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Thursday
Mar032011

Oil and Water; Jet Fuel and Labor

On June 25, 2008 I blogged asking the question:  Is Oil A Cancer Or A Cure?  At that time, the price of a barrel of oil had not yet reached its apex of $147 per barrel, but was well on its way.  Based on findings by the Air Transport Association’s superb economic analysis team led by chief economist John Heimlich, the U.S. airline industry paid the equivalent of $174.64 per barrel [price of a barrel of oil plus the equivalent cost to refine crude into jet fuel (the crack spread)] on July 11, 2008.  By December 23, 2008 the price of a barrel of West Texas Intermediate had fallen to $30.28 per barrel.  So far in 2011, we’ve seen a similar surge in oil prices, but based on current geopolitical events, I am not expecting another $117 drop in the price of a barrel of oil like we witnessed in 2008.

I’m actually wondering what happens if the wave of Mideast political upheaval washes over Algeria? Or Saudi Arabia? Some economic experts say the price of oil could rocket past the $200 threshold.

In 2011, the industry has paid an average of $89.15 per barrel of crude and another $25.80 in the crack spread for a total cost of “in the wing” jet fuel of nearly $115 per barrel.  Since February 22, 2011 the industry has paid more than the equivalent of $120 per barrel for jet fuel.  On March 1, 2011 the industry paid the equivalent of $132.17 per barrel for jet fuel including the crack spread of $32.54.  For all of 2008, the industry paid the equivalent of $25 per barrel to refine crude into jet fuel.  In the last five days of trading the crack spread paid by the industry is nearly $30 per barrel. 

That’s a lot of numbers, so let me put this in a way that might shock even the most ardent follower of the airline industry: Today’s cost of just refining oil into jet fuel is roughly equal to the total jet fuel price per barrel paid by the industry every year between 1978 and 2001.

1978 – 2001

The mindset of many airline stakeholders - and particularly labor - is based on the period between 1978 and 2001.  Deregulation began in 1978 and 2001 marks the beginning of wholesale industry restructuring. .. which actually should have started 24 years earlier.  To put this period into an oil perspective, over the first 25 years of a deregulated industry, the equivalent per barrel price of jet fuel was $28.93.  Oil was cheap (more than four times cheaper than in 2011) and it was the basis for the industry to grow too big, too fast.   After all, the biggest “uncontrollable cost” was a blip.  There was little change in either the price of a barrel of crude or the crack spread.

Based on analysis at MIT's Airline Data Project, between 1978 and 2001, the industry grew nearly 2.5 times in terms of available seat miles.  Traffic grew faster than capacity.  The great enabler in the growth in addition to the cost of jet fuel was the fact industry yields, or the amount the customer pays per mile, declined by 39% when adjusted for inflation.  Domestic yields fell by an inflation-adjusted 41 percent over the same period.  In other words, cheap seats. The price of an airline ticket was one of the great consumer bargains.  This fact ultimately led the network carriers to refocus their operations on international flying because their high cost structures struggled to conform to the realities of the domestic market economics.

As the industry added capacity, employment grew by nearly 220,000 full-time equivalents.  During the same period, the total cost of an employee to the industry declined by eight percent in real terms.  I can hear it now, ”no way – my salary is significantly less.”  Yes, it is true salary costs when adjusted for inflation have decreased. On the other hand, the cost of pension and benefits paid to airline workers has grown at a rate faster than inflation.  The cost of an employee to a company is not based on salary alone.

Over the 24 year period being discussed here, it is true that employee productivity in terms of available seat miles per employee and enplanements per employee increased 44 percent and 30 percent respectively.  Much of that is again driven by cutthroat competition driving prices downward in order to stimulate demand.  Here is the kicker.  The number of available seat miles produced per dollar spent on labor fell by 42 percent.  Or, labor is producing more output but the cost of that output is increasingly expensive.  This fact alone was unsustainable and the restructuring process was used to address the underlying economics.

Many areas of the income statement were addressed by managements over the period with the most noteworthy being the decision to stop paying legacy commission rates to travel agents.  This action alone saves the industry nearly $6 billion dollars per year although we can also say that the savings are largely competed away in the form of lower fares.  Food and advertising expenses were also reduced.  Each of these cost areas, like labor, is considered controllable costs.  Oil is not.  What the industry did realize over the period was a 30 percent efficiency improvement in the consumption of fuel.

2002 – Today

As 2001 came to a close, unit costs at the network carriers in the face of free falling unit revenue became the story.  US Airways was the first carrier to file for bankruptcy.  United was second.  And American followed with an out of court restructuring.  Each carrier had extremely high overall unit costs relative to the industry as shown by the MIT Airline Data Project.  The ADP also shows the three carriers were out-of-market with respect to unit labor costs relative to the industry.  The network carriers mentioned simply had costs so high, there was no choice but to seek some sort of a consensual restructuring either through bankruptcy or out of court if they were to live and fight another day.  The scary part is, oil was still reasonable during this time. The industry jet fuel price per barrel equivalent as restructuring commenced was $30.07.

While jet fuel prices are uncontrollable, so too is airline pricing, particularly in the U.S. domestic market.  Since 2001, the industry has only increased capacity by 2.5 percent as capacity discipline became the mantra.  Again traffic grew faster than capacity as inflation adjusted yields fell another 12.5 percent.  The nominal level of capacity growth can be attributed to the growth in regional carrier and low cost carrier flying.  Since 2001, mainline carriers have shed nearly 24 percent of their previous domestic capacity with nearly one-third of that capacity removed since the 2008 fuel spike.

Capacity cutting was all that was left in the face of high oil prices.  When carriers delete capacity, they also eliminate jobs.  Since 2001 the industry has shed nearly 155,000 jobs – a period when the jet fuel equivalent price per barrel averaged $73.08.  Labor productivity has improved significantly as the network carriers restructured.  But as I’ve talked about before, the problem with a seniority-based system is that average costs increase as the less expensive employees are the first to be let go.  In 2002, when the restructuring began, the average cost of a full time equivalent airline employee was $74,910.  Today, the average cost of a full-time equivalent employee is $83,869.  More troubling is the benefit and pension package for full- time employees in 2001 cost $11,560.  Today, the cost of that package is $18,195 reflecting seniority as well the country’s inability to reign in medical costs. 

So Here We Sit

The history of pattern bargaining - and resultant expectations - between labor and management was created on a basis of $30 per barrel for jet fuel.  Today, the cost of jet fuel is the equivalent of $132+ per barrel.  Yet labor doesn’t seem to acknowledge the fact that times – and oil prices – have changed.  There are 52 airline cases under the auspices of the National Mediation Board and I will wager few, if any, of the labor negotiating teams consider oil a major factor in a future contract. It’s “management’s problem.”

Well, it’s also labor’s. While the industry has been creative in finding new revenue to address the reality of fuel costs, consumer pass-throughs generally lag behind the rise in the price of fuel. The bigger issue, the one labor has trouble admitting, is the size of the revenue pie is finite.

Oil is uncontrollable and therefore difficult to predict how much of the revenue pie it will consume.  Cost reductions in many areas of the operation have already been largely realized.  And that’s where oil prices become labor’s problem.  Employees – rightfully - want their share of the pie, and they’d like to make-up the concessions of the past.  The problem is the pre-restructuring high water mark, when oil was around $30, is what labor wants to return to. That’s not possible and it’s certainly not sustainable.   

I have heard it said many times, "labor is not going to subsidize the price of oil again".  Well, truthfully, labor didn’t the first time. When restructuring began and adjustments to labor costs were realized the price of jet fuel was not the issue.  It was declining revenue.  After much pain inflicted on virtually every stakeholder group over the past decade, $100 per barrel jet fuel is the new reality.  Expectations of returning to the past should be forgotten.  I like to use history, but history is useless in evaluating this industry because the fundamentals that now govern the industry’s structure like oil and the economies of China and Germany and Brazil are new and rapidly evolving.

I had someone say to me the other day that shouldn’t we throw away the past and just start again making this apex the new reality?  The simple answer is yes.