July 16, 2008, 11:16 am
What Southwest Airlines Could Teach Delta and American
Posted by Heidi N. Moore

There is an interesting dichotomy at play in the airline industry: some airlines are actually profiting from rising oil prices.

Consider Delta Air Lines’ earnings today. The Atlanta airline, which has agreed to combine with Northwest Airlines, announced a $1.04 billion second-quarter net loss, partly because of rising fuel costs. But it could have been far worse. Delta actually earned a tidy bundle on the rising price of oil–more, in fact, than it counted in earnings this quarter.

Delta, with the help of its Wall Street investment bankers, created hedges to protect its business against rising oil prices. But as the WSJ reported today, “Delta hedged 49% of its fuel consumption and realized about $313 million in gains.” Delta’s earnings this quarter–excluding write-downs–were only $137 million.

American Airlines wasn’t as lucky, as its hedges missed the mark by a long shot. In June AMR revealed it had hedges on about 33% of fuel consumption. Taken in aggregate, it bet that oil prices wouldn’t rise above $78 a barrel this year. Oil today is at around $136 a barrel.

On the other side of the coin, consider Southwest Airlines. It has about $5 billion of fuel hedges, or about half of its market cap. Morgan Stanley analyst William Greene Tuesday went as far as to call Southwest an “oil play,” and complained that airlines’ fuel hedges cover a multitude of sins and may be an excuse for the airline to avoid cutting capacity. Greene wrote: “Considering that [Southwest’s] management recently suggested it may revisit its capacity plans and potentially raise growth suggests that management does not view its fuel hedge as a temporary comparative advantage but rather as a durable competitive advantage.

Not addressing the company’s economic challenges today may lead to a more difficult adjustment in the future.”The question, as always, is whether capacity cuts are what the industry needs. Greene believes they are. Still, late last week he presented several reasons why airlines would want to avoid any extensive cuts in capacity and “chase oil” instead.

In his words:
(1) The network effect of a hub-and-spoke model deteriorates as capacity is cut

(2) Labor contracts, fleet planning, and aircraft/facility financing make large capacity cuts difficult to reverse in the short-term

(3) An habitual (if currently muted) focus on maintaining and gaining market share

(4) An inability to predict competitive responses

(5) Lack of visibility in airline revenue trends

(6) Uncertainty surrounding oil prices, a pullback could quickly make many routes profitable

Employees who made significant concessions in union negotiations are going to be watching that bottom line very carefully. Especially the pilots at Delta and Northwest. As Delta noted today, “Pilots at both companies will receive pay raises and an equity stake in the combined company.” That money has to come from somewhere.