Why Legacy Airlines Love High Fuel Prices

The Phoenix Aviation Symposium is a great conference for talking about big picture items, and it generates some really good discussion. A couple weeks ago, Scott Mayerowitz, sparked by that discussion I believe, wrote about why high oil prices are good for airlines. I agree with everything he says, but there’s more to it than just that. So let’s get into detail about exactly why it is that the legacy airlines like fuel prices to be high.

The issue is not that legacy airlines like paying a lot for fuel. Of course, they’d rather have lower costs. But it has helped the competitive situation. As fuel prices have risen, it has made it harder for new entrants to start, yes. But more importantly, it has helped to reduce the cost differential between existing low cost carriers and legacy carriers. Scott Kirby, President of American, said this.

Low cost carrier costs have gone up as they age, but network carrier costs have come down through restructuring. One of the biggest changes has been the price of fuel. That’s the great equalizer because we all pay the same. Network carriers have a lot more ability to be more competitive in a market and actually win.

Let’s use some concrete examples.

Fuel Cost as Percent of Total

As you can see above, fuel costs were closer to 10 percent of total operating costs back in 1998 when fuel was cheap, but last year it was closer to a third of all costs. American’s 737-800s are going to burn the same amount of fuel as Southwest’s 737-800s (well, close, American’s might weigh more with inflight entertainment systems), and both airlines would pay the same rate for fuel.

Othere costs, however, are easier to get an advantage if you’re a low cost carrier. Let’s look at how Southwest’s costs broke down in 1998.

Southwest Cost Structure 1998

Salaries/wages/benefits? You can make people work harder and pay them less at a low cost carrier. Commissions? You don’t pay those anymore if you’re a low cost carrier. Landing fees? Fly to out-of-the-way airports that charge less. Aircraft rental/depreciation? Find cheaper, older aircraft to fly.

The point is that for most of these expenses, there are ways to reduce them if you want to keep costs down… except for fuel. In 1998, a low cost carrier could try to get an advantage on the 90 percent of its costs that weren’t fuel-related. Now, however, it can only do it on 66 percent of costs. That’s good news for the legacy airlines.

This is also the reason why it’s tougher to do long-haul low-cost flying. Fuel takes up a bigger percentage of total costs on a long-haul flight.

But let’s get back to the original issue, because I know some will disagree. Is it really true that you can’t pay less for fuel than others? Southwest certainly did that back in 2008 when it had fuel hedged but that was a different time. As fuel prices have become more volatile, the cost of hedging has gone up significantly. It’s to the point where the smarter airlines have stopped hedging. Back to Scott Kirby on this one…

Hedging is an incredibly expensive insurance policy. If you do systematic hedging… what you’re doing is buying the same amount of fuel each month as an airline that doesn’t hedge but you’re paying a lot of cost in call premiums. That’s a big expense. We’re pretty convinced that not hedging is the right approach.

What many airlines have done in the past is they just try to buy fuel at a certain price that they can lock in far in advance. The airlines will keep buying the same amount of fuel each month, but instead of using it right away, they will use it in future months. If the price of fuel goes up, then airlines do pay less for fuel. But it would have to go up a lot for the airlines to save more money than they’re spending on the hedge in the first place.

And if fuel prices go down? That’s the worst thing. Here’s Scott Kirby talking about the days when US Airways used to hedge.

I found myself hoping that fuel prices would not come down because we were hedged. United had real issues when fuel prices came down [in 2008/9], Southwest too. Hedging is not something that de-risks, it just trades one risk for another.

The result is that US Airways has paid less money for fuel than those who have hedged. It helps drive home the point – you’re not going to be able to pay less for fuel if you’re a low cost carrier. Sure, you might get lucky on the rare occasion of a massive fuel price spike like in 2008, but that’s unlikely and it’s definitely not sustainable.

The bigger chunk of total costs that fuel represents, the easier it is for legacy carriers to remain competitive with low cost carriers.

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