feeling the pain of seriously burned fingers. A major hedge fund or bank has yet to go bust, but let's not speak too soon. As one seasoned City observer puts it: how far will Wall Street and US Treasuries have to fall before the Fed is forced to delay its planned increase in rates. The irony is that the Fed created the problem for itself by holding off for too long.

GlaxoSmithKline

The way things are going, the big pharmaceutical companies will soon be spending more on defending themselves in court than they do on research and development. Big pharma has in recent years become a legal gravy train of truly wondrous proportions. Defending patents from the ever growing challenge of generic competition is one thing, yet the profits of big pharma are under attack from all directions.

The latest battle ground is the Canadian border with the United States. Pharmaceutical drugs are generally much more expensive in the United States, where their prices are uncontrolled, than they are elsewhere. As a consequence a big cross-border trade has developed between Canada and the US, which undermines both the sales and pricing power of prescribed drugs in what is far and away the world's biggest health care market.

The US Food and Drug Administration has been generally supportive of the industry's case, this on the grounds that any unregulated distribution of drugs is likely to put safety at risk. Yet the courts are becoming much less so. In a new setback, the Minnesota District Court has ordered GlaxoSmithKline to give up all documents relating to its efforts to stop the cross border sale of its drugs. The man behind the action is Mike Hatch, the Minnesota attorney general. Eliot Spitzer, the New York attorney general, has made his name by attacking Wall Street. Mr Hatch aims for the same with his attack on the alleged profiteering of the big pharmaceutical companies.

This is just a taste of his agenda: "The drug industry has used its political clout to bottle up virtually all legislation. As a result, to combat skyrocketing health care costs, many Minnesotans have been forced to take things into their own hands by buying drugs from Canada. Now the industry is trying to use its heavy hand to stop those efforts as well."

Depending on your point of view, this is either wholly admirable popularism or misinformed nonsense, yet there is no doubt that Mr Hatch's campaign and others like it are proving highly effective. The profits made by the big pharmaceutical companies in the US have long looked indefensible. No wonder Jean-Pierre Garnier, GSK's chief executive, sometimes refers to a perfect storm of problems. New drug discovery is becoming increasingly difficult and expensive at a time when the profitability of existing patents is becoming impossible to defend.

jeremy.warner@independent.co.uk