FROM THE ECONOMIST INTELLIGENCE UNIT

Barely recovered from the tourism impact of 9/11, the US airline sector is now under siege from record fuel prices. Does it have the resources to ride out the storm?

Every time America’s biggest carrier, United Airlines, wants to fly a Boeing 747 from Chicago to Hong Kong it must spend about US$173,000 on fuel – double the cost of four years ago. That amounts to US$500 for every passenger seat, even before the cost of crew salaries, in-flight meals, aircraft maintenance and marketing enter into the equation. The purchase price of the plane needs to be factored in, too. Small wonder triple-digit oil prices have airlines in a spin, however sanguine they may try to appear.

In 2007, the average price paid by US carriers for a barrel of crude oil was US$72, according to the country’s Air Transport Association. A barrel of refined jet fuel averaged about US$88. If this was bad enough, it now sounds cheap given the cost of crude has been as high as US$115 in recent weeks. Despite the slowdown of the US economy, factors such as China’s insatiable demand for fuel seem likely to sustain high oil prices for some time. Indeed, the shock isn’t so much that prices have gone up, but how quickly, and by how much. Airlines that had budgeted for 2008 oil costs in the range of US$85-90 a barrel have had to think again.

That’s a blow to a sector that saw greatly improved earnings in 2007, after six unprofitable years in the wake of the terrorist attacks of September 11 2001. Following a US$500m loss in 2006, the global industry posted a profit of US$5.6bn on sales of US$490bn in 2007, according to the International Air Transport Association (IATA). The biggest contribution was made by American carriers as they increased their load factors both in the domestic market – which still accounts for about 30% of global air traffic – and on international routes.

But now, the high fuel costs are compounded by an uncertain outlook for passenger traffic as the US credit crunch unfolds, and spreads to linked economies and travel markets like the UK. With 35% of its fleet more than a quarter of a century old, the US airline industry is highly exposed to higher fuel costs, since older planes tend to be 30-40% less fuel efficient than newer models. At the same time, most American airlines remain heavily in debt, and as credit tightens it will only get harder to secure finance for new and more efficient aircraft. So, instead of talking up their hopes for 2008, the country’s airlines are scaling back capacity or cutting routes, eliminating jobs and raising fares.

Evaporating profits

With industry net margins looking even more fragile than last year’s 1.1% effort, US investment bank Merrill Lynch has analysed how oil prices would affect the profits of publicly-owned American carriers' net profits in 2008. If oil prices average US$75 over the year (unlikely), all 12 airlines studied would be comfortably profitable. At US$95 a barrel (likely), five airlines would eek out limited profits, although the sector would lose US$322m. Should the price average out at US$110 a barrel (possible), just two airlines, Allegiant Air and Southwest, would make any money – and the group as a whole would haemorrhage US$3.3bn.

At Northwest Airlines, for example, an average oil price above US$100 would add US$1.7bn to the annual fuel bill – more than double the company's pre-tax profit in 2007 of US$764m. At current prices, Delta faces a fuel bill US$2bn higher than last year; American Airlines’ annual fuel bill climbs US$33m for every 1 cent increase in the average annual price of a gallon of jet fuel, and its modest US$504m profit in 2007 will be a pipe dream in the face of a US$2.6bn fuel bill increase to US$9.3bn. As recently as January, it had been forecasting an increase of US$1.5bn.

But low-cost carriers have always been most vulnerable to high oil prices, simply because fuel represents a bigger share of their operating budgets. Added to that, they have fewer assets to sell in order to generate the cash to get them through a bumpy patch. And so it comes as no real surprise that the first victims of the current malaise come from this segment of the market.

On 5 April, Skybus, an Ohio-based airline that launched mid-2007 announced that it was ceasing operations, following similar news from fellow budget players Aloha and ATA. Skybus had adopted the European low-fare model of extremely cheap tickets – as low as US$10 – supplemented by extra charges for checked bags, an assigned seat and in-flight drinks. The explanation from the airline, which had 450 employees, was to the point: “Skybus struggled to overcome the combination of rising jet fuel costs and a slowing economic environment. These two issues proved to be insurmountable for a new carrier.”

Flapping in the breeze

The pressure on the airlines to save money is made clear by the painstaking measures they are taking to lighten the load, literally, and thereby conserve fuel.

Delta has introduced a narrower, lighter seat. Alaska has invested in a beverage cart that is 20 pounds lighter than its predecessor, and could save the company US$500,000 in annual fuel costs. JetBlue has extracted six seats from its Airbus A320s, as well as extra rubbish bins and other supplies, saving nearly 500kg in weight – or US$16,000 in fuel on a three hour flight. Southwest has equipped planes with life vests so its pilots can fly more direct routes over bodies of water. American is using lighter cutlery in business and first class and redistributing weight in its cargo holds. It has also ordered pilots to taxi in on one engine. The airline burned 2.8bn gallons of fuel last year, but expects to cut that figure by 111m gallons in 2008.

On a larger scale, most airlines are revisiting their oil price hedging programmes, a somewhat risky way to cap fuel prices months or years in advance by entering into long-term contracts. They are also casting an eagle eye over their fleets. Between them Delta, United, JetBlue and US Airways plan to ground some 70 planes, while some small players like Frontier Airlines and AirTran will sell some of their near-new jets. Before announcing its closure, ATA Airlines tried to refocus on the charter market, where it is easier to pass on costs to customers. Looking ahead, Continental says it will deploy the new fuel-efficient Boeing jets it has on order not on growth routes but to replace 63 old gas-guzzlers by the end of 2009.

More noticeable to passengers are fuel surcharges, which are already commonplace on most international tickets. Now, experts are calling for such charges to be adopted as a fundamental part of the US domestic pricing system. But clearly, the prospect of upping fares in this way gives airlines the jitters given the intense competition. United led the way when it added up to US$50 on the price of a domestic round-trip, and most of its rivals followed suit to varying degrees. But they have had trouble making the charges stick, reflected in an almost comical series of new fee announcements and withdrawals.

Blood from a stone?

Even if oil prices don’t average over US$100 a barrel this year – the US government’s Energy Information Administration forecasts an average crude oil price of US$94 – airlines face a difficult year in America. Consolidation seems likely, resulting in a smaller, more expensive industry – Delta, for one, has admitted to hiring advisers to evaluate potential merger partners. Under the new open skies arrangement with the European Union, European airlines can buy up to a 25% stake in US carriers, so transatlantic partnerships are on the cards as well. Of course, open skies increases competition too, and American carriers will be even more vocal in their resistance to European calls for access to US domestic routes.

The challenge will be compounded by the often brutal cuts made post 9/11. Non-core assets were sold off, maintenance services were outsourced, customers were encouraged to book and check in using computers so jobs could be cut, and creature comforts like free food and drink and pillows disappeared even from ‘full service’ carriers. Indeed, non-fuel expenses have been reduced by 16% since 2001, sales and marketing costs have fallen by 25% and labour productivity has improved by 64%. Even so, several companies considered ‘institutions’ survived by the skin of their teeth – and only after buying time through Chapter 11 proceedings.

The spectre of bankruptcy helped airlines stave off creditors and extract massive concessions from trade unions, aircraft manufacturers and other suppliers. But in the current climate, observers wonder how much room is left for negotiations with trade unions and other protagonists. The only reason an airline would enter bankruptcy protection, they reason, would be to keep from running out of cash or defaulting on loans. For their part, the big airlines insist their balance sheets show they have the liquidity they need to deal with super-high fuel prices – for the time being at least.

SOURCE: Industry Briefing