Airlines awash in red ink

Hit by rising fuel costs, major carriers may have to shrink services further, say analysts.

To declare or not to declare bankruptcy.

That's the dilemma that may soon face some of the nation's major airlines, which are again losing millions of dollars. This time, much of their cash is draining directly into their fuel tanks because of record high oil prices.

To cope, the carriers have implemented an array of cost-saving and revenue-raising measures from parking older gas-guzzling planes and cutting routes to hiking ticket prices and charging extra for checked luggage. On Wednesday, American Airlines became the first network carrier to announce it will start charging $15 for the first piece of checked baggage, unless you have a level of elite status in their frequent-flier program. If there's not a passenger revolt, analysts say you can expect other carriers to follow suit.

But with the price of oil predicted to go as high as $140 a barrel this year, some airline analysts contend they'll have to do much more to avoid another round of bankruptcies. Top on many analysts' list is cutting the number of flights even more – by as much as twenty percent. That's the equivalent of two good-sized airlines.

That can be done in several ways. One is voluntary: cutting back schedules. American Airlines announced Wednesday that it was cutting the number of scheduled flights by as much as 12 percent.

Another way to trim capacity is not: A handful of smaller carriers have already declared bankruptcy this year and some have even liquidated.
While many analysts believe the major carriers will make it through this year without asking a court for bankruptcy protection, others aren't so sanguine.
"These fuel costs are just killing them," says Richard Gritta, an aviation economist at the University of Portland. "The only solution I see is some carriers going out of existence and some merging, and the Justice Department probably tolerating it because there isn't a viable alternative."

Here's why: The airlines' business model is premised on fuel costs that are much lower than they are now. For instance, in 2002 a barrel of oil cost roughly $25. Then fuel costs accounted for 13.5 percent of airlines' operating expenses, according to the Department of Transportation's Bureau of Transportation Statistics. They were losing money even then. In the fourth quarter of 2007, with oil in the $90-a-barrel range, the cost of fuel more than doubled to 29 percent of operating expenses.

Over the past seven years, the major network carriers have restructured, streamlined their operations, and cut other expenses like salaries, benefits, and pillows for your flying comfort. That was to deal with tough competition from low-cost carriers and the business community's discovery of cheaper fares on the Internet. The cost cutting has left most major carriers with some cash in the bank.

That is good news, at least for now. "Most of the airlines will make it through this year, even with the high fuel costs and the slowing economy," says Ray Neidl, an aviation analyst with Calyon Securities in New York. "But if it were to continue into next year without the airlines taking action to raise more cash or cut more capacity, then they'd be in trouble."

That trouble would translate into billions of dollars. Vaughn Cordle, an aviation analyst with AirlineForecasts, LLC in Washington, D.C., predicts that just this year the airlines could lose between $5 billion and $8 billion given predicted fuel costs.

"The industry will survive with $150, even $200 [a barrel] oil but will be 20 percent to 40 percent smaller at these price levels," Mr. Cordle wrote in an e-mail from Singapore. "The industry can only profitably support perhaps three major network airlines and a handful of point-to-point and hybrid airlines and commuter feeders."

The goal of shrinking is to allow the remaining airlines to raise prices. During the first quarter of this year, airlines have increased fares by an average of 7 percent. That's a hefty amount, but still not nearly enough to cover the unexpectedly high cost of oil.

Analysts contend prices will have to go up even higher to cover the cost of fuel.

"If we average $125 a barrel of crude for this year, that would take a 25 percent fare increase to cover that," says David Swierenga, an aviation economist with AeroEco in Austin, Texas.

Analysts disagree about how much capacity the airlines need to cut to raise prices that much. Calyon's Mr. Neidl and others believe the magic number is 20 percent. But Mr. Swierenga points out that most airlines are currently flying at 85 percent full. That means only 15 percent of their seats are now empty.

Usually, when there's a price hike, demand goes down. But despite the recent fare hikes over last year, demand has remained relatively strong. So there's a concern that if the airlines cut capacity too much, there will be some even more unhappy fliers fighting to find a seat.

"Carriers will not be able to cut back capacity enough to reduce their costs and still have enough seats available to meet the level of demand that we have today," says Swierenga. "I think what we'll have is some combination of the 25 percent fare increase and the 10 percent capacity cut."