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.


19 Responses to Why Legacy Airlines Love High Fuel Prices

  1. Jon says:

    “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.”

    Southwest’s employees consistently rank themselves as the happiest in the industry. Their pay is actually higher than others in the industry (especially as legacy domestic fleets shift to subcontractors like Republic who pay far less).
    http://blogs.wsj.com/middleseat/2009/06/16/pilot-pay-want-to-know-how-much-your-captain-earns/
    Starting pilot pay at majors averages at ~$36,000/yr. Starting pay at Southwest? Almost $50,000/yr.

    Additionally, Southwest’s average airplane age is just 11 years. United’s? 13. American’s? 14. Delta’s? 17 years.

    Combine the younger fleet with lower maintenance costs due to fleet age and fleet homogeneity and you see that there’s a reason Southwest has remained profitable for 3 decades while Legacys have all needed bankruptcies to reduce their liabilities while lowering services for flyers.

    When looking at a percentage of total operating expenses, as we are right now, one must also consider that two major factors have helped the legacies which don’t show up on pie charts:
    1) Massive consolidation
    2) Bankruptcies which have allowed them to cut costs and force concessions from their employees and their customers.
    3) Consumer-friendly Southwest policies that other airlines don’t have which generate revenue (2 free checked bags, fewer change fees, seat pitch, etc). The 2 checked bag one actually hits Southwest twice because they likely carry heavier planes than a similar passenger load on a legacy, and they don’t generate as much revenue when carrying the amount of non-passenger load they have.

    My Point? You’re looking at things backwards. It’s a *good* thing to have a higher percentage of fuel costs, because that means that you’re spending less money in other areas which may not generate revenue. Looking at a graph of costs without looking at revenues/expenses/profits takes the situation out of context. As legacies have to pay a higher percentage on maintaining a variety of aging fleets, a higher percentage on overpaid and bloated management, and as a higher percentage of their investment goes to the front of the cabin, the quicker legacies concede the vast economy market to LCC’s. And if Southwest is only focused on the economy market, then they’ll be quite happy to see fuel costs go up, as it signifies that costs elsewhere are going down – likely due to efficiency.

    • Kyle says:

      You are assuming that the pie as a whole has stayed the same when you state that having fuel costs as a higher % is good. Thats one fault of looking at only a pie chart. It is very well known that WN’s labor costs have gone up dramatically in the past decade or so as well. It’s really flawed to assume old aircraft cost more. If ownership costs are low enough then keeping some older planes may be more advantageous (see Delta and Allegiant). All in all, your point is flawed because you are only citing information that makes your point seem correct.

      • Jon says:

        Kyle, The same could quite literally be said of the blog post itself. In fact, that’s precisely what i’m saying.

        The numbers used to argue that Southwest is in dire straits because the legacies have miraculously “fixed” their decades-deep flaws are themselves taken out of context and are being used to cast doubt on the only remotely-successful US airline.

    • CF says:

      Jon – I’m not trying to focus on Southwest, but it’s the only really decent low cost-ish option when comparing costs from 15 years ago to today. Nobody else has been around long enough.

      But the point is the same. Low cost carriers (of which Southwest is barely one, if even that) can use all these tactics to lower their costs, but they can’t lower the cost of fuel.

      I’m not looking at things backwards. You seem to be looking at a macro view of the industry when I’m making one single point about fuel prices. Higher fuel prices benefit the legacy airlines because low cost carriers can’t get a discount on it. It helps keep costs closer together than would be the case with lower fuel prices. What happens with all the other costs is irrelevant to that particular argument.

  2. Jeff G says:

    “… but network carrier costs have come down through restructuring.”

    “Restructuring” meaning “bankruptcy.”

    And as Jon noted above, without seeing what the other costs (primarily labor) are as a percentage, this can be misleading.

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  4. Zack Rules says:

    High fuel prices have also taken a ton of capacity out of the market, entire hubs even! Rarely do legacy carriers through tons of planes at a competitor anymore (notwithstanding United after VX entered Newark). All that margin flying the name of market share has either gone or been sent to large hubs.

    • CF says:

      Zack – Definitely, and that’s one of the points Scott Mayerowitz made in his article. It instills more discipline in these guys. When your variable costs rise, it certainly makes you think twice about adding stupid capacity.

      • SEAN says:

        Brett,

        I think your entire premmase is flawed An airline no matter the size can not survive longterm if feul costs keep rising. A great example of this was Eastern & this was way before oil prices spiked beyond $100 pbl. Lucky for the magers, they had bankruptsy to fall back on to help there bloted obligations. I don’t know how many times they will be able to go to that well in the future.

        • CF says:

          SEAN – Seriously? I’m not suggesting that if oil went up to $10 billion a barrel that it would be a good thing. Nobody could make a living flying that way. But if you told someone a decade ago that airlines could be profitable flying with $100 a barrel oil, they would have laughed at you. This isn’t some kind of open-ended thing saying that the higher the fuel price the better. The point is that fuel prices today versus 15 years ago have benefited the legacy airlines.

  5. Jerry Mandel says:

    “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.”
    Not to me. Several shorter flights with circling to land and taxiing and full power at takeoffs would require more fuel than one long flight.

    • Noah says:

      You are correct that more fuel might be used on 3 short hops vs. 1 transcon, but I think the point is on a per ticket basis.

      For example: Lets assume only 2 costs-labor and fuel. If fuel costs $100 for both airlines, but labor costs are $100 at the legacy airline and $85 at the LCC. The LCC costs are 7.5% lower than the legacy. If fuel rises to $200, the LCC costs are now only 5% lower.

      As the largest portion of the cost is the same for both airlines, as that cost rises, the cost difference disappears. So on longer sectors, where propotionally more fuel is used, the LCC advantage is small. Even worse, LCCs have a disadvantage as they dont have the scale to fill planes as they dont have a cost advantage to pass along in the form of lower fares, and likely can deploy planes on multiple shorter segments to make more money.

  6. Dan says:

    I guess you can count me in the minority of people who can understand this article, judging by the comments, but a great and thought-provoking article indeed.

  7. 121 Pilot says:

    Brett,

    I’m with the previous poster and thought this was an excellent article and right on point. When the largest expense in operating an airline is a constant for all involved it makes it much harder to find a competitive cost advantage.

    And I can speak first hand to the impact of fuel on trans con flying. Flying across the country is much more expensive on a fuel per pax basis than shorter hops and the rising cost of fuel has caused my airline to reduce trans con flying over the last several years as we’ve sought more profitable ways to employ our aircraft.

  8. A says:

    I think what’s often overlooked is that at a certain level the demand for air travel will collapse. So while fuel is an expense that isn’t controllable and can level things out between airlines they all will hit the same wall when fuel prices force ticket prices higher than the market will bear. I’ve seen it first hand where ticket prices get to a point where businesses resort to technology to have meetings remotely. Thus, legacy carriers might like high fuel prices but there’s a limit to that. If seats go unsold, or sold at a level where they take a loss on the flights, well that isn’t very good anymore, right?

    • CF says:

      A – I don’t think it’s so much of a collapse as it is a more gradual decline as prices creep up. But that goes back to the part Scott Mayerowitz mentioned in his article about capacity discipline. Higher fuel prices make airlines take action faster to cut flights that are unprofitable. So if fuel prices go up, capacity will come down to match demand at that higher level. I think the real issue is if there’s an economic shock. Something like 9/11 or a bubble bursting can have a dramatic impact in a short amount of time. That’s hard to respond to.

  9. Allen says:

    “Hedging is not something that de-risks, it just trades one risk for another.” ~Scott Kirby

    Hedging fuel ALWAYS lowers risk. Yes, there are costs to doing it but it’s wrong to say it’s trading a risk for another. If they’re literally trading one risk for another, they’re not hedging.

    Look at this graph of jet fuel prices over a 12 year period. Yes, there are times when the expensive of hedging wouldn’t “pay off”. But it’s the roll of the dice. Look at the multi-year fuel prices and then look back at the news for an airline that wasn’t hedging. Hedging may crimp prices some years but in other years it ensures the company won’t go belly up.

    http://static.businessinsider.com/image/510295ec69bedd723b000021/image.jpg

    • Hey Allen, what are your qualifications for saying that? Kirby has studied an actual hedging program that US Airways was running, and he came to the conclusion.

      As I understand it, there is the possibility that you’ll end up paying MORE for fuel, because you hedged/prepurchased fuel, and then the price went down.

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