Could higher fuel prices actually help U.S. airlines?

Publicly, U.S. airlines are wringing their hands about rising fuel costs and using the continued spike in oil prices to justify each round of fare increases and new charges for former freebies like seat selection or checking a second bag. Many carriers claim consolidation is the only viable option to survive escalating operating costs. But privately, higher oil prices may be the cause of great jubilation in some airline board rooms. In the long run, some U.S. airlines could benefit substantially from a protracted fuel price crisis, and they may be some airlines you'd least expect.

In recent years, the big six network or legacy airlines have been the most vulnerable during adverse conditions in the airline industry, but that's no longer true in a world of $120+ per barrel oil. Most airlines, with the exception of Southwest which still has much of its fuel needs hedged this year, are affected by rising fuel costs. For a variety of reasons, low cost carriers (LCCs) are at greatest risk. Within the last few months, higher fuel costs have been a major factor in the liquidation of at least eight airlines (see accompanying chart on airline liquidation), most of which were LCCs. Frontier Airlines is also bankrupt and the current fuel crunch will likely claim more victims in the coming months.

Shrinking to profitability

I've always maintained that overcapacity in the airline industry was a myth, or a concept existing only in the minds of airline executives whose carriers couldn't compete effectively against lower cost rivals. Over the last three decades of deregulation, every time an airline cut capacity another airline was waiting to fill the void, effectively foiling the former airline's attempts to fly full with fewer seats and simultaneously raise airfares.

This repeating scenario assured the continued advance of LCCs across the USA and the slow demise of a host of legacy airlines, which have been whittled down to the big six of today. With oil prices rising, we find the big six in familiar posture, trying to shrink their way to profitability by eliminating unproductive flights and routes, grounding airplanes, or seeking consolidation to reduce overhead, cut capacity, or take another competitor out of the market. In the past, efforts by the big six to lower capacity proved futile, as other airlines would inevitably step in to eat the lunch at the table they abandoned.

But this time around something is very different. After so many bankruptcies, service reductions and other cost-cutting measures, operating costs between the big six and LCCs have narrowed substantially. As the playing field is leveled, fuel costs are affecting both groups equally. Everyone is struggling to survive and the fuel crisis has tipped the balance of power in favor of some big airlines for the first time in decades.

In this harsh environment, where jet fuel costs increased more than 70% in the past year and more than 200% in the past five years, every major U.S. airline is curbing expansion plans and scaling back operations. Most of the big six already cut domestic capacity by 5% in the last few months and are planning additional 5% to 10% cuts by year end, assuming oil prices remain at these levels. Even rapidly growing LCCs like Southwest and jetBlue have trimmed their expansion plans for the current year. For the first time in decades, as the big six contract, no airline is poised to replace those abandoned flights, routes and markets.

Premium cabin revenues

The big six airlines have another advantage over the LCCs: A substantial portion of revenue is derived from premium business and first class customers and extensive international operations. This premium and international travel business is far more profitable than domestic coach, where the big six compete with LCCs. The additional premium revenue will help the big six offset operating costs on less profitable domestic coach routes and survive an extended fuel price crunch, while most LCCs have no premium business to cushion the blow.

Deep pockets

In tough times cash is king and those airlines with lots of cash on hand today are better prepared to withstand the run up in fuel costs, plus they will benefit from the demise of every competitor. Most big six airlines have deeper pockets than most LCCs, especially since they've been in recovery mode in recent years. Some of the largest airlines have amassed considerable cash sums that will help them through these horrendous times (see chart below on airline cash positions). Though American Airlines has nearly $5 billion in their cookie jar, the airline incurred a $655 million increase in jet fuel costs in the first quarter over the same period in the previous year. This turned American's tidy $81 million profit in the first quarter of 2007 into a whopping $328 million loss during the quarter that ended most recently.

At current price levels, it would take American a little under four years to burn through all its cash. Not all U.S. airlines are as well positioned. United Airlines will run out of cash in just seven quarters if the airline is unable to take evasive action.

Those airlines with sufficient cash to hang on while weaker airlines fold will acquire the defunct airline's customers and find it easier to pull down additional capacity and raise airfares. With every capacity reduction or liquidation, the remaining airlines gain strength.

Grounding older airplanes

As airlines pull down capacity, they ground airplanes. Older, gas guzzling aircraft will be the first to go. Many parked airplanes will be sold or returned to the lessors, cutting costs and giving airlines an additional shot of cash. Delta Air Lines and Northwest Airlines each plan to remove up to 20 mainline jets by year end and Delta plans to remove up to 70 regional jets as well. United Airlines will eliminate 30 aircraft and US Airways will return six leased airplanes. Some airlines have large outstanding orders for new aircraft, but many of these orders will likely be canceled or deferred by cash-strapped airlines.

Alas, while the industry may find a silver lining in the current crisis, these developments are not good news for business travelers. As airlines reduce capacity with no fear of competitive reprisal, they will also continue to raise airfares. Those airlines know they'll lose some leisure passengers and even some discretionary business travelers. But they'll eventually be flying full with fewer seats overall and more people on board who are willing to pay a premium price – that is if they are one of the survivors.

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Send David your feedback: David Grossman is a veteran business traveler and former airline industry executive. He writes a column every other week on topics of interest and concern to business travelers. E-mail him at