Airline & Airport Closures

It's time for another random energy-crisis related posting. I know, the price of oil has dropped to less than half of what it was back in the spring. But trust me, this decrease is very temporary. You all know that for years, I've been warning about the impending oil crisis. And it's only in the past year that it's become mainstream enough that people finally are starting to believe the doomsayers such as myself. But rather than talk about the gradual decline in fossil fuel supplies and rising fuel prices, let's get into something a little more specific. Today, I'll dig out the crystal ball and talk about the effects of the energy crisis on the airline industry.

A couple years ago, I suggested that in the long term (ie. a three to five year horizon), a person could make a lot of money shorting airline stocks. Now for this posting to make sense, I need to explain what "shorting" a stock means. In the stock market, the traditional way to make money is to buy shares in a company, then to hope that the company either increases or is perceived to increase in value over time, so the shares are perceived to be worth more. You then turn around and sell those shares to someone for more than you originally bought them for, because that person thinks the shares are going to appreciate further in value. Simple. But in such a limited market, people can only make money when their stock is increasing in value. That's no fun. What if there was a way to make money when shares go down in value too? Well, there is. It's called "selling a stock short" or "shorting." Shorting a stock is intended to benefit you when you believe (correctly) that the shares of a company are going to decline in value. Essentially, what you do is "borrow" shares from a third party who owns shares. You've borrowed the shares, so they can't turn around and sell them, because they've loaned them to you. So anyway, you have these borrowed shares. You think the stock is worth more now than it will be in a few months. So you sell the shares on the open market for the current price. Then, assuming that you're correct, let's assume that the shares go down in price. A few months later, you buy them back on the open market for the lower price. You then give those shares back to the person that you originally borrowed them from. In effect, you've sold shares at a higher price, which you bought at a lower price, even though the chronological order of the two transactions is backward. I know, this is a moderately confusing concept, but hopefully I've boiled it down to the very basics that will make sense if you think about it. Not every investor in the stock market is savvy enough to be able to do this, but institutional and wealthy investors generally are qualified for this kind of trading. Incidentally, although I understand the concept, I've never dabbled in this kind of trading. My knowledge of trading is somewhat more extensive than my personal wealth.

So anyway, back to shorting airlines. Fuel prices have started to increase significantly over the past year (ignore this month's temporary decline). The airlines are all admitting that they are getting hammered on their financials. About a third to a half of the total operating costs of any airline right now is the cost of the aviation fuel. This is up from between ten and fifteen percent a few years ago. Needless to say, if your operating costs increase by twenty to thirty percent, and your profit margin was only a few percent in the first place, you're suddenly losing a lot of money. No other global industry is so heavily affected by fuel prices, and thus, no other global industry is likely to suffer financial catastrophe as quickly as the airlines when fuel prices rise. Therefore, as oil goes up in price over the next few years, the increased fuel costs are unquestionably going to drive a large number of airlines into bankruptcy.

The interesting thing about the US airline industry is that they historically have embraced "bankruptcy protection." This is a legal status whereby an airline asks for temporary court protection from their creditors because they are on the verge of financial ruin. In theory, this situation can give the airline a few months or years to make significant changes to their operational procedures, to allow them time to restructure or become more profitable. This practice has become especially common since the 1978 Airline Deregulation Act. Anyway, a number of the major US carriers have successfully used this "Chapter 11" protection in the past as a last-ditch effort to keep from true bankruptcy. But this avoidance measure is going to become increasingly ineffective. The financial pressures that the airlines are starting to face are simply too overwhelming. There are too many airlines competing for passengers' money, at the same time that the economy is stalling and people are flying less.

So who is going to go out of business first? Simply picking random airlines to "short" might prove effective, but you would be better off specifically picking the worst companies. In a general sense, it will be the leisure and travel specialists, and the commuters. Economy fares (especially for travel and leisure) are generally the cheapest and therefore least profitable. Smaller airlines and tour operators are in a bad position. The commuters are also handicapped because they run some of the least efficient fleets, out of the most marginal airports. The rising fuel prices are already causing airlines to drop their least profitable routes, reducing capacity, and parking planes (it is estimated that about five hundred planes are going to be permanently grounded this year, which is about ten percent of total US capacity). That's good, because the least fuel-efficient and oldest planes can be retired. But it's bad too, because that's not nearly enough of a reduction in supply. The industry needs to contract more than that, and ground more low-volume and low-profit routes.

In terms of the major airlines, I think that US Airways is in the worst position. Almost every North American airline is projected to sustain staggering losses for the next couple of years. US Air has a hub in Phoenix, which I've used many times. Some of their more popular airports are LaGuardia in New York, and McCarron in Las Vegas, which again are airports I've frequented numerous times. I will go out on a limb here and suggest that US Air is famous for being the most disliked airline in America. Although it is probably one of the five largest US airlines, it consistently ranks the lowest in consumer satisfaction surveys. It has eliminated free services with a vengeance since 9/11 and a subsequently temporary Chapter 11 protection period. However, US Air generally has an older and less fuel-efficient fleet, has less advantageous gates and routes than most of its competitors, is disliked by consumers, and doesn't have a large cash position to get it through the next several years. So I will put my reputation on the line and say that I predict that US Airways will be the first major US airline to fail. My guess would be in the fall of 2009, approximately twelve months from now. Of course, US Air does have a habit of hanging on by their fingernails. Regardless, my prediction is that the only thing that could possibly save them would be government subsidies or consolidation, both of which are politically difficult. Perhaps a merger with United (a good fit) would delay the end, or maybe US Air could sell their international routes to United to buy more time, but ultimately, for the long-term health of the airline industry, some major competitors need to fail so overall capacity is reduced. Of course, nobody really wants to merge with United, because they think they are worth a lot more than they really are. Continental thought about it, but pulled back.

So that's my medium-term assessment of where the airlines stand. In the long-term (five years plus) there will be fewer players in the field. The majors may not be the first to go, but they will still be susceptible. Fuel prices will be much higher, and ticket prices will be much higher. Fewer people will fly, and since the airlines benefit from larger volumes, it will be a catch-22 situation. Many existing routes will eventually be cancelled, so that less than a decade from now, only the very most popular routes will be remaining. It would not surprise me if fully one-quarter of US airports were to completely close within five years. Mind you, some of the smaller commuter airports and seasonals could close without a significant impact on the American way of life.

The "global marketplace" is going to become a thing of the past in another three to five years. Expect global trends towards regionalization of services and production. We're watching the sunset of global jet-setting, except for the wealthy. If you've ever dreamed of traveling to foreign countries or to see the world, and you're on a tight budget, I would strongly recommend you do it in the next year or two, before it's too late. And if you've got lots of frequent flyer points, use them while you can, before the airlines start making it impossible to get the best benefits from your points.