By: Janel Forte
This has been one heck of a year for the airline industry.
Through the year’s first nine months, earnings at every major carrier have risen. The year-end numbers due out soon will confirm what the industry, and Wall Street, already expect: the upward trend isn’t likely to be ending anytime soon.
The industry is benefiting from declining fuel prices, strong demand and — thanks to consolidation among players — the absence of the kind of profit busting price wars that once plagued the airline sector.
“The forces that have driven oil down to where it is today are not likely to change in the near term,” said Fred Lowrance, an analyst at Avondale Partners LLC. “Demand is strong and the industry is situated to perform well in the upcoming year.”
The International Air Transport Association trade group estimates that global airline profits could increase to a record $25 billion next year if oil prices continue to fall. That would be about a 25 percent improvement over this year’s expected $19.9 billion industry profit.
The airline sector’s current earnings are dramatically above the profits of $10.6 billion in 2013, and an even smaller $6.1 billion in 2012.
With jet fuel projected to average about $100 a barrel in 2015, down from $130 a barrel this year, airlines will eventually see a huge break on operational costs. That’s because fuel can account for nearly 30 percent of total costs. But falling prices will take a while to kick in for carriers, however. That’s because carriers, to protect themselves from future fuel-price increases, use hedging practices to lock in current prices. When prices are soaring, hedging helps hold down costs. But when prices are in decline, as they are now, the hedges oblige the carriers to pay above-market rates, temporarily.
“It’s going to be six months or so before airlines are seeing lower fuel costs, and at that point, consumers are likely to see a fall in travel costs,” said Brian Pearce, IATA’s chief economist.
Even so, major carriers say they expect to cut the average fare by 5 percent next year, excluding surcharges and taxes.
The move to more fuel-efficient planes will also help the less expensive jet fuel go the extra mile, literally. Helped by the stronger profits, major carriers are moving to update their fleets, replacing many older aircraft that burn more fuel and require costly maintenance to stay airworthy.
Notably American Airlines is in the process of swapping its aging Super-80 aircraft for the trendy Boeing 737’s, and Delta Airlines just made a deal to order 50 wide bodies from Airbus.
“In addition to better fuel use, airlines are investing in denser aircraft,” said Lowrance. “They’re serving more passengers, without adding to fuel costs.”
The sector’s ascension in profits also reflects the impact of a near-total transformation of the industry, one that’s been long in the making.
“The current success in the industry is a combination of benefits of three things: consolidation, capacity discipline and ancillary revenues,” said Michael Derchin, an analyst at CRT Capital Group LLC.
The beginning of 2014 was led by the emergence of the new American Airlines, formed from the merger of American Airlines and US Airways. The earlier combination of United and Continental has advanced, and the merged company has finally consolidated many of its troubled platforms. Southwest’s pairing with smaller Air Tran has also reduced the number of competitors in the sector.
As recently as 2005, the domestic U.S. market was served by 11 major airlines. Not quite a decade later, the number has been reduced to six. With fewer players in the industry, carriers enjoy considerable pricing power. And paired with soaring demand in air travel and air traffic expected to increase by 7 percent in 2015, planes will remain full and profit margins are predicted to increase even more.
That’s where capacity discipline comes into play.
“The airlines are playing it smart by having very low, single digit growth in capacity and only growing supply at a rate that trails demand,” said Lowrance. “By doing this, carriers are able to pass on higher fares and generate higher margins.”
Ancillary fees account for things such as checked baggage, inflight food and beverages and being able to choose your seat — extras that are not included in the standard ticket fare. In 2013, these fees accounted for 10.2 percent of industry revenue, and as carriers like JetBlue, who once opposed many standard ancillary fees, announce plans to incorporated checked bag fees, this number is sure to rise.
According to a report by IATA: “Without ancillaries, the industry would be making a loss from its core seat and cargo products.”
Despite the industry’s increased profits in 2014, the year wasn’t completely smooth sailing. Airlines have had to overcome some pretty hefty obstacles along the way.
“The Ebola issue took out a lot of gains that the industry reaped prior to October,” said Lowrance.
The harsh winter at the beginning of the year in the form of a Nor’Easter, two polar vortexes, record cold temperatures and a lot of snow, also dampened profits. According to MasFlight, a flight tracker, over 1 million flights were cancelled between December 1, 2013 and March 3, 2014, costing the industry about $500 million.
Luckily the industry was better positioned financially to absorb those losses. Moving forward, the industry appears poised to prosper again in 2015.
But what could go wrong?
“Well the airline industry is very sensitive to the global economy,” said Derchin. “If there’s a recession, or if there’s a black swan event – like a natural disaster – that profitability could be nipped.”
And fuel volatility also plays a big role.
“Oil is a huge wild card,” said Lowrance. “If prices went back to $90 a barrel (from the current low-$60s), then the industry would definitely be in trouble.”
IATA’s director and chief executive officer Tony Tyler also warned of “political unrests, conflicts and some weak regional economies.”
Still investors are pretty optimistic. All the major carriers’ share prices are dancing around their 52-week highs.