Airline Industry CEOs Hoping You’re As Ignorant About Economics As Everyone Thinks You Are
Um, Guys? Speculators Aren’t Your Problem
By blackhedd Posted in Airlines | CEOs | Economy | Oil Prices | regulation | speculation — Comments (19) / Email this page » / Leave a comment »
I’m going to avoid linking to this because you can find it yourself, and because I don’t know who the original authoritative source is. But you’ve certainly heard that a dozen CEOs of major US airlines, including all the big names, have put out a letter urging you, their customer, to agitate for more regulation of the commodities-futures markets.
Unfortunately time is too short to fully consider the issues raised in this carefully-written letter. The basic idea is something you’ve heard me discuss several times now: speculation in crude-oil futures and derivatives is raising the price.
That’s true enough, as I’ve said before. It’s also true that the airline industry is under as much pressure from high oil prices as anyone else (more on that in a moment).
What’s not true is that speculative pressure (or more precisely, buying pressure originating ultimately from institutional investors) is a permanent support for the price of oil. Thus, the conclusions reached by the airline CEOs are wrong, but they’re wrong in ways you wouldn’t expect from experienced business people.
Read on…
We have a few regular commenters on this board who know a lot about the airline business, and I do hope they chime in with comments. For now, I’ll say that airlines are an extremely capital-intensive business. They have very high labor costs, and high capital costs (which they manage partly by leasing equipment). But as the price of jet fuel has increased along with crude oil, fuel has become the dominant aspect of their variable-cost equation.
Because airlines compete in an environment that is only semi-deregulated, they aren’t necessarily going to rationalize their own operations in response to high fuel prices as you might expect. Airlines have a hard time raising prices unless they do it in a de facto coordinated way, because otherwise they’ll lose market share against each other. I’m glossing over a lot of interesting detail, but let’s get to the point.
The major-airline CEOs have gotten together to request a regulatory response to their biggest business problem. Because of the semi-regulated environment they operate in already, this isn’t altogether inappropriate.
But for them to explain that speculative trading in oil futures and derivatives adds “$30 to $60 per barrel in unnecessary speculative costs” and that “consumers pick up the final tab” is begging the question.
The ordinary speculative activity in futures markets is what makes those markets function smoothly. As major participants in those very same futures markets, airline CEOs certainly know that speculators provide the liquidity needed for producers and consumers to perform the hedging operations that allow them to manage risk and plan their businesses. Why are these people trying to sell us something they know is a lie?
The CEOs are also looking for increased “disclosure, transparency and sound market oversight.” I’ve already written here about how challenging these objectives are. It’s no longer the case that crude oil (and jet fuel for that matter) are traded exclusively in open pits in lower Manhattan, on an exchange that is fully regulated by the CFTC. Things are a lot more complicated than that, these days. The regulatory environment does need to be improved, but doing so will take far more time than the airlines have before they start facing a serious risk of bankruptcy.
The real reason that oil prices are high is that oil prices are high.
What the heck do I mean by that? I mean that the global supply/demand picture for oil means that the stuff will have at least some stable long-term value in any plausible forecast.
But in a deflating and de-leveraging financial world, that means that oil itself is an attractive asset for investors to hold. Because the price is high, they want to own it. And that makes the price higher.
So we’re not really talking about speculators in the traditional sense. We’re talking about the hedge funds that institutional investors buy into. And these people will keep buying oil as long as they have few good alternative investments.
Two points: first, you might as well try to boil the ocean as tell the world’s investors what they may or may not buy. And second, they’re going to drop the oil markets like a hot potato as soon as the price momentum in oil reverses, which it inevitably will do someday.
Enlarging the point somewhat: we need to face the fact that commercial aviation in the US may not be long-term viable in its current form. The CEOs are scrambling madly to buy a bit more time to keep operating as they always have. But they’re facing a losing battle.
This industry can’t survive with its current cost structures, which are extremely union-bound at most of the major carriers. But in addition to that, the construction of new capacity (which this country badly needs) is curtailed by a raft of outdated regulations left over from the Civil Aeronautics Board era. These include restrictions on new landing slots at airports, and an inability to modernize the air-traffic control system.
We need to make a decision one way or the other: either bring back full-on regulation as it existed before 1977, or de-regulate the industry completely. I almost don’t care which choice we make, but let’s make one.
-Francis Cianfrocca
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Airline Industry CEOs Hoping You’re As Ignorant About Economics As Everyone Thinks You Are 19 Comments (0 topical, 19 editorial, 0 hidden) Post a comment »
with their jet fuel hedges (speculation by another name). No one complains when they have the foresight or luck to lock in low prices. It's a very tough business, but that doesn't justify telling lies and crying to Congress just because crude oil demand has outstripped production.
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"Enlightened statesmen will not always be at the helm." -- James Madison
In normal times, you take a big risk forward-buying fuel because the bet may go against you. Many people have forgotten that prices move in both directions. And in an environment characterized by a lot of trading in derivatives (as all markets are now, except maybe bartering for rice in Zimbabwe), the price moves in either direction can be very sharp and very fast.
In abnormal times like these, you take all those risks and add the fact that the options and other derivatives involved in hedging get much more expensive as volatility grows.
Any airline that forward-buys fuel in a big way at current prices faces bankruptcy if prices fall, just as much as someone that doesn't if prices rise.
the markets are not very active that far into the future.
And it gets hard to get good prices in certain market environments, like the one we have now. While economists can make a good case for $80 crude a couple of years in the future based on real demand, the forward futures market, driven by traders with mathematical models), has a very flat curve centered around $130-$140.
Hedgers can limit their risk somewhat by purchasing options, which limits the loss to the cost of the options. But as blackhedd notes, volatility makes options more expensive. Airlines don't really have the credit anymore to do swaps (except Southwest), which is just as well, because there is virtually unlimited downside on swaps, and you can lose your shirt. Assuming passengers obsessed with cheapo fares left you one.
http://www.stopoilspeculationnow.com/
Lots to think about here, and I hope to comment later, or maybe in subsequent blogs depending on time constraints. But the central political question is this: should oil be treated as an asset class like real estate, and are we willing to put up with the risks of speculation with the former as we did with the latter?
And the price inflation in oil, detached from any economic reality, has been far worse than real estate. After all, when your house "doubles" in value, your mortgage payment doesn't. When energy does this - it means acute distress- not just for airlines, but for the whole travel and leisure industry, which has become a big section of our economy. And obviously, there are implications for other sectors, such as autos and manufacturing.
(BTW, blackhedd, you let your GW heresy show when you imply that boiling the oceans is an impossibility. We have been reliably informed that this event is imminent. Please get witht the program!)
Speculation is a terrible crime. Airlines speculate that they can raise rates on a route, cram people into 17" seats and overbook passengers, speculating that not all will show up.
For once, I agree with the airline CEOs: end speculation. Indeed, let's follow their lead and apply it first to their industry, given their broad support for the cessation of the practice. Allow airlines to make a 2% annual return above costs. Par CEO salaries to minimum wage (why are we speculating that some fancy dresser with a Harvard MBA is any better than a 18-year-old from the Bronx?). Tear out first and business class - we should never speculate that there would be a market that would treat different classes of seating differently. End all promotions, marketing, advertising, sales by agency or Internet, etc. as all encourage speculation. The same goes for different prices for different markets, which speculates that the market will pay a premium for additional liquidity provided to high demand markets.
This last point is critical: why should we reward the airlines for taking a risk and providing capital that they believe would result in greater profit by serving New York City to LA with more planes than, say, Youngstown Ohio to Fargo ND? This is forward thinking made to schedule routes well before anyone has ordered a ticket, much like evil oil speculators who look at an inept Congress frozen by intentional inaction and presume that globally increasing demand and frozen supply will increase prices. Instead, one plane should be scheduled for every market. In fact, I'd argue that planes must be flown to all airports, even if there isn't commercial service, given that we don't *know* that there isn't a need, and to make these guesses is purely speculative.
Please give it a try, oh, and let's not permit any speculation that taxpayers will bail out the soon-to-be bankrupt airlines after this experiment.
Even if there was any form of control put on the speculators, it still would not change the overall cost of the fuel as this is a supply and demand problem. Additionally, a return to the days of aviation regulation will not change the cost of fuel, it will only add to the operational cost of the airline.
The real problem all airlines are facing today is that with the high cost of fuel and a hyper competitive pricing model (see http://www.southwest.com/) where the only institutional knowledge the pricing analysts know is “lower fares”. And make no mistake about it, the legacy carriers do not understand how Southwest can maintain such low fares and still turn a profit. And that was even before the current price of fuel.
What is at hand here is the overall need to take multiple steps in order to maintain financial growth. We will not hear about them however, because they have negative perceptions.
1) Decrease capacity – This simply means remove destinations and frequency of flights
2) Reduce payroll – With a decreased capacity well, you don’t need as many folks.
3) Increase ticket price – This is the key problem today with all the nickel and diming that is taking place. The senior managers in charge of pricing will not/can not increase fare rates either because they are not allowed to or because they refuse to. It is not cheap to run an airplane and the people in yield management are tasked to pull as much revenue from every seat.
Make no mistake about the current fare pricing scheme. It is designed to trap the consumer with a price that appears to be cheap, and nail them with the fees. This is the fault of the internet and the ability to price shop. If we review the index page of Southwest, we see how they are just beating the other carriers mercilessly with that “Bags Flies Free” ad. Consumers will see that the fare from PHX to LAX on Southwest is $69 and on US Air is $69. Each carrier stays competitive at the point of purchase yet there are no further fees on Southwest. And since the average air traveler only hears on the news how all airlines charge for bags and soda et. al. they make the assumption that each airline are equal and can pick based on schedule.
And lastly, make no mistake about it, Jet-A is EXPENSIVE. A look at todays spot price at the FBO shows us that a gallon of Jet-A is $6.47/gallon. Sure, airlines pay less because they use more, but not by much. A contact at US Air I know told me that today’s price is $5.01/gal. And to put volume in perspective, it takes about 12,000 pounds (1764 gallons) of Jet-A for that PHX-LAX flight equaling $8837 in just fuel cost.
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It is the mark of an educated mind to be able to entertain a thought without accepting it.
--Aristotle
A typical 737-300 holds 137 people. That means each seat is assessed a fuel cost of $64.50.
If every seat is filled, and they paid the average fare for that trip of $190.00, then the airline earned $26,030 for the passengers. - the fuel NET $17193.
Then you have to pay your crew (in-flight (-150), pilots (-415) and ground (-150)). =16,478.
Then you have to pay for the rest of the direct support people, dispatcher, load planner, ground support people (think dumping the lavs) and then the cost to move all the equipment around (more gas) and then the percentage of lease for the airplane and the facilities.
Before you know it, that full flight was a loss.
US Air CEO announced on TV a few weeks ago that the cost to move 1 seat averages $745/flight. Seems a bit high to me, but at the same time, if you just paid $69 for that seat, there is a huge loss going on.
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It is the mark of an educated mind to be able to entertain a thought without accepting it.
--Aristotle
What's amazing to me about the Jet-A cost is that jet fuel has seen the largest demand destruction of any fuel.
Gasoline is bouncing around -3.5% to -4% y/y for the US instead of the normal 1% growth. Diesel is seeing a 2% y/y growth.
Jet fuel has seen a -7% y/y drop. At that huge drop, it's amazing that there is such a persistent high price.
This Thursday evening, CNBC Business Nation will examine how a fuel bill of more than $10 billion will impact American Airlines. Managing Editor Tyler Mathisen goes behind the scenes and visit with company executives, employees and Fuel Smart team members, which is American' inhouse group charged with fuel-saving initiatives.
The segment airs at 8 p.m. Central time.
Just bringing this up as a meditation on an analytical framework.
Just because the Borgia popes have a theoretical linkage to St Peter, doesn't mean we owe them the same reverence and respect, or that they witnessed to the same salvific grace as St. Peter did.
Likewise, just because the oil markets have commonalities with our wonderful free market system, which has brought so much prosperity to this country, doesn't mean we're dealing with benign powers. Always remember that on the producing end, there is a cartel dominated by none-too-friendly foreign powers, and on the financial end, a market subject to manipulation by highly connected players who dispose of mountains of cash and who have the power to generate their own price movements through technical momentum alone.
In both cases, the Borgias and the oil markets, the needs of the people can be served. At a price!
http://www.cnbc.com/id/15840232?video=783125392
Note how the company tries to find every conceivable way of conserving fuel that it can.
Just for more perspective on the challenges facing the airline industry...
Those curvy things you see on aircraft wings don't just look sleek, they save a lot of money, too.
As this article explains:
http://www.dallasnews.com/sharedcontent/dws/bus/stories/042607dnbusaawin...
Once we install winglets on all of our current Boeing 737, Boeing 757, and the B767-300 fleet, we will be saving over 42 million gallons of fuel per year,” said Bob Reding, American’s senior vice president of technical operations.
When this article was written in April 2007, jet was $2.09 per gallon. The June 2008 average was $3.88 per gallon. !!!
I'm no expert on the airline industry, but I can think about it.
Agreeing with what you said, it seems that airlines are faced with a huge dislocation within their cost of business, as the cost of fuel has shot way out of proportion to what their business models call for. Perhaps outside the boundaries of what they thought possible a couple of years ago.
Most are stuck with union contracts that restrict their ability to maneuver.
They also have no good way of knowing whether to continue bidding their fuel price up or not. Unknown = higher risk premium, should = higher ticket prices.
They are in a competitive industry which helps hold their ticket prices down, but as with anything else, increased volume doesn't help if they don't recover their costs.
The only way they can cut down total cost is to cut staff and cut down fleet size, and perhaps cut down the number of ports of call, which means fewer flights. This may not be bad, as higher ticket prices will reduce demand.
Given the above, I'd predict higher ticket prices, lower passenger volume, less need for expansion, downsizing, and some more consolidations and/or bankruptcies, unless prices stabilize soon.
Pluto, the Ninth Planet - Forever!
I sighed and shook my head when I got the email. I always enjoy reading your analysis and look forward to hearing what others - especially those who know the airline industry in depth - have to say.