Showing posts with label airlines. Show all posts
Showing posts with label airlines. Show all posts

Saturday, March 08, 2008

No LUV, or Maybe Too Much, from the FAA

As a longtime flyer of Southwest Airlines, this was not welcome news:

WASHINGTON – The Federal Aviation Administration said Thursday it would fine Southwest Airlines Co. $10.2 million for safety violations that included knowingly flying more than three dozen jets without mandatory inspections for structural damage.

Southwest, which found cracks in the bodies of six of its jets during belated inspections, said safety was never jeopardized.

The fine would be the largest ever levied against an airline, the FAA said.

When Southwest belatedly conducted the inspections, it found cracks in the bodies of six Boeing 737-300s, with the largest measuring 4 inches. Serious fractures can depressurize an aircraft and in 1988 caused an Aloha Airlines jet to rip apart, killing a flight attendant.

The FAA announced the fine a week before congressional investigators were to disclose findings from their own inquiry into Southwest's failure to meet airworthiness directives. That investigation was prompted by information provided by Dallas-based FAA inspectors who said their supervisors allowed the planes to keep flying even after Southwest reported its failure to make the scheduled inspections.

The FAA doesn't come out looking too good, either. Regulatory capture, anyone?

Saturday, July 07, 2007

Getting There Was More than Half the ...

For my second to last post about our trip to Hawaii, I wanted to point out something about energy consumption and CO2 emissions that I had not previously appreciated.

We flew from Boston to San Francisco (2704 miles) and then San Francisco to Honolulu (2398 miles), for a total of 5102 miles each way or 10204 miles total. How much fuel did we use (assigning us our per capita share for the plane as a whole)?

This page cites an FAA estimate of 48 miles-per-gallon-per-seat and notes that a gallon of jet fuel and a gallon of gasoline create about the same amount of CO2 emissions. This means that as a family, our share of the fuel used was about 4 x 10204 / 48 = 850 gallons. Let's compare that to two other fuel numbers around the Samwick household.

First, I estimate that we drive our cars no more than 1000 miles a month on average and get at least 20 miles per gallon on average, resulting in gasoline consumption of no more than (12 x 1000 / 20) = 600 gallons per year.

Second, we have used about 1100 gallons of #2 fuel oil to heat our home in each of the past few years. (What can I say, we like to be comfortable?) This page shows the CO2 emissions by fuel type, putting the fuel oil on a par with jet fuel, which are both a bit higher than gasoline.

One (glorious) trip to Hawaii used 75% of the fuel we use to heat our home or 140% of the fuel we use to power our cars, with corresponding amounts of CO2 emitted.

As it pertains to energy and environmental policy, this example shows how important it is to be comprehensive in our attempts to reduce oil demand. The most straightforward way to do that is to levy a tax on all fuel products derived from petroleum. It allows abatement to occur at every possible margin--by flying, driving, or heating less or by using technologies that are more fuel efficient.

Tuesday, July 03, 2007

The First Mile

Continuing with my Hawaii retroblogging, it was no easy task, though easier than I thought it would be, to get from Hanover to Honolulu with two young children.

The toughest part was literally the first mile, from the hotel at Logan airport in Boston to the gate. At five o'clock in the morning on the first Saturday of the summer, the terminal was an absolute mob scene. Not quite at the level of my experiences in Beijing or Delhi or even Toronto on a summer travel weekend during a labor strike. We left ourselves two hours and made it with little time to spare.

We flew United by way of San Francisco, and all of the usual inconveniences were there, but the planes were filled to capacity, the tickets weren't cheap, and the service was generally okay. It was more apparent what was behind recent good news in the financial markets for the company. So I assume the airline is making as much money as it is ever going to, unless it can magically lower fuel prices or overcome historic management challenges.

Another interesting event--the flight from Honolulu back to San Francisco was the first time I recall having women as both the captain and the first officer.

Tuesday, June 12, 2007

Does the Senate Have Any Bite, or Is It All Bark?

As I posted a couple of weeks ago, Continental and American did an end run around compromises reached in the pension reform legislation last year. In his column yesterday, Jeffrey Birnbaum reports that the Senate Finance Committee is not happy about it:

The top brass at the Senate Finance Committee are incensed over a legislative end-around engineered by American and Continental airlines. The airlines used their contacts with the Democratic leadership in Congress to sneak into the Iraq war spending bill a provision that will reduce the payments they have to make to their workers' pension plans, a move that will save them millions.

The Finance Committee's senior members are not pleased. They have asked the airlines' chief executives to explain themselves and are warning that theirs may well have been a Pyrrhic victory.

"These two airlines flew around the Finance Committee to get this pension provision in the spending bill, but we will review, in the light of day, exactly what deal they got," Chairman Max Baucus (D-Mont.) said ominously.

"The committees of jurisdiction spent many months working on a pension bill that took each airline's status into account," added Sen. Charles E. Grassley of Iowa, the panel's ranking Republican. "These two airlines and their allies in Congress have undermined that work."

In other words, flyboys, you've made some powerful foes.

Really? I'll believe it when I see it. If the Senate Finance Committee is incensed, then there is nothing that prevents Baucus and Grassley from introducing new legislation to undo the end-around and building the support to pass it. There may yet be hope for the Senate if they do.

Tuesday, May 29, 2007

If You Ever Wanted a Reason for a Line Item Veto ...

... now you have it. From the Review and Outlook in today's WSJ:

Pension Crash Landing
May 29, 2007; Page A14

When Congress passed a broad pension reform last year prodding companies to get their retirement programs in order, it seemed too good to be true. Now we know it was.

That's the lesson of an amazing bit of corporate welfare the Senate tucked into the Iraq war supplemental last week. Last year's bill included a hard-fought political compromise: Carriers that agreed to a "hard freeze" of their pension plans would be allowed to use a higher interest rate in calculating their plans -- which would reduce their net liabilities. The idea was to discourage airlines from buying union peace by running up their pension tabs, which they might later dump on taxpayers. A few airlines, such as Northwest and Delta, took this medicine.

Their competitors, namely American and Continental, headed back to the Beltway and last week their lobbying blew apart last year's compromise. Under the Senate's backroom fix, the airlines can use a higher interest rate even if they promise higher pension benefits. The airlines claim this is about "leveling the playing field," which makes little sense because American and Continental could have accepted the same rules all along. This is about giving those two a competitive advantage over other airlines that have already agreed to play by the reform rules.

The taxpayer-backed Pension Benefit Guaranty Corp. is obliged to bail out any company that can't meet its pension obligations, so there is once again little reason for these airlines to practice any pension restraint. The PBGC conservatively estimates that this airline fixeroo will result in an additional $2 billion in underfunded pension obligations over the next 10 years.

No Senator is taking credit for this pension earmark, though we'd note that both Continental and American hail from the great state of Texas. Meanwhile, the architects of the provision were nothing if not clever; by including this in a war supplemental, they made it veto proof.


This is simply unbelievable. When even good legislation is undermined by backroom dealing, it shows a corrosive lack of seriousness on the part of the legislature itself. I think this bumper sticker sums it up pretty well.

Thursday, May 10, 2007

Innovations in Distance Grandparenting

Jennifer 8. Lee reports in today's New York Times on "The Incredible Flying Granny Nanny," with examples of grandmothers who commute by airplane on a weekly basis to look after their grandchildren while both parents are at work. Here's one example:

Terri P. Tepper of Barrington, Ill., made a similar trek every week for a year to help care for her granddaughter so that her daughter could pursue her career. Beginning in 2001, Ms. Tepper flew to New York on Sundays and returned to Chicago on Thursdays.

“It was cheaper than getting a nanny,” said Ms. Tepper, 64. The round-trip tickets, which her daughter paid for, cost between $190 and $230. “I actually saved them a lot of money,” Ms. Tepper said. Her daughter later made partner in her consulting firm.

It's fascinating to see how relative prices can drive behavior here. The article has the economics right, but I think it gets the sociology and history wrong, in the following passages (with my emphasis):
Even at a time when grandparents are more involved than ever in the lives of their children and grandchildren, the efforts of Mrs. Kim and Ms. Tepper are extraordinary. But many grandparents these days are making extreme efforts to help their children bridge the work-life divide.

[...]

Intercity commuting is just one way they provide that help. Grandparents are also taking time off from work, retiring early, moving to the United States from overseas or selling their home to be near grandchildren.

The greater involvement results from a confluence of factors, including the financial burdens of child care and anxiety over the quality of care. But most notably it is influenced by a generation of grandparents who have the time and the financial wherewithal to pitch in.

“This is the first generation where we have so many older people living long enough, being healthy enough and being affluent enough to provide these services on a large scale” since women entered the workplace in large numbers, Dr. Cherlin said.
While it is true that more grandparents are living to old ages and are more affluent than earlier generations of grandparents, it is also true that parents are having their first children later in life and are having fewer children than in earlier generations. (The latter effect is compounded, since it is true of both the parents' generation and the grandchildren's generation.) That generates less opportunity for interactions between grandparents and grandchildren. In addition, the children and grandchildren are often living further away from the grandparents than in prior generations. The article is motivated by the unusual expenses that some families are incurring to recreate what used to occur for free.

In prior generations, the grandparents were needed to help the non-working parent take care of a larger number of young kids. Now, the grandparents are stepping in to take care of one young kid while both parents work. It is not the least bit clear to me that longevity and affluence trump fertility and proximity in this comparison, but I'd be curious to know what others think.

The Cystic Fibrosis pledge drive is still on. If Great Strides is not your thing, how about donations in honor of Mother's Day?

Thursday, March 29, 2007

And in the Skies Above

Two items in the world of aviation caught my eye this week, courtesy of USA Today's travel blog:

First, that Airbus 380 is one big plane. Take a look at these two slideshows as it made its first flights to the United States. I'm curious to see whether a 500-plus passenger aircraft is viable in our air transportation system.

Second, it looks like Southwest is making Philadelphia the City of Brotherly LUV. It's a distant second to US Airways in passenger volume at Philadelphia International, but it appears to be responsible for all of the growth--and lower fares to boot:

More than a decade ago, federal regulators adopted the term "the Southwest effect" to describe the way air fares plunged and passenger traffic soared each time Southwest Airlines started flying to a new city.

Today, there's no better example of the phenomenon than what's happened at Philadelphia International Airport since Southwest came to town in May 2004, according to airport data.

In 2006, for the second year in a row, Philadelphia set a record for passenger traffic, with all of the growth attributable to a 23 percent increase in Southwest customers. The airport had a total of 31.8 million passengers last year, and 31.5 million in 2005.

Greater volume and lower prices? Better be careful. That can be a recipe for a backlash.

Wednesday, January 31, 2007

Well, That Was Easy Money

We learn today that US Airways has withdrawn its offer to buy Delta Airlines for what turned out to be about $9.8 billion. As I noted back in November when this madness was announced at the lower value of about $8 billion, "US Airways doesn't have it and Delta isn't worth it." For that reason, I also expected Delta's creditors to leap at the offer (and dump the US Airways stock immediately upon doing so). But here's how the deal was undone:

US Airways dropped its hostile $9.8 billion bid for Delta on Wednesday after Delta's creditors threw their support behind the airline's plan to emerge from bankruptcy on its own.

Delta Air Lines Inc.'s official unsecured creditors committee said in a statement it reached its decision after a lengthy review of both Delta's proposal and US Airways Group Inc.'s proposal.

So it was the creditors who pulled the plug after "extensive discussions." That's a surprise.

What was not a surprise was that there was money to be made here by the ordinary investor. Here's a chart of US Airways' stock price over the past three months:



That big spike in the middle of November was the roughly 16 percent increase in the stock price when the announcement was made, plus some continued appreciation. This was very unusual--the classic result from the finance literature is that upon announcement, the acquirer's stock price is either unchanged or slightly lower. It is the target's stock price that goes up. The reason, I think, is that acquirers often overpay, probably because they overstate the amount of "synergies" they'll get from the acquisition.

I could see no reason for this acquisition to be such a good thing for US Airways, so I sold short. You can see that the position was not always in the black, but eventually, it seemed pretty clear that that gain would be reversed. I managed to pocket a cool 10 percent based on when I got in and out of the position.

Wednesday, November 15, 2006

US Airways Makes a Bid for Delta

This is the strangest news in a while from a very strange industry.

US Airways offered today to acquire Delta Air Lines, now under bankruptcy-court protection, for $8 billion.

The combined company would carry more passengers each year than any other airline in the world, eclipsing American Airlines, the current leader.

The offer, extended to Delta’s bankruptcy lenders, is an attempt by the chief executive of US Airways, W. Douglas Parker, to circumvent Delta’s top management, who rebuffed two earlier approaches from Mr. Parker about merging the two airlines.

In a letter today addressed to Delta’s chief executive, Gerald Grinstein, Mr. Parker said he was disappointed that the two executives could not reach an agreement.

US Airways said today that it is offering $4 billion in cash, plus US Airways stock that was valued at $4 billion at the close on Tuesday. That price would represent a substantial premium for Delta’s creditors over what the airline’s unsecured debts now trade for. The creditors would own about 45 percent of the combined company.

Today, shares of US Airways jumped $8.57, or 16.8 percent, to close at $59.50 on the New York Stock Exchange. Other airline stocks including Continental and Airtran Holdings also rose.
Let's see. US Airways doesn't have it and Delta isn't worth it. Other than that, a lovely idea. I would expect Delta creditors to leap at the offer and US Airways stockholders to pocket these gains (which I cannot really explain) and run.

Tuesday, August 22, 2006

Passing Along the Cost of Security

Via Ben Mutzabaugh's excellent Today in the Sky blog, we discover a place in Paris that could be described as a microeconomics-free zone. It's the IATA. Consider:

PARIS (AFX) - Giovanni Bisignani, director general of the International Air Transport Association (IATA), said national governments should pay for the additional security costs required to protect airlines from terrorist attacks, instead of imposing new security levies on passenger tickets.

In an interview with French daily Le Monde on Saturday, Bisignani said it is too early to estimate the financial impact of the disruptions seen after an alleged airline terror plot was foiled in the UK earlier this month.

However, he said the global airline industry already pays an additional 5.6 bln usd per year in security costs since the Sept 11, 2001 terror attacks in the US.

'National security is the responsibility of governments,' Bisignani said. 'Very clearly, governments must bear these additional costs for security.'

'There is no reason why rail stations and sports stadiums should benefit from state subsidies, but not airports and airlines,' he added.

It is true that most aspects of national security are the responsibility of governments, including the top level of oversight and a considerable amount of the implementation. But his statement that "... governments must bear these additional costs for security..." is inaccurate in this context.

The presence of a security threat increases the social cost of an additional person taking a flight. Imposing a security levy on people taking flights helps bring the private cost of taking the flight in line with the social cost. A Pigovian tax is exactly the right policy here. (Though I don't claim that the current or prospective levels of these security fees are optimally set.)

On his last statement, I might be tempted to agree with the first part, "There is no reason why rail stations and sports stadiums should benefit from state subsidies ..." if he ended it there. I have always been skeptical of why sports stadiums need public funding--the social and private returns appear to be in line. I don't mind subsidies for rail transportation (again, without signing on to the optimality of the current system), given its ability to relieve congestion and reduce pollution, the benefits of which don't accrue only to the rail passengers.

Thursday, March 23, 2006

Bradley Belt, We Hardly Knew You

Via my former partner in crime, Phill Swagel, I learn that Bradley Belt, executive director of the Pension Benefit Guaranty Corporation, has submitted his resignation. To find out why, you could read the letter and get to the phrase "the time has come to pursue other opportunities." Or you could read his remarks to the National Association of Business Economics from ten days ago. Everything up to the statement "But there is hope ..." constitutes one of the best expositions of why we face these troubles in the defined benefit universe. My tenure in DC overlapped very briefly with Belt's, and I wish him well.

The shorter version of Belt's remarks is that the entirety of pension regulation is set up to distort and minimize the impact of economic conditions on the firm's reported pension liabilities. He takes particular aim at smoothing of asset and liability values:

And thus we come to another figment of imagination in pension-land—smoothing. “Smoothing” is a seductive marketing word. It conveys the sense that we are sparing investors from the rude jolt they would receive if pension losses were reported at full value and saving companies from the terrible burden of repairing pension deficits as quickly as they were created.

In the accounting context, smoothing allows companies to show pension losses to investors in small slivers over time rather than all at once. This helps make a company’s reported earnings look smoother as well, which is to say, more divorced from economic reality. But if we have learned anything from recent economic history, it is that attempting to manage reported earnings leads to trouble. Going back a few years further, would we have avoided the need for an S&L bailout if we had allowed thrifts to smooth interest-rate spikes over a several year period? Would the economic reality of their asset and liability mismatch have been any different? In the pension context, it should be a wake-up call when the deputy chief accountant of the SEC derides smoothing for its potential to render financial statements “meaningless.”

But as problematic as smoothing may be in the pension accounting context, in some ways it is even worse in the pension funding context.

Under the pension funding rules contained in ERISA and the Internal Revenue Code, a company can skip needed contributions to its pension plan on the grounds that “smoothed” assets and liabilities make the plan look well-funded. When followed by a corporate bankruptcy, this policy of ignoring economic reality and failing to make needed contributions can lead to devastating losses of retirement income for long-serving employees.

On the asset side, the funding rules allow companies to use values smoothed over five years. The only constraint is that the market value of the assets cannot be more than twenty percent different than the so-called “actuarial” value of assets. In practice, this means a pension plan with $1.2 billion in liabilities and $1.2 billion in “actuarial” assets may not be fully funded but rather $200 million short of what’s needed to pay promised benefits. If I tried to pay my bills with the “actuarial” value of my bank account, I’d be bouncing checks left and right—which, unfortunately, is what some companies are doing with their pension plans.

If anything, the situation is even more perverse on the liability side. Companies are permitted to calculate the present value of their pension liability using the four-year average of a corporate bond index. It should go without saying that interest rates from four years ago have absolutely nothing to do with the value of the pension liability today (or tomorrow). This is akin to driving down the highway at a high rate of speed looking only in the rear-view mirror.

Still, I can understand why plan sponsors want the flexibility afforded by smoothing the discount rate. It is a fact of life that pension liabilities are extremely sensitive to movements in interest rates. If the discount rate drops by one hundred basis points, that can easily drive up liabilities by ten percent or more. Better to “smooth in” that rate drop slowly over time to avoid unpleasant hiccups in the plan’s funded status. Of course hiding the volatility doesn’t mean it isn’t there.

Without these (and other) smoothing mechanisms, the argument is made that companies won’t be able to “predict” their pension contributions and won’t be able to budget accordingly. This is a particularly fascinating line of reasoning. How can a CFO of an airline possibly function without being able to “predict” future oil prices? Or the CFO of an auto manufacturer with respect to steel prices? Or the CFO of a multinational enterprise that has to deal with currency fluctuations? Or, perhaps most similarly, a bank or insurance company CFO whose business is especially sensitive to changes in interest rates?

Ah, say the inhabitants of pension-land, but our obligations are “long term.” These benefits are going to be paid out over decades, so there’s no need to value the liability based on what interest rates are doing today.

Nonsense. I want to know the market value of my house today even if I have a thirty-year mortgage and plan to live in it for another thirty years—it affects my net worth and my ability to borrow. Moreover, there’s always the chance that I may have to sell my house earlier than I expected.

Similarly, workers and retirees need to know the funded status of the pension plan today even if the benefits are going to be paid out over thirty years. Not only should it affect their planning for retirement, but there’s always the possibility that their company may go bankrupt and turn its pension plan over to the PBGC. I can assure you: At that point a liability calculation based on interest rates from the year 2002 is utterly meaningless and misleading. Yes, most pension obligations are long term. But, there have been more than 160,000 standard terminations of fully funded plans over the past thirty years. There have been 3,600 terminations of underfunded pension plans. Ask the participants in these plans whether these are necessarily long-term obligations.

The argument that something other than the current market values of assets and liabilities should be reflected on corporate financial statements is bizarre. I suppose it comes from an idea that a corporation should not have to suffer the consequences of reporting the impact of return volatility in its pension funds because ... it is doing the world a favor by sponsoring the pension. Paraphrasing Belt, that's "nonsense." It is only doing the world a favor if it does bear the consequences of that volatility. Those consequences should drive it to fully fund its liabilities and duration match its assets and liabilities (e.g., in a heavily bond rather than equity portfolio). Only then would it really be doing the world a favor and merit the substantial tax advantage of the pension relative to other forms of compensation.

More on pensions tomorrow, focusing on the GM/UAW deal.

Tuesday, November 01, 2005

The End of Pensions

Roger Lowenstein is an interesting contributor the New York Times magazine. In Sunday's article, with the same title as this post, he investigates the status of the employer-provided pension system, from both private and state- and local-government employers. On balance, I suggest reading the whole thing, though I do disagree with several of the conclusions he draws along the way. I explained my views on pension insurance in April, and I still have those views. In fact, this passage is directly relevant, and the thrust of it is missing from Lowenstein's article:

Defined benefit (DB) pension plans pay out benefits to retirees (and often survivors and occasionally the disabled) based on formulas that may increase with age, years of service, and earnings. The obligations look like the payment stream from a bond. In fact, a pension sponsor with a steady aggregate earnings profile and employee hiring and turnover could fully fund the liabilities and insure against risk with a portfolio heavily weighted toward bonds.

There is therefore no need for formal pension insurance. The government already provides the means for any conscientious pension sponsor to (nearly) fully insure. Every defined benefit pension plan has the opportunity to invest in Treasuries, to avoid the rate-of-return risk inherent in every other investment opportunity. With Treasuries [maturities] of a long enough maturity, the pension sponsor can even choose Treasuries to match the duration of its fund to those of its obligations, so that even shifts in the riskless rate of return do not affect its pension plan's financial position.

If you wanted to figure out what the cost of funding a pension plan with a given formula is, you would need to calculate the required annual contribution under the assumption that the pension plan sponsor were following the duration-matched Treasury investment strategy. The federal government shares the cost of this investment by allowing the pension fund to accumulate at the pre-tax rather than the post-tax return. (It also defers the employee's tax liability on compensation taken through a pension plan.)

Any deviation from this funding strategy should be examined with suspicion. The biggest deviation is to invest some of the fund in equities. This allows pension plan sponsors to assume a higher average return on the plan's assets and thus reduce contributions required to support it. This strategy is okay, as long as the pension fund is small relative to the firm's assets, so that the firm can make up the shortfall if the fund's asset values drop. As the article points out, we are learning that this isn't necessarily the case with a lot of the airline, steel, and auto companies. Almost by definition, it is not the case when a company approaches bankruptcy.

The problem is nicely illustrated by this passage from Lowenstein's article:


G.M. and other industrial companies, along with their unions, have harshly attacked the Bush pension proposal, which would force many old-economy-type corporations to put more money into their pension funds just when their basic businesses are hurting.

Well, no kidding. The industrial companies and their unions that encouraged them have no one to blame but themselves for their current troubles. They used their pension funds as speculative investment vehicles, and the combination of low interest rates, sagging stock market values, and optimistic funding assumptions put them in this position. Who but their shareholders and workers should be asked to make those additional contributions?

The government has decided through ERISA that it will permit the investment of pension funds in equities and subject plan sponsors to a set of minimum funding rules and require them to purchase (vastly underpriced) PBGC insurance. This is a bad strategy, in my view, because of the numerous ways to game it, which Lowenstein's article discusses in good detail. It creates the appearance that someone else is responsible for these companies, and that may ultimately prove to be the reality, with the taxpayers being asked to step in to make up the shortfall.

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Thursday, October 20, 2005

A Question that Answered Itself

A month ago, I posted on the question, "Should Airlines Hedge Fuel Costs?" focusing on Southwest's aggressive use of hedging compared to the rest of the industry. Today, we get more evidence for an answer in the affirmative, courtesy of the Wall Street Journal:

Southwest Airlines continued its pattern of profits in the worst of industry times, nearly doubling its net income in the third quarter, as fast-growing rival discounter JetBlue Airways squeaked out a profit and warned of losses for the rest of the year.

Thanks to a fuel-hedging program that locked in lower prices, Dallas-based Southwest has been profitable as other carriers have posted hundreds of millions of dollars in losses amid soaring fuel costs. Southwest, the seventh-largest U.S. airline based on passenger traffic at the beginning of the year, has taken advantage of rising demand for air travel, increasing fares five times since the beginning of the year, according to J.P. Morgan analyst Jamie Baker.

Southwest reported net income of $227 million, or 28 cents a share, compared with $119 million, or 15 cents a share, a year ago. Southwest said the results include a gain of $87 million before taxes associated with its hedging program. Revenue rose 19% to $1.99 billion.

Southwest flexed its muscle yesterday by announcing that it will launch service in Denver, one of the few major U.S. cities it doesn't already serve. Southwest is stepping into the space created as UAL Corp.'s United Airlines, which dominates Denver traffic with a 57% market share, has scaled back in an effort to emerge from bankruptcy protection. Southwest will also be taking on fellow low-cost carrier Frontier Airlines, which has a 19% market share but has struggled with losses because of jet-fuel costs. Southwest said it would begin service early in 2006.

The move underscores Southwest's capacity to grow when rivals are shrinking, but it also is evidence of the increasing risks the maturing carrier must face to expand. Southwest had shunned Denver because the Denver International Airport fees were too high, shaving profit margins too thin for Southwest's low fares. Southwest said it now views Denver's costs as more manageable.

Raymond James analyst Jim Parker downgraded Frontier Airlines, citing Southwest's lower costs and a belief that "it is very difficult for any airline to beat Southwest in head-to-head competition."

He's got that right. And now I'm daydreaming about reliable air service to ski the Rockies.

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Monday, October 10, 2005

The Flying Spare


I second the nomination of David Leonhardt's "Have Recessions Absolutely, Positively Become Less Painful?" for a Voxy. I am not sure that I sign on to the term "micro-recession," but this is a wonderful piece of journalism that helps illuminate why the macro economy have been giving mixed signals over the past 4 years. The focus of the article is on how FedEx, riding in the HOV lanes of the global shipping highways, has made its operational model more flexible, thereby allowing the U.S. economy to weather more difficulties without sharp, economy-wide declines in output. The title of my post is drawn from:

On a recent Wednesday, the empty plane that departs each night from Las Vegas had to travel to San Diego - rather than making its usual flight to Memphis - to fill in for a broken plane. But ground workers in Las Vegas had become so used to its completing its typical route that they had loaded some packages marked for the Memphis hub onto the plane. The packages ended up in Oakland instead.

"That's the risk with that flying spare," Mr. Dunavant, using company lingo for the empty planes, said during the call. "That's one of the things they get lulled to sleep on."

Besides Las Vegas, the flying spares leave from Duluth, Minn.; Laredo, Tex.; Fort Myers, Fla.; and Portland, Me. All take circuitous paths to Memphis, passing near major cities like Dallas, Denver and St. Louis.

On a typical night, one of the five makes an unexpected stop to collect an overflow of packages, one lands to bail out a plane needing a repair, and three arrive in Memphis as empty as they were when they took off.

Until a year ago, FedEx used just one flying spare, leaving from Las Vegas, but executives decided they needed an even larger reserve army to fight uncertainty. Every night, the company also keeps about 10 percent of planes half empty, allowing them to make unplanned stops and pick up more cargo.


There is an interesting lesson here that is often forgotten--less volatility of the outcome is often the result of more volatility of the inputs, to smooth out the impact of unexpected shocks to the production process or market demand.

Imagine if passenger airline companies were paying this much attention to their business models, or if other industries in which distribution is essential planned so well for daily contingencies, ...

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Sunday, September 25, 2005

And Speaking of Which

Sometimes, I just need a name. I need the name of the person employed by United Airlines who thought that this moviewould be suitable in-flight entertainment on a noontime flight. Granted, it was no Prizzi's Honor,but we're not working with the same talent here. Huge explosions? Check. Indiscriminate gunfire? Check. Plenty of nice violent images for the kids making the trip to Chicago ...

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Thursday, September 22, 2005

Tuesday, September 13, 2005

Delta in Cincinnati

Ben Mutzabaugh of USA Today speculates as to the impact of Delta's recent announcement of reduced service from its Cincinnati hub on the possibility of competition by a discount carrier:

Will Delta's Cincy cuts invite low-cost competition? Delta's announcement this week that it would cut flights at its Cincinnati hub by 26% may have been a necessity for the financially strapped airline, but experts say the move comes with a big risk. Delta currently dominates the Cincinnati market, meaning the carrier can typically set fares there without fear of being undercut by rivals. Delta's Cincinnati dominance also has helped scare off low-cost carriers from that market, but the cuts could leave an opening that may make Cincinnati too tempting a target for a low-cost carrier to avoid. "I hope (Delta) thought this through very carefully – downsizing a hub is a very delicate proposition," Aaron Gellman, an economics professor at Northwestern University, tells The Cincinnati Post. "I wouldn't be surprised to see a
low-cost carrier come in." And if low-cost carriers do arrive, Delta would likely be forced to cut its Cincinnati fares to match that of its new rivals.
Presumably, the cuts will come in the least essential parts of Delta's service, and in such a way that best protects its market share in Cincinnati. Another report had this to say:
Delta's hub operations accounted for about 92 percent of the nearly 22 million passengers who went through the Cincinnati airport last year, airport spokesman Ted Bushelman said.

Delta and the Delta Connection operate 599 flights a day, out of about 660 by all carriers. Delta will reduce its 128 flights Cincinnati flights to 94, and Delta Connection flights will be cut from 471 to 348, he said.

Travelers will lose nine destinations served by Delta Connection carriers, Bushelman said. The nonstop flights being eliminated are to Moline, Ill.; Mobile and Montgomery, Ala.; Islip, L.I.; Baton Rouge, La.; and Fort Walton Beach, Pensacola, Tallahassee and Daytona Beach, Fla.

The reduction from 660 to 503 flights represents a 24% reduction for the airport as a whole, but before any additional carriers come in, these reductions still leave Delta 88% (442/503) of the flights--barely down from its current 91% share. If the reductions are concentrated in the cities listed, then they appear not to open up any major markets. But I suspect that the airport authorities will be eager to not have a reduction in activity, and so they may be inclined to seek out new carriers to get back the missing quarter of their current traffic.

Saturday, September 10, 2005

Should Airlines Hedge Fuel Costs?

A discussion about corporate hedging developed in the comments to an earlier post on the impact of Hurricane Katrina. It seemed like a useful topic to follow up in a new post. The issue at hand is why Southwest seems to be the only major airline that hedges a large part of its fuel costs. It could be that they are just speculating in the fuel market and got insanely lucky here, but I doubt that. Southwest's management is extremely shrewd--if they were making a bet, they knew what they were doing.

An economic approach to the issue would be to start by identifying the conditions under which hedging would be irrelevant. If trading is costless and markets are completely efficient, then hedging wouldn't add value. Under these assumptions, any transaction that the firm does can be undone by the shareholders outside of the firm at the same relative prices. So we look for market imperfections of one sort or another to explain hedging.

In most cases, the market imperfection is the cost associated with financial distress or bankruptcy. If unexpectedly high operating costs need to be covered by borrowing, and if borrowing is costly when done on short notice, then it makes sense to smooth out the variation in operating costs. Hedging--in this case, locking in a forward price of a key input to production--allows that to happen. This theory cannot explain why Southwest hedges its fuel costs and the other airlines don't, because it is in the best financial shape.

Perhaps we can tweak it a bit (as was being done in the comments) to suggest that Southwest is one of the few airlines mentioned where the stockholders are actually the residual claimants. The other companies are much closer to bankruptcy, when the equity holders get essentially nothing and any assets get assigned to the debtholders. Refusing to hedge in this case is a form of risk-shifting onto a financially weak firm's creditors. It may also be that the weak financial position of the other airlines doesn't allow them to enter into the long-term contracts involved with hedging next year's fuel costs.

Another possibility is that Southwest has a very unusual business model and is a $10 billion company because it rigorously applies that business model and looks for ways to improve it. If they lock in the price of their fuel, then fluctuations in the price of fuel won't interfere with their ability to figure out what routes are profitable, what schedules improve efficiency, or what the next city on their route map should be. Variation in performance month-to-month will better reflect choices they made rather than fluctuations they couldn't control.

But maybe this is overthinking the problem. Two months ago, David Grossman wrote in USA Today:

Southwest reported a profit of $235 million and saved approximately $351 million during the first six months of this year. If Southwest hadn't hedged, that profit would have been a $116 million loss and the first time in 57 consecutive quarters that the company did not report a profit.


Maybe they hedge to keep the streak alive.

This topic comes up any time fuel costs increase. About a year ago, Jim Garven noted most of these points and provided links to empirical and case studies of fuel hedging. Some other good discussions are here and here at the Conglomerate blog.

Tuesday, September 06, 2005

Katrina and the Airlines

Mark Tatge and Phyllis Berman pose the question, "Will Katrina Ground Airlines for Good?" in last week's article in Forbes. They argue that Delta is likely to be hit twice--by rising fuel costs and by its dependence on traffic in the affected areas. They judge Northwest to be near the brink, too. The second paragraph below tells us almost everything we need to know about the industry:

Now, the situation is at a breaking point. Not just for Delta, but for the entire industry. Katrina should reduce total refining output by 43 million barrels over the next two months, according to Lehman Brothers. That translates to about a 10% to 15% reduction in the supply of jet fuel. Oil prices, despite falling back slightly in the past day, are expected to stay above $70 per barrel until at least the end of the year.

Both Delta and Northwest have no hedges against exposure to rising fuel prices. AMR's American Airlines and Continental Airlines, although in better financial shape, have no hedges in place either. The only airline with significant hedging is Southwest Airlines, which holds hedges for 65% of its 2006 fuel needs--most of it at $32 per barrel, according to Lehman Brothers.

Checking the stock ticker, Southwest has a market capitalization of $10.9 billion. American is at $2 billion, and the total of Continental, Delta, Northwest, and United is no more than $1.5 billion. Given the thrust of the article, these relative magnitudes should come as little surprise.

Monday, April 25, 2005

Pensions Lost in Translation

It has finally happened. The Pension Benefit Guaranty Corporation (PBGC) has assumed responsibility for the four defined benefit (DB) pension plans at United Airlines. The impact, as reported in The New York Times is as follows:

The federal government said yesterday that it had reached an agreement to take over all four of United Airlines' employee pension plans, with a shortfall of $9.8 billion, making it the biggest pension failure since the government began insuring pension benefits in 1974.
Because the PBGC caps the benefit amounts it insures, only $6.6 billion of this amount is guaranteed, but even that hit to its balance sheet will increase the PBGC's net deficit (reported as $23.3 billion last September) substantially. Plus, we can now expect all of the other legacy airlines to seek the same sort of treatment from the PBGC.

However, there has been a tendency in news reports to suggest that the American taxpayer is somehow on the hook for this money. That isn't true, unless the federal government passes new legislation to make it true. At present, it is the rest of the DB pension sponsors in the PBGC-insured universe who are on the hook. As the PBGC's press release explains:

By law, the PBGC is required to keep premiums as low as possible and has no call on the U.S. Treasury beyond a $100 million line of credit. ...

The PBGC is a federal corporation created under the Employee Retirement Income Security Act of 1974. It currently guarantees payment of basic pension benefits for about 44 million American workers and retirees participating in over 31,000 private-sector defined benefit pension plans.


Pension insurance--not the idea but its implementation, and certainly not the dedicated people who work at the PBGC--is a complete joke. There are three problem's with the PBGC's setup:

1) The premium amounts are too low. On average, companies do not pay enough to cover the risk to which they expose the PBGC.
2) The premium formula is inadequately linked to underfunding. Pension sponsors whose plans are underfunded do pay slightly more in premiums than pension sponsors whose plans are fully funded, but the amount of additional premiums does not adequately compensate the PBGC for the added risk of a claim.
3) The premium formula is unrelated to the PBGC's risk exposure--the portfolio allocation between stocks and bonds and the bankruptcy risk of the company.

There are some extremely smart people working on pension insurance, both at the PBGC and outside. The issue is not that we couldn't figure out how to charge the appropriate premiums. The issue is entirely that Congress will never allow the PBGC to charge actuarially fair premiums. That would put too large of a burden on key political constituencies. United would have been paying enormous premiums over the past few years. Airline, steel, autos--these are the industries that have been least responsible in funding their pension plans. So this is what we get--subsidized risk-taking at the expense of responsible plan sponsors.

Defined benefit (DB) pension plans pay out benefits to retirees (and often survivors and occasionally the disabled) based on formulas that may increase with age, years of service, and earnings. The obligations look like the payment stream from a bond. In fact, a pension sponsor with a steady aggregate earnings profile and employee hiring and turnover could fully fund the liabilities and insure against risk with a portfolio heavily weighted toward bonds.

With PBGC insurance, the company has an incentive to invest in a portfolio heavily weighted toward stocks. If the stocks do well, the company can cut back on future contributions. If the stocks do poorly, then in some cases, the company can terminate the plan and leave the liability with the PBGC. Classic moral hazard. When the economy goes through a period of weak stock market returns (so the pension fund's assets fall in value) and low interest rates (so the present value of the future liabilities rise in value), we get tremendous underfunding. And the laws governing minimum pension contributions don't require pension sponsors to make up the difference quickly enough.

What to do? Impose a levy on each DB pension plan sponsor that is proportional to the current value of all past PBGC premiums paid for current participants. Impose the levy based on 2004 data, so there is no rush to the exit. The levy should be enough to put the PBGC at a zero balance position. Then retire the PBGC and allow companies to obtain pension insurance privately if they so desire. For current sponsors, pass a law that moves pension participants' claims in bankruptcy ahead of all unsecured creditors. If this means that fewer firms offer DB pensions, then so be it. Unhealthy companies--like United--ought not to be making promises to pay beneficiaries decades into the future.

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