U.S. airlines got a little fat and happy when fuel prices were at historically low levels. Passengers loved it too, because prices on competitive routes came down. But that's ending now, and travelers should get used to the new normal.
The recent series of earnings calls from airlines makes one thing clear: the rapid rise in fuel prices is starting to drive strategy across the industry and that may result in passengers paying more to fly.
Perhaps Doug Parker, the CEO of American Airlines, captured it best on his earnings call last week: “To the extent any of us were viewing this quick run-up as a spike that would quickly correct itself, we should abandon that notion.
“The fact is there are many activities that make sense at $45 a barrel of oil, which no longer make sense at $75 per barrel,” Parker noted.
When oil is cheap, U.S. airlines executives often get giddy, ordering aircraft and launching routes that wouldn’t have been viable a few years earlier.
It doesn’t happen right away, of course.
First, with memories of an earlier price spike still fresh, executives are often careful, telling Wall Street they plan to engage in “capacity discipline,” by limiting new flights. Travelers may remember 2008 through roughly 2014, when some airline executives said on earnings calls they were loath to grow capacity more than G.D.P., even as air travel demand rebounded. Eventually, the U.S. Justice Department asked if airlines were colluding to maintain high prices. (Airlines have denied the charges, but some have paid tens of millions of dollars to settle them.)
This all seems like ancient history. During the past four years, most U.S. carriers have returned to their old ways. Many have ordered aircraft, and the Big Three have been on a global binge, with United Airlines starting the longest flight ever by U.S. airline, American Airlines expanding in Asia and Australia and Delta Air Lines adding flights from smaller U.S. cities, including Indianapolis, to Europe.
Low-cost and ultra-low-cost carriers have gotten bigger, too. Discounters Allegiant Air, Frontier Airlines and Spirit Airlines have been growing rapidly, offering cheap fares and engaging larger carriers in consumer-friendly price wars. Southwest Airlines, Alaska Airlines and JetBlue Airways also have bulked up to keep pace.
They push not because they have forgotten past lessons — airline executives have long memories — but because investors expect it. During flush times, Wall Street wants airlines to maximize profits by adding routes and airplanes. It’s what successful businesses do.
It’s tough to unwind that sort of growth, but U.S. airlines are beginning to try. With oil prices up more than 50 percent since June 2017 and showing no signs they’ll fall soon, carriers say they’re ready to react to what many call the new normal. Even airlines that hedge a significant portion of their fuel, such as Southwest, are still seeing their costs rise, though not by as much as unhedged competitors, like United.
Most are already passing on their higher costs to passengers — Delta said it offset about two-thirds of the fuel price increase during the second quarter while United said it “recaptured” about 75 percent through higher fares and other means — but there’s more to be done, so passengers should prepare for higher prices as airlines adjust their capacity. Travlers might even see more fees.
Supply and Demand
As savvy travelers know, airlines don’t price their product like most companies.
Rather than pricing each ticket based on how much it costs to fly the segment, with perhaps a built-in profit margin, airlines set fares based on supply and demand. It’s why a flight on Thursday evening, when more business travelers fly, is more expensive than on a Saturday morning, even though the operating cost is the same.
When airlines want to raise ticket prices, they need to alter supply. By making seats more scarce, they should be able to raise prices. “Capacity drives pricing,” Maury Gallagher, Allegiant’s CEO, said last week.
Airlines will be tactical about the flights they remove. A decade ago, when fuel prices spiked amid a massive recession, airlines moved to slash all the flying they could, even parking aircraft because it was cheaper to sit them than fly them.
This situation is not so dire. U.S. airlines remain profitable and are still in growth mode — just not as much as in recent years. So rather than making massive cuts, they will trim some marginal performers, mostly during off-peak periods, so they can improve pricing power.
For larger airlines, marginal flights are often red-eyes and early morning departures. When fuel is cheap, an airline might send an aircraft that otherwise would sit overnight at a West Coast airport to Latin America, Chicago or Houston, and send it back to San Francisco or Las Vegas or San Diego in time to fly its regular schedule the next morning.
Passengers don’t like redeyes or 6 a.m flights, so an airline might offer discount pricing to fill seats, but when fuel is cheap, they can do it and still make money.
“[It’s] what we call utilization flying,” American’s Parker said. “That is flying where aircraft are otherwise sitting due to our hub-and-spoke structure, and we can fly them somewhere and back – and get them back into the hub. … But that variable cost is largely fuel. If you can’t cover the cost, that doesn’t make sense to fly.”
American said last week it will increase capacity only 1.6 percent, year-over-year, for the fourth quarter — a full percentage point less than it had planned. American also deferred some aircraft orders, saying it won’t need them in 2019.
“We’re still growing somewhat, and the routes that we’re reducing, we’re reducing because they’re not profitable at these levels of fuel price,” Parker said.
Allegiant, which mostly carries leisure travelers, is making similar cuts to its off-peak schedule, executives said last week.
As one example, when fuel prices were lower, the airline would sometimes stretch the timeframe it operated seasonal routes, so a flight to Florida that had been flown only in winter might extend into spring. But that’s tougher now, executives said.
“We’ve generated our profitability per route, and we’ll pull the capacity accordingly,” Gallagher said. “Particularly, you start with some of your longer-haul stuff and pull that down because that’s always weaker.”
Travelers and investors shouldn’t be too worried, as this is not a 2008 redux. Back then oil hit almost $150 a barrel amid a global recession.
As they struggled to raise ticket prices to make up for the lost revenue, airlines needed to be creative, which is why larger airlines decided to start charging for the first checked bag.
Passengers probably won’t see new fees at $75 a barrel fuel. But they might notice airlines become more sophisticated in how they charge for extras, such as seat assignments in coach, premium economy seats, or even checked baggage.
Most airlines want to improve how they price those products, so they can more often set prices dynamically — according to supply and demand. Today, some airlines vary pricing well, while others are just beginning to try.
By raising change fees and improving strategies for selling premium seats — essentially by charging more for extra legroom seats on peak flights — Alaska Airlines said last week it can increase revenues by $20 million in the second half of this year.
Still, not every airline is so worried about rising fuel prices. Earlier this month, United Airlines trimmed its growth estimates slightly for 2018, saying it will add 4.5 to 5 percent capacity this year, rather than an earlier range of 4.5 to 5.5. percent. But otherwise it plans to stay on course.
“Fuel’s a little more volatile than it’s been but we’re managing that I think just fine,” said United interim CFO Gerry Laderman.
Photo credit: American Airlines will grow capacity by a lot less than expected in the fourth quarter. Pictured is an American Boeing 737 at New York JFK. Alan Wilson / Flickr