Fuel Costs Fliers

<B>Fuel Costs Fliers</B>
<I>Continental Prompts Others To Add Ticket Surcharge</I>

By David Jonas

The largest U.S. airlines last week implemented a $10 one-way surcharge on all domestic tickets to compensate for the extremely high prices of jet fuel that negatively impacted recent fourth-quarter earnings. However, most analysts predict jet fuel prices to trend downward throughout 2000, saving carriers millions and limiting motivation for price hikes, traditional or otherwise.

Following the move toward fuel surcharges for cargo operations earlier this month, Continental was the first to add the $20 roundtrip ($10 one-way) charge for passenger tickets, followed by American, Delta, Northwest and United. Meanwhile, Alaska opted to charge $5 each way. The surcharge, which will cost the largest corporate buyers millions of dollars, applies to all domestic flights beginning Feb. 1 and is not included in quoted fares, though it does appear on tickets.

Greg Brenneman, Continental's president and COO, said the move was warranted because revenues "have been unable to recover the dramatic increase in fuel prices."

Indeed, last week's price of crude oil was more than double the levels from a year ago. Citing the highest prices since the Gulf War, Continental CFO Larry Kellner summed up the industry perspective, stating, "We are running on incredibly thin margins and are at the mercy of fuel."

At presstime, the other major carriers had not matched.

For buyers, the surcharge immediately and simply means more expensive air travel via the equivalent of a fare hike, regardless of negotiated discounts. For example, Mark Vilcsek, senior purchasing manager for travel services at National Semiconductor in Sunnyvale, Calif., said the $10 charge on approximately 16,000 annual segments flown on American and United translates to another $160,000. "This may not fall under the auspices of a fare increase, but it's a different way to offset their costs," he said.

Should the other major airlines fall in line, Bloomington, Ill.-based State Farm Insurance would be hit even harder. The corporation would have to foot another $1.3 million to cover the charges on 65,000 annual roundtrip tickets. "The airlines keep finding ways to get more money on their side, but our travelers still need to travel," said Melinda Samp, supervisor of the air travel & lodging unit.

Jack O'Neill, vice president of airline partnerships at Maritz Travel, said he saw the writing on the wall. "The more fuel prices go up, the more visual it becomes," he said. "Since they more than doubled in the past year, we will hear more about fare increases tied to fuel price increases."

Calling the surcharge a "bush league" approach to a fare hike, Terry Trippler, airline expert at Onetravel.com, mapped out the impact on a few city-pairs. "On Houston-Dallas, Continental offers a $78 roundtrip fare, including tax. But when all 'surcharges' are added, the price is 35 percent higher at $106 per round trip." Similarly, Trippler discovered United's $104 fare, including tax, for Chicago-Kansas City tops off at $140 with all the trimmings.

It is important to note that corporations with a majority of short-haul flights are just as affected as those with more transcon segments. That begs the question of why the airlines chose to introduce the surcharge on domestic flights only when long-haul operations burn much more fuel.

But a more important question is whether the carriers will roll back the surcharge if fuel prices abate. "It's difficult to talk about what might happen to pricing activities in the future, but this is an appropriate response to the current environment," said Doug Hacker, United's executive vice president and CFO. "There seems to be a broad expectation that fuel prices will come down. Instead of counting on that, we have decided to implement the surcharge."

So how hard have the carriers been hit? In a note to investor's last week, Sam Buttrick of Paine Webber estimated that industry operating profits declined 22 percent in the fourth quarter, and "higher jet fuel prices cost the industry a forecast $400 million. On a fuel-neutral basis, operating profits would have been up 10+ percent." Last year's industry-wide fuel price tag of $10.2 billion came in nearly $1 billion over the 1998 figure reported by the Air Transport Association.

As fourth-quarter earnings reports filtered in last week, fuel was a main topic and it became clear that no carrier was spared (see chart). All reported increases in quarterly fuel expenses, ranging from 9 percent at Delta and 12 percent at United to 60 percent at US Airways and a staggering 71 percent at Southwest. The result was higher costs per available seat mile across the board, with the exception of Northwest, which posted improved numbers compared with last year, when a pilots strike devastated operations.

For the most part, the airlines also reported lower passenger yields for the quarter. Northwest aside, American and United fared best and actually improved yields, with 4 percent and 2.9 percent increases, respectively. US Airways and Southwest reported the largest yield decreases.

The new $10 surcharge notwithstanding, higher fuel costs do not necessarily translate to higher prices in today's complex aviation industry. Because jet fuel is such an expense for airlines, and because it fluctuates so often, the carriers use hedging programs to offset the peaks and valleys associated with crude oil pricing trends.

Delta, the last of the big three to add the surcharge, said its "fuel needs for the remainder of fiscal year 2000 are approximately 75 percent hedged and will continue to limit jet fuel price volatility." In fact, the carrier's hedging program saved it roughly $113 million in Q4 alone. American said it saved $90 million in the quarter by hedging. The carrier is 50 percent hedged for 2000.

United, which also hedges aggressively, said its program shaved 10 cents off the gallon in the fourth quarter and should further benefit the carrier in 2000. Nevertheless, United expects unit costs to rise another 5 percent in the first quarter of 2000, primarily due to the fuel environment. America West, meanwhile, said its hedging strategy saved it $11 million last quarter.

On the other hand, Southwest and US Airways, both known for not hedging, were impacted the most severely.

Hedging aside, the carriers were able to compensate for fuel prices by finding cash in other areas, particularly travel agency commissions. As one industry observer noted, "The commission cuts were very important in offsetting fuel prices because commissions are one of the few cost items over which airline management has control." Indeed, the latest cut helped to lower total commission costs, which according to ATA, reached an estimated $5.6 billion in 1999--$400 million less than a year earlier. Other industry observers pegged the annual savings of the October travel agency commission reductions between $700 million and $1 billion.

"The surcharge is not appropriate, especially after the sharp commission cut," Samp said. "They made a significant increase in their financial stability and should not pass along this cost so quickly afterward."

Looking forward, the industry is split on where fuel will go, though many do not foresee prices maintaining at current levels. Buttrick, for example, forecast the average price for a barrel of crude oil in 2000 to be around $21.50, compared with the peak price near $29 last week. As expected, the airlines stated far less optimistic goals.

United, for example, already said it expects its fuel expenses to average 25 percent above 1999 levels, despite its aggressive hedging strategy. Southwest's CFO Gary Kelly said the airline's outlook is cautious, but is well positioned to absorb volatile fuel prices. "We are a bit surprised that prices have been so stubbornly high," he said. "But at these levels, we should still be nicely profitable this quarter."

Continental may not be as fortunate. Kellner said, "If high fuel costs continue without an improvement in the revenue environment, the company may not post a profit in 1Q00," its first quarter in the red in over four years. "However, we don't believe current levels are sustainable on a long-term basis."

Of course, fuel is an issue for carriers all around the globe. "We have been impacted a lot by fuel and now are suffering," said Jean-Louis Pinson, Air France's new executive vice president and COO of the Americas. However, he said strong profitability from Amadeus' initial public offering helped offset fuel costs in 1999 and a renewed effort to hedge fuel will help moving forward. "We are not all that concerned because we expect the price to drop a bit," Pinson said.

Several other industry observers also expect fuel prices to be a continued problem, resulting in higher airfares. The National Business Travelers Association has predicted a 7.7 percent jump in business fares, partially attributable to fuel. "The possibility of lower prices through March 2000 are narrow," the association predicted, adding that jet fuel accounts for 15 percent of the airlines' total costs. American Express, in its most recent airfare forecast, also said jet fuel prices would pressure fares upward.

Should fuel costs retreat, the airlines presumably would have the means to follow through with their service-oriented promises and distribution enhancements, or even set their sights on new acquisition targets. But more importantly for buyers, a downward trend means the airlines cannot point their fingers at fuel for any fare hikes and would be expected to rescind the surcharge.