MIAMI — Few changes in macroeconomic conditions have been more impactful for the global airline industry than the precipitous drop in oil prices from June 2014 to the present. From a peak of $115.49 per barrel, the price of global-benchmark Brent Crude oil fell to $57.88 Monday, near a five-year low.
The fall in oil prices will have a mixed impact on the world’s airlines, but will be primarily positive for US airlines, who operate in an economy not dependent on high oil prices and generally have diversified networks not highly reliant on oil industry business travel. Lower oil prices mean lower fuel costs, and as the largest expense for US airlines, the reduction in oil prices more than offsets adverse demand effects in select markets. But despite the prospective boost to US airline earnings, the fall in oil prices has also been accompanied by a small but growing undercurrent of naysayers, who fret that lower oil prices will drive airline management to engage in fare and capacity wars in an attempt to boost market share (see here and here). Most notable of these worriers is Hunter Keay, the airlines analyst at investment firm Wolfe Research.
Respectfully, (as Mr. Keay is one of the best in the business), I fundamentally disagree with his assessment. I do not believe that lower oil prices will cause airlines to sacrifice hard-won capacity discipline and I will go on record stating that I believe that 2015 will be yet another year of record profitability for US airlines (and that lower fuel prices will be a net positive contributor to higher pre-tax earnings). The idea that US airlines would, once again, devolve into a war for market share is founded on a misunderstanding of the new structure of US airlines, and a misdiagnosis of localized conflicts between airlines in certain markets as indicative of a broader trend towards increased competition.
Starting with the present structure of the US airline industry, the first thing to keep in mind is that years of consolidation, increased regulation from the FAA, have fundamentally altered the dynamics in the US airline market. We are unquestionably living with an air travel oligopoly, though I am not unsympathetic to arguments that the present oligoply is a net positive as a reimbursement to the stakeholders (airline employees and shareholders) who effectively subsidized lower-than-cost air travel for the general public for years (employees through wage and benefit cuts, shareholders through investment losses [and eventually Chapter 11 Bankruptcy]).
However, no oligopoly can hold without strategic convergence. And that is where capacity discipline amongst airlines comes into play. The early 2000s were a period of giddy catch-up growth in the US airline industry post 9/11, but after the late 2000s recessions, new airline management pivoted sharply towards capacity discipline. Even today, total system capacity for US airlines, as measured by available seat miles (ASMs) is 3.1% below its 2007 peak, with domestic ASMs down 8.0% and international ASMs up 6.8%. But ASMs alone don’t give a complete picture. Total available seats (both domestic and international) in the US airline industry are still a whopping 7.9% below levels in 2007, even as total enplaned passengers have largely recovered.
This kind of en-masse capacity reduction does not happen without across-the-board discipline at every major US carrier. Sure there was a deep recession, the deepest since the Great Depression, but judging by the pattern of recovery from every other recession, if US airlines were being managed the way they were in the late 80s, 90s, and early 2000s, capacity would already be 10-15% ahead of its 2007 levels, even adjusting for the severity of the recession. This is a different breed of airline management.
Post-2009, airline managers have ridden capacity discipline to boost revenues and profits. In fact, by almost any financial metric, the current crop of airline management is the most successful in the US since deregulation. They have little incentive to act like previous generations of airline management, their compensation is largely tied to ROIC and shareholder returns, and shareholders are not in the mood to reward airlines for growth (revenue/market share), instead preferring profitability.
There have certainly been myriad examples of US airline management squandering positive exogenous shocks (fuel prices, GDP growth in the early 2000s), but what in the behavior of current airline management leads anyone to believe that this group of managers will repeat those mistakes? Remember, this is the same management group that (instead of allowing passengers to reap a modest reduction in fares) responded to the FAA’s inability to collect taxes in mid 2011, by gleefully raising base fares to where total out of pocket costs were exactly the same (earning a windfall of $28.5 million per day).
This is the same management group that has closed redundant hub after hub, that has retired 50-seat regional jets at remarkable rates, that has implemented revenue-based frequent flyer programs (which have certainly driven away incremental passenger traffic). Heck, this is the same management group that has shied away from competing directly with Spirit Airlines on fares, allowing Spirit to gain a foothold in many legacy airline hubs. To reiterate, Spirit presented US majors with a clear opportunity to defend market share… And they responded by largely ignoring the ultra-low cost carrier (ULCC). This is a different breed of airline management.
Now the obvious counterpoint is to look at Seattle, the Dallas-Fort Worth Metroplex, and Los Angeles, currently the hottest battlegrounds amongst major US airlines. Starting with Seattle, this is certainly an area of competitive concern, particularly for Alaska who has already begun to see some softness in Seattle margins in the wake of Delta’s domestic expansion. But at the end of the day, Seattle is still Delta adding a bunch of RJ flights to key west coast destinations, with a handful of narrowbodies likely to eventually ply routes to key non-hub business markets in the rest of the country. I’m not going to argue that Delta’s growth in Seattle isn’t going to affect Alaska somewhat, but in Delta’s overall network, it’s a drop in the bucket. Lower oil prices aren’t going to magically make Delta add dozens of new daily flights in the market. If anything, they’ll help the two airlines co-exist, by improving margins for both.
Los Angeles might be more worrying, with both Delta and American adding capacity at a dizzying pace. However, I see United as likely to blink soon (and reduce frequency and capacity in the market). Moreover, any serious expansion (large enough to put a meaningful dent in the overall industry’s fare levels) is impossible given the facility constraints at the airport. Dallas Fort Worth has recently been thrown into a new fit of competitive fare pressures thanks to the expiration of the Wright Amendment and Spirit’s continued growth in the market.
Certainly the market dynamics have been altered somewhat, but the potential for further capacity additions and fare wars in the Metroplex is still limited. Southwest is boxed in by facility restrictions at Love Field and while American’s new management has been aggressive competing against Southwest in the past, they are also smart enough to realize that unlike Philadelphia, Southwest are here to stay in the Metroplex.
The long run interplay between the two carriers is much more likely to resemble that in Phoenix (another shared hub), where the competition is far more amicable (though American will hold far more market power in the former). As far as Spirit, they will certainly continue to fly the routes that they already do, but I see them as unlikely to add a lot of further capacity. Spirit CEO Ben Baldanza has famously said that the carrier has 750 markets in the domestic US identified and ready to go that meet Spirit’s margin criteria. At the same time, Spirit has specifically called out Dallas Fort Worth as a market where it is experiencing significant fare weakness. Why would Spirit add more capacity in a three-way battle in the Metroplex when there are plenty of viable routes around the country in far less competitive environments?
In addition to Spirit, fellow ULCCs Allegiant and Frontier would hypothetically be good candidates to drive capacity growth and fare wars in the industry given their high levels of proposed growth. However, there are two key issues with this thesis. First, the major airlines by and large don’t seem interested in combatting Spirit and the ULCCs. ULCCs today mostly cater to a previously unserved segment in the market, a segment that the US majors abandoned in the wake of consolidation and the last recession.
A fare war requires some sort of competitive response to low fares, and a broad-based competitive response to the ULCCs doesn’t appear imminent. Second, Spirit and Frontier are largely locked in to their present levels of growth, which the industry has already planned for and taken into account for 2015. The way that Spirit and Frontier would drag the overall industry down is by growing much faster than they have previously indicated. But unlike US majors, Spirit and Frontier don’t have slack in their fleet. Their aircraft are (mostly) highly utilized and with a relatively set number of new aircraft deliveries for the year, they cannot wholesale add 10 percentage points to their capacity growth plans, they simply lack the spare and newly arriving capacity to do so.
So let me end with a question to you the readers. Will airlines squander the windfall from oil in 2015 as they chase market share? Or will a new brand of profit-focused managers act in a responsible manner, using lower fuel prices to boost margins and profits even further? I’m betting on the latter, and I’m willing to put my money where my mouth is, as my disclosures below the fold should indicate.