Airlines to Cut Supply of Seats to Force Fare Prices Up
July 29, 2009
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    June 23, 2008

    Faced with a looming financial disaster, the U.S. airline industry is boning up on an Economics 101 principle for its salvation: supply and demand.

    The airlines are hoping that major cuts in their flying after Labor Day will allow them to create a scarcity of seats sufficient to drive up the average price of an airline ticket, particularly on domestic routes.

    But will airlines be able to increase fares enough to cover their additional fuel costs, up 50 percent or more for most major carriers?

    Even the airline executives don’t know.

    AMR Corp. and American Airlines Inc. chairman and chief executive Gerard Arpey said at an industry conference last week that the slumping economy makes it tough to raise fares and impose fees.

    “Nonetheless, if we are going to have an airline business, and I am pretty sure we are, our customers must ultimately compensate us for the costs we incur flying them around the United States and the world,” he said.

    Airline industry analyst Ray Neidl projected earlier this year that airline fares would have to jump 20 percent to cover the airlines’ higher fuel bills. Now, he says, that figure was probably conservative.

    “My feeling is with oil up over 82 percent for the past six months, fares have to go up even more than 20 percent.”

    Nine of the 10 major carriers have announced reductions in their domestic systems, ranging from fairly small – a 5 percent cutback at AirTran Airways – to rather significant – 13.5 percent to 14.5 percent by United Airlines Inc.

    Among the 10 largest carriers, only Dallas-based Southwest Airlines Co. still expects to grow later this year, but at a much smaller pace than the 8 percent to 10 percent expansion in capacity that it has typically added.

    American, the world’s largest airline, is planning to cut its domestic capacity 11 percent to 12 percent by the fourth quarter compared with a year earlier.

    Delta Air Lines Inc., No. 3 behind United, last week said it will reduce its domestic flying 13 percent, up from earlier announced reductions of 10 percent.

    Put together, the domestic capacity cuts are big enough to create an airline bigger than No. 9 AirTran Airways Inc. and No. 10 Alaska Airlines Inc. combined, bigger than No. 8 JetBlue Airways Corp. or bigger than No. 5 Northwest Airlines Inc.’s domestic system.

    Other, smaller airlines will reduce capacity as well.

    And the industry will operate without all the capacity of ATA Airlines Inc., Skybus Airlines Inc., Aloha Air Inc., Champion Air Inc. and Big Sky Airways – all of which have disappeared in the first half of 2008.

    Delta and other carriers set the size of their flying cuts when crude oil was selling for $100 or $110 a barrel. They’ve come back once or twice to increase the cutbacks as oil moved past $120, then $125 and finally to $135.

    The Air Transport Association predicts that U.S. airlines will spend $61 billion on jet fuel in 2008, up $20 billion from last year.

    AMR Corp., parent of American and American Eagle, says its carriers will pay $10.15 billion for jet fuel in 2008, up nearly $3.5 billion, or 52 percent, from 2007 despite a 4 percent drop in fuel usage.

    With one analyst describing the situation as a crisis headed for a catastrophe, the tremendous jump in fuel costs has raised questions about whether airlines will be able to raise their revenue or cut their costs enough to survive for long.

    Southern Methodist University professor Dan Howard said if the airline industry faces collapse, the government will step in to save it. But the airlines will survive without government intervention, he said.

    “The big question is in what form,” said Dr. Howard, chairman of the marketing department at SMU’s Cox School of Business.

    As prices go up, fewer people will be able to afford to fly. Those who can afford the higher fares will be asking themselves if they want to fly at those prices, he said.

    “You’re getting a reduction in demand because of that,” he said. “Yes, it is an elasticity of demand issue. And as the price goes up, the demand goes down. Now does that mean that the airlines are going to just price themselves out of business? I don’t believe so.”

    Speaking to the same industry conference as Mr. Arpey, Southwest chairman and chief executive Gary Kelly noted that raising fares doesn’t necessarily mean that the average price an airline receives will go up much.

    “We had six fare increases in 2007, and we moved the needle 1.5 percent,” he said. “If you move the top fares too far, then people shop harder and they buy down. And that’s just the way the airline industry prices.”

    So far, airlines are still filling their airplanes as they push out fare increases. According to the Air Transport Association, the average passenger paid 15.42 cents per mile for a ticket in May, up 6.8 percent from May 2007. Through the first five months of 2008, fares were up 6.7 percent.

    But that won’t be enough, Mr. Neidl said, and that calls for airlines to reduce capacity even more than they already have.

    The capacity cuts announced thus far “will go a long ways” toward covering the airlines’ fuel costs, he said. “My gut tells me a little bit more has to be done.”

    Without airline failures or more mergers, it will be difficult to eliminate more service than what airlines are contemplating, he said.

    “The question you have to ask of each individual airline is: Will they start cutting into muscle?”

    He added: “Further cuts are going to be tough, but I think some additional cuts are going to be necessary if oil stays up at $130 [a barrel]. You’re going to get airfares up 20 percent, if not more.”

    For consumers, the impact will be simple, he said: “Less frequency, higher ticket prices.”

    “It’s going to take some time to adjust,” Mr. Neidl said. “But at the end of the day, the consumer is used to flying. Big price increases aren’t outrageous, considering the cost of everything else going up led by fuel costs. They will adjust over time.”

    Date: 2008-06-23