The rising price of oil has been devastating for the airline industry, causing costs to soar and fueling industry losses at a time when results should be stronger. But $40-plus oil may also be the best thing that could happen to the industry, forcing carriers to slim down or go belly up. Every time the price of a barrel of crude oil increases by $1, the industry's costs increase $425 million, according to research from Bear Stearns. And with at least three carriers -- Delta Air Lines ( DAL), Northwest Airlines ( NWAC) and US Airways ( UAIR) -- actively pushing for employees to cut their own pay, chronically high fuel costs have shortened the amount of time they have to seek concessions, while deepening the amount they're asking for. "Unsustainably high jet fuel prices could, in fact, be good for the industry," said Susan Donofrio, analyst at Fulcrum Global Partners, in a research report. "While we concur with labor that the current bloated cost structures at many of the airlines
is not labor's fault, we still think that the numbers show there is the need to become more competitive."
Two days after Delta announced deeper second-quarter losses, pilots presented a
$700 million concession package to management. By the end of August, both sides will begin negotiations, with Delta pushing for $1 billion in annual labor concessions, $150 million more than it sought earlier in the year because of rising fuel costs. But pay cuts are merely the first, not the only, step in restructuring an airline. Even companies that have received billions of dollars in concessions from employees can't escape the rising cost of fuel, forcing them to make deeper structural changes to compete over the long term. Consider American Airlines, unit of AMR ( AMR), whose successful restructuring plan is $1 billion behind schedule -- in part because of fuel. While American's second-quarter labor costs dropped 8.9% from last year, fuel costs rose 41.7% -- a $270 million increase. In 2004, fuel accounted for 20% of American's second-quarter expenses, up from 15% in 2003. Ultimately, the company said it would have made $232 million more without the spike in fuel. "Had fuel prices been at 1999 levels, our costs would have been lower by a staggering $480 million," said Gerard Arpey, American's CEO, in the earnings release.
In 2004, the price of oil cracked the $40 barrier, has had an average price of $37.41 and could remain above $35 for months, if the current supply and demand equation is any indication. The International Energy Agency and other analysts are suggesting that OPEC may have a
limited ability to produce more oil than it already is using with its current infrastructure. With Russia investigating Yukos and civil unrest threatening the production output in Venezuela and Nigeria, problems outside the Middle East could make supplies even tighter. And output may be peaking at a time when demand seems unquenchable -- across the globe, from fully developed nations to the undeveloped ones, oil is the substance that lubricates economic growth. China's and India's thirst for oil is growing rapidly. For the airline industry, pining away for the days when oil was below $20 is akin to wishing it were suddenly 1977, when regulations kept low-cost upstarts like Southwest Airlines ( LUV) from expanding. Oil has been a slap in the face for an industry knocked around by terrorism, war, SARS and an economic slump. But the slap has been a wake-up call. Carriers recognize fuel costs could stay high and are moving to streamline operations, weeding out bloat amassed through decades of evolving technologies and business strategies. So while American noted costs could have been a half-billion dollars cheaper if it was 1999, the company isn't betting that fuel will fall significantly. "High fuel prices are not an excuse," Arpey said. "Rather, they are a reminder that we must continually work to remove costs and improve the underlying profitability of our business anywhere and everywhere we can." "Those who think $42 oil is here to stay should stop reading and short all airline stocks," said Gary Chase, airline analyst at Lehman Brothers, in a research note. "At $35, long term, we see most stocks as fairly valued. At $30, however, we see material upside from current levels. Stocks are unlikely to show meaningful gains until fuel prices begin to ease." Airlines are now reverse-engineering the low-cost model, a step the industry spent years resisting, believing exclusive routes, strong brands and perks like meal service would enable them to charge a premium for seats. They were wrong. Airline seats are commodities and the low-cost producers control pricing. The situation is bad now, but if oil gets cheap again, there is a big reward for airlines that dig the deepest -- they'll be in the best position to profit.