Airlines Come Back to Earth

It’s hard to write a post about the current state of air travel without making any crashing references, but that’s probably not entirely appropriate in the wake of the US Airways crash landing on the Hudson. The current state of the four major carriers is just that, however, crashing down, down, down. AMR, the parent company for American Airlines just reported fourth quarter losses on $340 million and UAL, the parent company for United Airlines, reported losses of $1.3 billion. Yes, that is billion with a b. These losses follow a year of losses in which high fuel prices cut deeply into profits, and labor disagreements threatened to ground the legacy carriers all year.

The outlook for 2009 does not look good either. Dan Kasper, the airline guru at LECG LLC, said, “It’s very hard to be optimistic about travel demand given what we know about the economy.” This might be the understatement of the year (notice how I used hyperbole to make a statement about lack of hyperbole). Fuel prices are creeping back up. While they were low in second half of the year, it looks like OPEC and other producers may have stemmed the tide of falling prices. Of course, falling fuel is what got United into trouble in the first place.

United bet big that fuel prices would rise and hedged against this by entering into futures contracts to buy fuel. When prices fell, they were left holding these contracts to buy fuel well above market rates. Of course, who could blame them. The industry has been calling Southwest Airlines a bunch of geniuses for properly hedging against fuel price increases over the last several years, and it would have been very difficult to predict that prices would fall as low as they did. Of course, UAL stated that even without the fuel hedges, the quarterly loss was $555 million. Not too good.

Fuel is not the biggest problem for the airlines, however. The declining economy has really put air travel in a bind. Businesses are working to reduce costs, which means they buy fewer and cheaper air tickets. This declining demand has caused United to announce capacity cuts (as much as 10 percent) and job cuts of about 1,000 employees. These capacity cuts are designed to cut away the cheapest seats and drive up relative demand for the remaining seats. Read this as the average ticket price will increase or the airlines are going to go under.

Let us not forget, also, that the airlines were in trouble before the economy headed south. They are still under the yoke of 1970s-style labor contracts that push pay for pilots, flight attendants, mechanics, and airport personnel way above market rates. These labor contracts drive costs for the airlines up and they are inflexible to the point that many analyses of airline cost structure consider labor to be a fixed cost in the way that aircrafts are. Now before you run out and tell me that this is about safety, let me remind you that Southwest, the airline every chooses to fly (because it is cheap) is not subject to many of these labor agreements, and they are perfectly safe. In fact, deep down, I think it is insulting to airline workers to say that the only reason they keep us–and themselves–safe is because they are in a union. In fact, most Americans do their jobs as well as they can do them regardless of whether union rules dictate that or not.

So how can we fix the airlines? First, we probably need to get rid of one or two of them. This will reduce capacity and raise average fares. Since there are lots of fixed costs, this will likely happen by merger (e.g. Delta + Northwest) rather than shutting down competely (ATA). Second, the big guys (American, United, Delta, Continental) might need to go through bankruptcy again. Fuel prices are what they are, and the only way to reduce costs is to shed the expensive labor contracts that are bringing them down. Third, as American is doing, they need to invest in more fuel-efficient aircrafts. Fuel is either the largest or second largest cost for an airline, and anything they can do to reduce consumption will help profits.