For Economic Tutor

Student X

Research Paper:

Oil Versus the Airlines

Presented to:

Professor Thomas C. Makemson

In Partial Fulfillment of the Requirements of:

Managerial Economics

Fall 2, 2012

Section QS

ABSTRACT

For an industry whose success is based on seemingly price alone, the airline industry faced yet another economic setback during 2008. Since the Airline Deregulation Act of 1978, an airline’s survival is derived from ticket price. Such a phenomenon seems intuitive, yet it is not. From a non airline manager’s perspective, setting the ticket price for a flight is simple; calculate the marginal cost for the seat and apply an appropriate markup. The result is the ticket price for a flight. However, such price determination is not the case. Airline managers are faced with the challenging of meeting or beating the ticket price for each competing carrier in the markets they compete in. For example, when setting the ticket price for a flight between St. Louis, MO and Chicago, IL, an American Airlines manager is most likely concerned with Southwest Airline’s ticket price for a flight between the same two cities rather than American’s marginal cost for the ticket.

The above example presents a problem for airline managers; the ticket price is less a function of the cost for a flight than the competition’s ticket price for that market. Although the same is true for many industries, most firms outside of the airline industry are better able to differentiate their product thus allowing prices to be set according to cost. The traveling public has made product differentiation nearly impossible for the airlines by purchasing a ticket on price alone, not any particular feature of a carrier. For example, two separate individuals, Joe and Jill, find him and herself hungry for dinner. Joe wants something quick and cheap while Jill would like formal dinner. Given these distinct preferences, it is easy to see how restaurants can differentiate their food based on more than price alone.

A fast-food drive-through, such as McDonald’s or Burger King, appeals to Joe but not Jill; a sit down establishment, such as Olive Garden or Cheesecake Factory, appeals to Jill but not Joe. As a result, McDonalds can focus on delivering its food fast with a low price and appeal to the many “Joes” while Olive Garden can focus on providing an eloquent evening while charging a higher price and appealing to the many “Jills.” While restaurants have the ability to differentiate their product and charge different prices than the competition, airlines cannot. Consider again Joe and Jill. Each needs to travel from Houston, TX to Las Vegas, NV for business, leaving on December 23, 2008 and returning December 26, 2008. The only selection criterion for Joe and Jill is the cheapest direct flight between the two cities; neither is concerned with leg-room, snacks, video-entertainment, pillows, blankets, or any other amenities.

Armed with his and her travel dates, Joe and Jill each compare airlines online and find two direct flight options between Houston and Las Vegas. Continental Airlines offers non-stop service for $704.00 while Southwest Airlines serves the same route for only $412.50. Which airline will be awarded Joe and Jill’s travel dollar? Southwest Airlines will most likely be picked by each but not because Southwest has differentiated its product from Continental. Continental looses two potential passengers because its ticket price is nearly $300 more than Southwest.

Given the highly competitive and price sensitive market the airlines operate within, how do they adjust their prices when extraordinary expenses arise? More specifically, what if a budgeted expense nearly doubles within several months? How do air carriers react? Do entire business models change? These questions in response to the hypothetical cost escalation were asked during the Summer of 2008 when the price of oil spiked to record highs; as the cost of a barrel of oil grew exponentially so did every airlines’ largest expense – fuel. How did each carrier react? Through this paper, this question will be answered. Additionally, research will be provided to highlight the crippling affect the oil price run-up had on the airline industry.

OIL CRISIS of the SUMMER OF 2008

Nearly every American was affected by the wildly escalating oil prices during the Summer of 2008. Whether it was higher gas bills to travel to work or increased shipping expenses to get product to market, personal and business budgets were stretched thin. Whereas the objective of this paper is not to determine the reason for the oil crisis, a brief overview of the price run-up is required in setting the foundation for a closer look at the airlines’ response.

Twenty-one years of historical oil prices were analyzed; in the early 2000s, the price found equilibrium between $20 and $30 per barrel.2 As a result of this relative price stability, only 5 years of historical data will be presented. The following graph presents a rather shocking picture of oil from December 9, 2003 to December 9, 2008:

Graph 1: Constructed based on oil prices Dec. 9, 2003 through Dec. 9, 2008

At the beginning of the five year period, oil was $30.27 per barrel. The following December 9, 2004 brought $36.77 oil; December 9, 2005 saw $57.23 oil; December 8, 2006 experienced $63.67 oil; December 10, 2007 was the start of a slow increase in price at $87.33 per barrel; the price topped at $143.95 on July 3, 2008; however, the price rapidly declined to $39.77 a barrel on December 9, 2008.3 The next graph highlights the spike in oil prices beginning one year prior to July 3, 2008 (the date of the record price) through December 9, 2008:

Graph 2: Highlighting oil prices from one year prior of the highest price per barrel (July 3 2008)

As previously noted, the record price of oil was on July 3, 2008 at $143.95. One year prior, on July 3, 2007, the price per barrel was $74.26.3 This was a $69.69 jump in oil price in one year. This 93.85% jump in price affected many companies across many industries. However, the focus of this paper is oil’s near doubling in price over one year and its effect on the airlines. More importantly, how did each airline react to the price increase and to the reaction of each competitor? Before continuing, it should be noted that numerous airlines go in to and out of business on a yearly basis. As a result, the top seven airlines will be analyzed as a representation of the industry as a whole. These airlines are American Airlines, Continental Airlines, Delta Airlines, Northwest Airlines, United Airlines, and Southwest Airlines.

OIL’S EFFECT on the AIRLINES

Before discussing each of the “Big Seven’s” reactions to the skyrocketing oil prices, the bottom line effect on each carrier will be presented. By comparing 2008 financial results to 2007 financial results, the relationship between an airline’s income or loss and the price of oil will become evident. For the observer who is unclear as to why oil has such a dramatic effect on airlines, the following analogy should clear up any confusion. An automobile burns gas to drive; an aircraft burns gas to fly. Both automobile gas and aircraft gas (jet fuel) are a direct byproduct of oil. However, an airplane burns substantially more gas than a car does, thus as the price of oil skyrockets so does one of the primary expenses of an airline. Given that comparison, the following table presents the quarterly operating results for the “Big Seven” for 2008 compared with 2007:

NET INCOME (LOSS) of the "BIG SEVEN" (in millions)
Airline	1st Qtr.	2nd Qtr.	3rd Qtr.	9 Months Ended Sept. 30
	Year		Year		Year		Year
	2008	2007	Change	2008	2007	Change	2008	2007	Change	2007	2008	Change
American	($328)	$81	($409)	($1,448)	$317	($1,765)	$45	$175	($130)	($1,731)	$573	($2,304)
Continental	($80)	$22	($102)	($3)	$228	($231)	($236)	$241	($477)	($319)	$491	($810)
Delta	($6,390)	($130)	($6,260)	($1,000)	$1,600	($2,600)	($50)	$220	($270)	($7,440)	$1,690	($9,130)
Northwest	($4,139)	($292)	($3,847)	($377)	$2,149	($2,526)	($317)	$244	($561)	($4,833)	$2,101	($6,934)
United	($537)	($152)	($385)	($2,729)	$465	($3,194)	($779)	$334	($1,113)	($4,045)	$647	($4,692)
U.S. Airways	($236)	$66	($302)	($567)	$263	($830)	($865)	$177	($1,042)	($1,668)	$506	($2,174)
Southwest	$34	$93	($59)	$321	$278	$43	($120)	$162	($282)	$235	$533	($298)
Total	($11,676)	($312)	($11,364)	($5,803)	$5,300	($11,103)	($2,322)	$1,553	($3,875)	($19,801)	$6,541	($26,342)

Table 1: Comparison of 2008 and 2007 Financial Performance the “Big Seven”

Although a direct correlation cannot yet be drawn between oil price and each airline’s performance, each carrier performed substantially worse in 2008 than in 2007. By concentrating on the “Nine Months Ended September 30,” American Airlines showed a $2,304,000,000 negative turn in income for 2008 than in the same period in 2008. Continental went $810,000,000 in the wrong direction. Delta’s earnings fell victim to the same fate; they dropped by $9,130,000,000 in one year. Northwest, United, and U.S. Airways fell from positive earnings by -$6,934,000,000, -$4,692,000,000, and -$2,174,000,000, respectfully. Southwest Airlines was the only carrier among the “Big Seven” that showed a profit for the nine months in 2008; however, they too showed a negative turn from 2007 earnings. By contrast to the other six carriers, Southwest’s negative turn of $298,000,000 signifies either better luck or better management. That distinction is also too early to determine.

At this point, the only certain conclusion from the above graph is that each airline performed worse, period-for-period, in 2008 than 2007. Each airline earned net income in the second and third quarter of 2007 but quickly turned negative in 2008. In order to better associate fuel cost with earnings, the table on the following page presents each airline’s increase in fuel expense for the first three quarters of 2008 over the same periods in 2007:

FUEL EXPENSE of the "BIG SEVEN"
(in millions)
Airline	1st Quarter	2nd Quarter
	Year	Change	Year	Change
	2008	2007	Dollar	%	2008	2007	Dollar	%
American	$2,050	$1,410	$640	45.4%	$2,423	$1,644	$779	47.4%
Continental	$1,048	$684	$364	53.2%	$1,363	$821	$542	66.0%
Delta	$1,422	$958	$464	48.4%	$1,678	$1,112	$566	50.9%
Northwest	$1,114	$704	$410	58.2%	$1,207	$855	$352	41.2%
United	$1,575	$1,041	$534	51.3%	$1,848	$1,206	$642	53.2%
U.S. Airways	$823	$550	$273	49.6%	$1,086	$658	$428	65.0%
Southwest	$753	$564	$189	33.5%	$894	$607	$287	47.3%
Total	$8,785	$5,911	$2,874	48.6%	$10,499	$6,903	$3,596	52.1%
Airline	3rd Quarter	9 Months Ended Sept. 30
	Year	Change	Year	Change
	2008	2007	Dollar	%	2008	2007	Dollar	%
American	$2,722	$1,743	$979	56.2%	$7,195	$4,797	$2,398	50.0%
Continental	$1,501	$895	$606	67.7%	$3,912	$2,400	$1,512	63.0%
Delta	$1,952	$1,270	$682	53.7%	$5,052	$3,340	$1,712	51.3%
Northwest	$1,912	$882	$1,030	116.8%	$4,233	$2,441	$1,792	73.4%
United	$2,461	$1,324	$1,137	85.9%	$5,884	$3,571	$2,313	64.8%
U.S. Airways	$1,110	$692	$418	60.4%	$3,019	$1,900	$1,119	58.9%
Southwest	$1,000	$660	$340	51.5%	$2,647	$1,831	$816	44.6%
Total	$12,658	$7,466	$5,192	69.5%	$31,942	$20,280	$11,662	57.5%

Table 2: Comparison of 2008 vs. 2007 Fuel Expense of the “Big Seven”

The relationship between oil price and airline earnings is beginning to develop considering the staggering percentages that each airline’s fuel expense rose in 2008 over the previous period in 2007. Northwest Airlines suffered the most, with a 73.4% increase in fuel for the first three quarters in 2008 over 2007; although, all but Southwest Airlines suffered at least a 50% increase in fuel expense for the same period. Recall the day of the record high price per barrel, July 3, 2008. The high began the third quarter 2008, with oil remaining above $100 per barrel until two days prior to the end of the third quarter; this time period was the worst in 2008 for the airlines. Northwest saw the highest fuel expense increase of 116.8%; United followed with a 85.9% increase; Continental’s 67.7% increase was third; U.S. Airways increase of 60.4% ranked it fourth; American saw its fuel expense increase 56.2%; Delta experienced a close 53.7% increase; the best performer was Southwest. Although, its fuel expense increase still exceeded 50% of the previous year. Some carriers were affected worse than others.

For the observer who is familiar with operating data, the question arises, “what about the remaining expenses? Airlines have other expenses other than fuel.” This observer is correct in his remark regarding additional expenses the airlines incur; such is why there is yet one missing link directly proving oil price as the culprit behind 2008’s airline plight. The following chart ties fuel expense together with each airline’s total expenses for 2008 over 2007:

INCREASE in OPERATING EXPENSES of the "BIG SEVEN" ATTRIBUTABLE to INCREASE in FUEL EXPENSE
2008 vs. 2007
(in millions)
Airline	1st Quarter	2nd Quarter	3rd Quarter	9 Months Ended Sept. 30
	Increase	%	Increase	%	Increase	%	Increase	%
	Total	Fuel	Due to	Total	Fuel	Due to	Total	Fuel	Due to	Total	Fuel	Due to
	Expense	Expense	Fuel	Expense	Expense	Fuel	Expense	Expense	Fuel	Expense	Expense	Fuel
American	$705	$640	90.8%	$2,057	$779	37.9%	$1,010	$979	96.9%	$3,772	$2,398	63.6%
Continental	$521	$364	69.9%	$668	$542	81.1%	$768	$606	78.9%	$1,957	$1,512	77.3%
Delta	$6,941	$464	6.7%	$2,073	$566	27.3%	$814	$682	83.8%	$9,828	$1,712	17.4%
Northwest	$4,508	$410	9.1%	$1,052	$352	33.5%	$1,095	$1,030	94.1%	$6,655	$1,792	26.9%
United	$687	$534	77.7%	$3,389	$642	18.9%	$1,185	$1,137	95.9%	$5,261	$2,313	44.0%
U.S. Airways	$420	$273	65.0%	$927	$428	46.2%	$1,116	$418	37.5%	$2,463	$1,119	45.4%
Southwest	$328	$189	57.6%	$409	$287	70.2%	$468	$340	72.6%	$1,205	$816	67.7%
Total	$14,110	$2,874	20.4%	$10,575	$3,596	34.0%	$6,456	$5,192	80.4%	$31,141	$11,662	37.4%

Table 3: Percentage of operating expenses caused by increase in oil price

Now the picture is clear: American, Continental, Delta, Northwest, United, U.S. Airways, and Southwest’s poor financial performance in 2008 is nearly 100% attributable to the rapid increase in oil price. Several carriers, such as Delta and Northwest had several non-cash expense items that increased total expenses ; however, 70 to 95 percent increased fuel expense to total expense increase ratios tell most of the story. Continental suffered the worse over the entire nine month period, while American suffered two of the worst quarters of any carrier in the first and third quarters.

Although it is not the only objective of this paper to equate increased oil price to decreased oil price, it is important to present the severity of the oil versus earnings dilemma. More critical is developing a managerial plan to combat oil prices. Once the problem has been identified, each carrier has one of two decisions: 1 – do nothing and hope for the best; or 2 – implement a revised strategic plan to compensate for the problem. The remainder of this paper addresses the strategic plans of the “Big Seven.” Throughout the planning process, managers have to be cognizant of economic theory and the potential demand reaction to every decision, especially pricing decisions.

DEMAND ELASTICITY and AIRLINE TICKET PRICES

The obvious solution to an increase in a business’ expenses is an increase in the price of the company’s product; for the airlines, the answer to rising fuel prices is not quite as simple. As the opening story about Joe and Jill alluded to, the average airline passenger is quite sensitive to ticket price. Most travelers pick a flight based solely on price; the airline with the lowest ticket price for a given route will win a potential passenger’s travel dollar. Secondly, many potential travelers are finding viable substitutes to air travel, exacerbating the pricing problem. More specifically, leisure travelers are relying on alternate modes of transportation, such as bus, train, or driving, or not traveling at all. Business travelers are beginning to rely on video-conferencing, telephone-conferencing, or less meetings altogether.

Consumer price sensitivity is the primary factor airline managers must take into account when implementing strategic plans; however, how sensitive is the consumer to a price change, and how much will quantity demanded shift when ticket prices are increased? Consumer price sensitivity to a change in a products price is expressed by the product’s own price elasticity. Multiplying the own price elasticity of a product with the percentage increase in price of a product will provide a manger with the percentage change in quantity demanded for his product. For example, if a manager knows the own price elasticity for his product is -1.5, and he must increase the products price by 12% to cover increasing expenses, quantity demanded for the product will decrease by 18% (-1.5 x 12%).

If armed with this information, airline managers can estimate the effect a ticket price increase will have on quantity demanded for their airline. Since the most likely option to combat rising fuel prices is to charge higher ticket prices, airline managers must derive an estimate of the own price elasticity for their airline. However, such a task is well beyond the economics expertise of the average airline manager and the author of this paper; an entire branch of economics is dedicated to estimating demand functions and demand elasticities. These econometrics pofessionals use sophisticated analysis and computer software to develop accurate estimates of the own price elasticity for a firms products. As such, airline managers should not “guesstimate” such an important variable for their company; either internal economists or external consultants should be trusted for and accurate estimate of the own price elasticity.

Just as airline managers should rely on economics professionals for their data, so will the author of this paper. Over the past several years, numerous economics professionals have researched airline pricing and consumer reaction. Kenneth J. Button of the Center for Transportation Policy, Operations, and Logistics compiled much of this elasticity research while studying the effects of taxation on air transportation. His findings show that the elasticity of demand for ticket prices varies on many factors ranging from personal to business travel and domestic to international travel. Additionally, length of a particular route affects the elasticity of ticket prices. The following table presents Button’s findings:

Table 4: Own price elasticity for airline ticket prices12

Button’s compilation brings about another dilemma for airline managers; elasticity can vary dramatically based on the type of flight. Business travel has the lowest values; most business travel elasticities presented are inelastic in that business travel demand will not fluctuate as much as the increase or decrease in price. However, economy, discount, or pleasure travel present larger values and are elastic in that demand will fluctuate more than the increase or decrease in price. For example, if American Airlines needed to raise prices 20%, how would demand be affected? For international business travelers, own price elasticity is -.26, thus a 20% increase in price leads to only a 5.2% decrease (-.36 x 20%) in business travelers. However, for cross country leisure travelers, own price elasticity is -1.52, thus the same 20% increase in ticket price leads to a 30.4% decrease (-1.52 x 20%) in leisure travelers.

As can be seen, airline managers must be aware of the different elasticities affecting each market segment; each type of customer and type of route will react differently to price changes. A detailed route and customer analysis is beyond the scope of this paper, but non-the-less it is important to note the complex demand structure an airline faces. More specifically, American Airlines faces own price elasticities ranging from -1.58 to -2.34. While a 10% price increase only causes a 15.8% decrease (-1.58 x 10%) in demand on the low end, the same price increase causes at 23.4% decrease (-2.34 x 10%) in demand on the high end. Considering this demand variability, combating increasing prices presents a rather difficult dilemma. Armed with elasticity data for the industry as a whole, the following analysis aims to present solutions for rising oil prices.

DEMAND ELASTICITY and OIL PRICES

Considering the potential price sensitivity of airline travelers, combating increasing oil prices is not as simple as raising ticket prices to cover the increased price of fuel. Mangers must cover the increasing price of oil but at the same time must be cautious about decreasing passenger demand. As a starting point to address the increasing losses associate with fuel, the first step is to determine how much passenger revenue must be increased to compensate for increased fuel. However, demand effects must be considered before raising ticket prices by this percentage, thus approximating an own price elasticity for each airline is required. With these two values, the decrease in demand associated with the increase in price can be determined. The following table presents this information:

PRICE INCREASE REQUIRED to COMPENSATE for FUEL
(and subsequent demand decrease) 9 MONTHS ENDED SEPTEMBER 30, 2008
Airline	Passenger	Fuel	Price	Approximate	Demand
	Revenue	Expense	Increase	Price	Decrease
	(000,000s)	(000,000s)	Required	Elasticity
American	$14,060	$2,398	17.06%	-1.50	-25.58%
Continental	$10,633	$1,512	14.22%	-1.50	-21.33%
Delta	$13,848	$1,712	12.36%	-1.50	-18.54%
Northwest	$7,529	$1,792	23.80%	-1.50	-35.70%
United	$14,270	$2,313	16.21%	-1.50	-24.31%
U.S. Airways	$8,594	$1,119	13.02%	-1.50	-19.53%
Southwest	$7,927	$816	10.29%	-2.00	-20.59%

Table 5: Demand decrease associated with an increase in ticket price

In calculating the demand decrease associated with each airline’s price increase, the approximate price elasticities were estimated as follows: American, Continental, Delta, Northwest, United, and U.S. Airways all focus on both leisure and business travelers on short through long distances. As a result, the price elasticity was estimated from Sutton’s table presented earlier; since all six operate similar structures, the best approximation for price elasticity was a combination of the various market segments served. As a result, the best own price elasticity approximation is -1.50. Since Southwest focuses primarily on leisure, budget minded traveler’s, the best approximation from Sutton’s table is an own price elasticity of -2.00. Given the information presented, each airline’s management team has a problem on its hands. To cover fuel expenses with passenger revenue, demand will fall dramatically; this scenario would have the opposite effect, declining revenues. Several solutions are available to counteract the associated demand decrease; they are as follows:

-Supply can be decreased.

-Alternate forms of income can be established.

-Inefficient aircraft can be replaced with fuel efficient aircraft.

-Mitigate fuel expense through fixed contracts.

One or more of the above strategies should be used to compensate for the estimated decrease in demand associated with price increases. Interestingly enough, each carrier in the “Big Seven” responded to rising oil prices with a mixed strategy. The following sections highlight the response of each carrier to the oil induced financial distress of 2008.

AMERICAN AIRLINES’ STRATEGY

Led by CEO Gerald Arpey, American Airlines instituted several changes in an effort to combat rising oil prices. Fares were increased but not at the rate shown above. Instead, additional stream of revenue were created. For example, beginning on June 15, 2008, they began charging $15 for the first checked bag. Airlines have historically charged $25 for a second bag but charging for the first bag was a rather unprecedented move. Other additional fees include $125 to $699 for traveling with pets and from $3 to $6 for food on-board. Perhaps the most notable fee, a fuel surcharge will be added to each ticket. Capacity cuts of 11 to 12 percent in the fourth quarter of 2008 were also planned; as a result of capacity cuts, 8,000 jobs will also be shed. The company also placed 34% of its anticipated jet fuel on contracts for 2008. The final move by American Airlines is to retire 85 of its inefficient aircraft.

CONTINENTAL AIRLINES’ STRATEGY

Larry Kellner, CEO of Continental Airlines, and his team responded quite similar to American. Capacity reductions of up to 11% by the end of the fourth quarter, 2008 were announced during the summer of 2008. Sixty-seven older aircraft will be retired. These old Boeing 737 aircraft will be replaced with new, more fuel efficient 737s; however, the fleet will still be reduced from 375 aircraft to 344 aircraft at the end of the transition. Associated with the capacity reductions, Continental announced layoffs of 3,000 employs.17 All of these changes were on top of ticket price increases and fuel surcharges. Also, Continental implemented a $15 first bag fee.16

DELTA AIRLINES’ STRATEGY

With perhaps the boldest of all moves, Delta Airlines CEO Richard Anderson announced plans to merge with Northwest Airlines in order to share expenses and expand global capacity; as this paper is being written, the merger has passed. Will the intended cost-savings emerge? Only time will tell. Along with the merger, Delta also announced capacity cuts of 8% to 10% by the end of the fourth quarter, 2008. Along with the capacity reduction comes 4,000 layoffs.17 Delta joined with other domestic carriers in implementing a $15 first bag fee; fuel surcharges and price increases were also put in place on many routes.

NORTHWEST AIRLINES’ STRATEGY

As discussed above, Northwest Airlines merged with Delta Airlines in an attempt to share expenses and expand global capacity. Prior to the merger, Northwest CEO Edward Bastian announced capacity cuts up to 9.5% by the end of 2008. However, in contrast to other carriers, he hoped to reduce the workforce through natural attrition instead of layoffs. The company tried to fend of rising oil prices by hedging 54% of its anticipated 2008 fuel needs. Along with higher fares and fuel surcharges, Northwest implemented a $15 first bag fee, fees for food ranging from $3 for a snack to $10 for a meal, and a $5 - $35 fee for extra leg room and seat choice for domestic flights and $15 - $75 for international flights.20

UNITED AIRLINES’ STRATEGY

Glenn Tilton, CEO of United Airlines, announced the largest capacity cuts of any carrier, with 17% to 18% capacity reductions by the end of 2008 in to 2009. Whereas Northwest Airlines hopes to trim employment through attrition, United reduced its workforce by 1,100 employes. Other drastic measures by United include retiring 70 older jets from its fleet and eliminating its discount carrier, Ted.22 The company also has a list of new fees including the $15 first bag fee, fees for food ranging from $3 for a snack to $9 for a fresh meal, increased fees for pets ranging from $175 to $250, and fees to upgrade to “economy plus” of $14 to $109. These recent charges are on top of fare increases and fuel surcharges.20

U.S. AIRWAYS’ STRATEGY

CEO Doug Parker and the entire U.S. Airways management team have followed suit with the previous carriers. Fare increases and fuel surcharges were the first of several revenue generating steps. Additionally, U.S. Airways instituted the $15 first checked bag fee of its counterparts. Along with the bag fee, U.S. Airways also charges $5 to $7 for food, $5 for choice seats, and $100 to travel with pets in the cabin. A fee unique to U.S. Airways is a charge for drinks, $2 for non-alcoholic drinks and $5 to $7 for alcoholic beverages. Capacity reductions are also underway of 2% to 4% by the end of 2008; the company will also allow leases to run out on 28 aircraft. These will be replaced with fourteen Embraer-190s and five Airbus-321 aircraft. Associated with the capacity reductions will come 1,700 job losses.

SOUTHWEST AIRLINES’ STRATEGY

As the financial tables above show, Southwest Airlines survived the fuel crisis better than any of its “Big Seven” counterparts. Incredibly, while the other six carriers mounted huge losses for the nine months ended September 20, 2008, Southwest earned a profit. Initially, Southwest CEO Gary Kelley not only announced no cut-backs but additional capacity would be added in 2009. Although, it now appears oil prices were slow to catch up with Southwest. As of the beginning of December, 2008, Southwest announced a 4% to 5% reduction in flying for the first quarter, 2009. The airline plans to keep its fleet the same size.25 Another considerable difference between Southwest and the other carriers is the lack of additional fees. Southwest has increased fares but has not added fuel surcharges, bag fees, snack fees, drink fess, or cabin upgrade fees.24

Instead of charging additional fees, Southwest attempted to control rising costs through fuel contracts. According to Kelly, his company saved $1.3 billion through the end of the third quarter 2008 from its fuel hedging program. Even with the recent decline in crude oil prices, Southwest’s program is still in the money; as of October 15, 2008, it was valued at $550 million. The airline has such faith in its finance department that it has fuel contracts through 2012. 85% of Southwest’s anticipated fuel requirements of the fourth quarter of 2008 is contracted at $62 per barrel; 75% of 2009 at $90 per barrel; 50% of 2010 at $90 per barrel; 40% of 2011 at $93 per barrel; and 35% of 2012 at $90 per barrel.

DIFFERENCES in STRATEGIES

After reviewing each of the “Big Seven’s” survival strategies, it becomes quite evident that one of the airlines is not like the others. Whereas Southwest Airlines has focused on controlling its costs through fuel contracts, the other six have focused on increasing revenue. The better strategy is apparent after reviewing the financial data presented in the beginning of this paper; Southwest Airline’s strategy has resulted in positive earnings for the first nine months of the year while the others are all in the red. However, Southwest’s strategy has been set for many years. American, Continental, Delta, Northwest, United, and U.S. Airways have been on the defensive against oil in the past year. Southwest, on the other hand, has been on the offensive against fuel prices for nearly twenty years. Since the time when current CEO, then CFO, Gary Kelly took office in 1989, he began locking in fuel contracts to stabilize the airlines income statement.

Given Southwest’s huge success with its fuel hedging program, why do other airlines not have such programs in place? If one airline can save over one billion dollars in three quarters, the average person would assume others would follow suit. However, the hidden side of contracts, such as Southwest’s fuel contracts, is the cost. For example, commodities clearing houses require a margin of nearly 10% of the contract price to be paid at contract signing. A contract of 100,000 barrels at $100 per barrel is worth $10,000,000, thus to hedge at that price, an airline would face an upfront cost of $1,000,000.

Additionally, airlines (and other such investors) incur transaction costs for each contract; Southwest incurs one more cost as well. What if oil prices fall below the contract price? In a traditional contract, the airline is still responsible for the contracted amount at the contracted price resulting in a loss on the hedge. To protect against such an occurrence, Southwest pays premiums offering downward price protection. If the spot price drops below the contract price, Southwest can and will let the option expire and not pay the higher price. While the airline saves on fuel costs, it still loses the premium paid for the contract. These fees are paid as an insurance policy for the airline. As with all insurance, there is risk involved. Southwest is willing to pay a premium to protect itself against rising fuel costs in spite of the financial risk involved with the contacts.28

This additional information regarding contracts, such as fuel hedging, is the underlying factor preventing every other airline from participating in the same fuel cost saving measures as Southwest. Given the huge upfront costs of hedging - 10% margins, transactions costs, and potentially downward price protection – airlines are faced with an expensive proposition, and as any reader of the USA Today knows, the average airline does not have much additional cash lying around to cover such additional expenses. According to Peter Fusaro, founder of an energy-trading information firm, “Facing higher energy prices and billions of dollars in debt, most airlines can’t afford to hedge.”28

Secondly, as discussed above, if the spot price of oil falls below the contract price, the airline will face losses associated with the hedge. As a result, many airline managers view such financial contracts as risks and most are striving to eliminate as many risks as possible these days. Energy consultant Stephen Schork agrees: “I think airlines have been reluctant to hedge because corporate culture views futures as a gambling tool.” However, he adds, “but they’ve been reluctant to their own detriment. If you’re an airline without a significant hedge, you’re in a difficult spot.”

Although it would seem easy to copy Southwest’s fuel hedging program and save over a billion dollars in fuel, many airlines simply cannot afford to do so, or their management is reluctant to do so based on speculative reasons. Either way, Southwest will remain to have a significant cost advantage over nearly every other competitor. If the other six continue to raise prices, will additional capacity cuts be required? Only time will tell.

CONCLUSION

Two important conclusions can be drawn from this research. First, regardless of the cause, the oil crisis of the Summer of 2008 drove the airline industry into some of the worst financial performance in recent times. Even though the increase in oil price heightened during the summer months of 2008, data clearly shows that high oil prices began before 2008 began. Second, one airline was better prepared to handle escalating oil prices than others. Some may call it luck, others may call it superior management, but either way, Southwest Airlines, through long standing fuel contracts, survived the oil crisis better than its competitors.

Whereas American, Continental, Delta, Northwest, United, and U.S. Airways have been on the defensive for many months, Southwest has been on the offensive for nearly twenty years. Southwest focuses on controlling fuel costs; the other six focus on increasing revenue. Which strategy will prevail in the long-run? Although no manager can predict the future, it is simple to tell which airline has prevailed thus far. Will the rapidly declining oil prices of the Fall of 2008 bring better financial results to the airlines? Most would assume yes, but some of the toughest economic times in years might decide otherwise. However, that is a topic for another paper on another day. For now, the airlines will continue their battle against oil.

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� Airfare based on a flight search from Houston, TX to Las Vegas, NV on Orbitz.com and Southwest.com.

� Energy Information Administration: Daily Europe Brent Spot Price. Released Dec. 10, 2008.

� Energy Information Administration: Daily Europe Brent Spot Price. Released Dec. 10, 2008.

� FareCompare.com: “Did You Know? Top Ten Largest US-Based Airlines.” April 15, 2008.

� Net Income(Loss) presentation calculated based on each airline’s quarterly SEC 10-Q filings.

� Fuel expense presentation and calculation based on each airline’s quarterly SEC 10-Q filings.

� Total expense and fuel expense presentation and calculation based on each airline’s quarterly SEC 10-Q filings.

� Non-cash expenses/write-offs from each airline’s quarterly SEC-10Q filings.

� Journal of Consumer Affairs: “Where Are the Airlines Headed?” July 1, 2005.

� Michael R. Baye, “Managerial Economics and Business Strategy.” Pages 75 - 80. 2009.

� Michael R. Baye, “Managerial Economics and Business Strategy.” Page 96. 2009.

� Kenneth J. Button: “The Taxation of Air Travel” April, 2005.

� Gillen, Morrison, & Stewart’s own price elasticities as presented by Sutton.

� Oum, Zhang, and Zhang’s own price elasticities as presented by Sutton.

� Passenger revenue and fuel expense based on each airline’s quarterly SEC 10-Q filings.

� Kayak.com: Airline Fees. Copyright 2008.

� MSNBC.com:“Airlines Move to Make a Bad Situation Worse.” June 4, 2008.

� American Airline’quarterly SEC 10-Q filing.

� Delta Airline’s quarterly SEC 10-Q filings.

� Kayak.com: Airline Fees. Copyright 2008.

� Delta Airline’s quarterly SEC 10-Q filings.

� MSNBC.com: “Airlines Move to Make a Bad Situation Worse.” June 4, 2008.

� Northwest Airlines quarterly SEC 10-Q filings.

� Kayak.com: Airline Fees. Copyright 2008.

� MSNBC.com: “Airlines Move to Make a Bad Situation Worse.” June 4, 2008.

� “Southwest Airlines Reports Third Quarter Financial Results.” Forbes.com. October 16, 2008.

� Christopher Hinton, “Storm Clouds Gather, but Southwest CEO Has a Plan.” MarketWatch, Dec. 4, 2008.

� Moira Herbst. “Hedging Against $200 Oil.” Business Week Online. May 7, 2008.

� Moira Herbst. “Hedging Against $200 Oil.” Business Week Online. May 7, 2008.