Jet fuel falls as volcanic ash cloud fears revive

LONDON Tue May 24, 2011 12:49pm EDT

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LONDON (Reuters) - Jet fuel traders are on alert for flight disruptions after an ash cloud from an Icelandic volcano reached air space over parts of Britain and Ireland on Tuesday, knocking the fuel's prices lower.

The Grimsvotn volcano burst into life on Saturday, spewing out ash and steam and raising fears of a repeat of the travel chaos that followed last year's Icelandic volcanic eruption.

Prompt jet fuel prices fell to $88-$89 a tonne fob ARA over June ICE gasoil futures on Tuesday, from premiums of $94 a tonne fob ARA on Friday, as air traffic controllers warned that disruptions were expected and the first round of flights in the UK were canceled.

But jet fuel prices have touched the highest levels since September 2008 this quarter and could be overvalued, according to analysts and traders, who argue the drop in prices may overstate concern about air travel disruption.

"I think jet is overvalued in any case, the ash cloud just puts it in the front of people's minds," a distillates trader said.

Olivier Jakob, an oil analyst at Petromatrix, had similar views.

"If some people think jet is already expensive, maybe now is a good time to take profit and if you need to hedge maybe it is better to wait to see how it develops," he said.

Airlines hedge consumption of jet fuel, so if there is a big drop in consumption due to an interruption in flights, they will have too many hedges and will need to sell them.

Jakob said the physical market could also be hit by the disruption as the big airlines that are traditionally active in the barge market may hold off buying until a clearer picture emerges.

The impact is already being felt in the paper market -- June swaps have started to tumble, echoing a drop of at least 7 percent during last year's ash cloud disruption.

At 1436 GMT (10:36 a.m. EDT) on Tuesday, June jet fuel cargo differential swaps were at $93.15 a tonne cif NWE, down from $99.45 a tonne if NWE on Monday.

Further airline cancellations could accelerate the fall, according to some analysts and traders.

"Our analysis shows that the current jet differential is currently priced slightly above its five-year average," said James Zhang, energy analyst at Standard Bank Commodities in a note on Tuesday. "Hence, our view is that further disruptions to air travel could see an increasing risk of a decline in the jet differential."

But so far, substitution fuels such as diesel and gasoline used in other forms of transport, have not jumped in reaction as they did a year ago when some of the lost air travel was made up by other means.

LESSON LEARNED?

During last year's volcanic eruption airline kerosene demand shrank by close to a fifth, or 1.2 million barrels a day, as more than 100,000 flights were canceled and worldwide airline capacity was reduced by 30 percent.

The scale of the disruption this time is thought unlikely to match last year's, although Germany has insisted on closing skies as a precaution where there are signs of significant ash.

Analysts and traders have largely played down the impact of the volcanic ash cloud, pointing to a more favorable wind direction, cloud density and the fact that regulators were heavily criticized for over-reacting last time.

"I heard a report that this ash is a lot more dense than the previous cloud so its dynamics will be very different," said a distillates trader, highlighting one difficulty in predicting an outcome.

Officials have dismissed fears of a mass shutdown of European airspace and Iceland's meteorological office said on Tuesday that a reduction in volcanic activity could indicate the worst of the outburst may be over.

About 250 flights were canceled in the UK on Tuesday, and the amount of ash in north German airspace is expected to reach the threshold for a flight ban at about 0600 GMT (2 a.m. EDT) on Wednesday morning.

"I think the UK cancellations are only ex-Scotland, and experts are claiming the south won't be impacted, but I guess only time will tell," said a jet fuel trader.

He added that the volcanic ash cloud was unlikely to worry markets unless disruptions began to hit major airports and any impact on demand so far has been slight.

"I think this time the market impact will be less panic-like," agreed Thorbjorn Bak Jensen, an analyst at Global Risk Management.

"Last year the aviation community was caught by surprise, no one knew what the impact would be on airplanes. This year there is a better plan for what should happen."

(Reporting by Jessica Donati and Claire Milhench; additional reporting by Emma Farge; editing by Anthony Barker)

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