The Airline Industry (Part 7): Hedging, PR, and the Future

Hedging Today (Conclusion)

Airlines that started hedging when oil traded at lower levels also face challenges. For example, Southwest’s $61/barrel hedges gradually expire through 2012. The company is 55% hedged in 2009, 30% in 2010, and 15% in 2011 and 2012. This leaves the company with many important decisions about how to continue its strategy. Using collars to construct price bands will be successful if oil prices continue to rise, but could be devastating if prices fall. Internally, Southwest is discussing a call-option strategy that would protect the airline from catastrophically high prices (above $200/barrel) but would allow the airline to participate in market declines.

Even if Southwest’s hedges expire entirely, the company will have adequate time to adjust its business model appropriately, a luxury many of its competitors do not enjoy. Ultimately, the key benefit of successful hedging is this security to make long-term plans to deal with fuel cost issues regardless of where prices go. Delta’s treasurer Paul Jacobson echoes this idea:

We view our program as insurance. Our goal is to minimize the volatility of fuel expenses. To do that, you’ve got to be in the market actively without an opinion as to what energy prices will do.

Good hedging strategies give companies the time they need to plan routes and fare structures that match stable fuel costs.

Public Relations

Now that we’ve learned why airlines struggle financially and examined some potential remedies, we need to cover one more important problem: the industry’s inability to manage public relations.

Airlines are doing a terrible job of explaining to consumers why they need to raise fares. Rather than increase ticket prices, airlines have tried a nickel-and-dime approach which has only alienated travelers who are assailed by rising fuel prices every day. Airlines are charging for checked baggage, implying that the extra weight of passenger cargo directly impacts the amount of fuel consumed on a flight. Some airlines are considering taking this measure one step further by actually weighing passengers and adjusting ticket prices accordingly.

This logic is completely flawed. The combined weight of passengers and their cargo make up only 1-2% of a plane’s total takeoff weight. Customers understand this intuitively and have reacted with collective skepticism to the airlines’ surcharge strategy.

This skepticism can be traced to a general lack of customer service savvy on the part of major carriers. The Bureau of Transportation Statistics reported that more than 25% of all domestic flights were either delayed or cancelled last year. In many cases, the airlines were not to blame. However, the airlines’ history of poor service and a lack of accountability have eroded public confidence to the point that airlines will be blamed for all service interruptions, regardless of cause.

Even as airlines struggle to maintain demand amidst fare increases they still commit preventable P.R. gaffes. Southwest flew planes without mandatory inspections and drew a record fine from the FAA. Shortly thereafter, American Airlines had to cancel over 3,000 flights due to concerns over faulty wiring in MD-80 aircraft. At first, the airline was not forthcoming about the reason for the cancellations. When a spokesperson was asked if the cancellations involved a safety issue, he simply walked off camera without answering.

Customer perception probably hit a low point in February 2007 when some JetBlue passengers were stranded in airplanes for up to eight hours with overflowing sewage, no food, and little water. JetBlue’s sluggish response ultimately forced the founder-CEO David Neeleman to resign in disgrace.

As a group, airlines do not focus on customer service as a business priority. Many carriers blame the decline on cost-saving cutbacks. Whatever the cause, airlines would be better able to weather economic downturns and fuel cost shocks if customers were more confident in their ability to provide a dependable product. Constant public relations blunders will only further erode consumer sentiment.

The Future

The road to airline profitability is a long one. Warren Buffett estimates that (in aggregate) airlines have lost more money than they have made since the Wright brothers first flight in 1903. There are many steps airlines can take to begin to return to profitability. The first is to remove domestic capacity but control public relations. Airlines need to remove overlapping routes and raise fares on existing routes to cover the costs of doing business.

Reducing capacity is difficult to manage. Airplanes are capital leases which cost airlines even if they are grounded. Therefore it is in the best interest of the airlines to fly as many routes as they can, but only if the routes are price appropriately and generate profits. As a former pilot points out, airlines can do this by distributing fuel costs to consumers directly, not through bag surcharges or other schemes (see example to the left). Demand will decrease as fares rise, but customers will be more receptive to honest discussions about the increases. Trying to obfuscate the obvious through trivial charges will alienate travelers.

Greater efficiency in operations will also help airlines control costs. Some help will come from the government and the FAA. Right now, flight patterns are governed by a series of ground-based facilities that track aircraft. Planes have to fly in certain patterns to stay within tracking range. New satellite-based GPS tracking systems will improve the routes planes can fly, the distance between planes, and the speed at which they travel. However, outfitting planes for this new technology will be expensive and the FAA doesn’t expect completion until 2025 at the earliest. Still, there are technological improvements in weather tracking and data communication that should help ease congestion in the long term.

Legacy carriers have one main advantage over low-cost carriers: international routes. Legacy carriers should consolidate their international positions and make sure that these routes are priced appropriately. International travelers are less price elastic than their domestic counterparts, and legacy carriers can exploit these higher fares to help offset losses elsewhere. There is also an additional bonus for the airlines – some return fares can be denominated in currencies trading at favorable exchange rates to the dollar. This can help to offset dollar depreciation and rising oil prices.

Cost control will remain important for airlines, but they must be discriminating in consolidation. Airlines should not merge unless the partners have many overlapping routes. Otherwise, the combined airline will simply have higher labor costs.

Airlines should also consider fuel hedging programs. Since oil prices are near record highs, it may not be a good time to buy swaps or collars if airlines expect a decline in prices. However, it would wise to set price ceilings through call options or other means to make sure that future gains produce less extreme effects.

There are also steps that airlines can take for free to help control public relations. First, stress polite, courteous customer service. Even if an airline has a rigid structure, it can provide friendly service to customers. Also, airlines need to be honest with consumers. Acknowledge safety issues, be flexible when possible, and remember that higher prices mean customers have tough decisions to make. A responsive, courteous airline will be in a better position to win the business of a shrinking customer pool.

Ultimately, airlines will be forced to cut capacity if fuel prices stay at historic highs. Some of this will come through bankruptcy. Since many carriers have already filed Chapter 11, subsequent bankruptcies may require liquidation rather than restructuring. Surviving airlines will be able to consolidate routes and increase fares accordingly. The best strategy is to remove capacity, cover the cost of doing business with appropriate fares, and exploit market opportunities as they present themselves.

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