03.3.2011 « Oil and Water; Jet Fuel and Labor »
On June 25, 2008 I blogged asking the question: Is Oil A Cancer Or A Cure? At that time, the price of a barrel of oil had not yet reached its apex of $147 per barrel, but was well on its way. Based on findings by the Air Transport Association’s superb economic analysis team led by chief economist John Heimlich, the U.S. airline industry paid the equivalent of $174.64 per barrel [price of a barrel of oil plus the equivalent cost to refine crude into jet fuel (the crack spread)] on July 11, 2008. By December 23, 2008 the price of a barrel of West Texas Intermediate had fallen to $30.28 per barrel. So far in 2011, we’ve seen a similar surge in oil prices, but based on current geopolitical events, I am not expecting another $117 drop in the price of a barrel of oil like we witnessed in 2008.
I’m actually wondering what happens if the wave of Mideast political upheaval washes over Algeria? Or Saudi Arabia? Some economic experts say the price of oil could rocket past the $200 threshold.
In 2011, the industry has paid an average of $89.15 per barrel of crude and another $25.80 in the crack spread for a total cost of “in the wing” jet fuel of nearly $115 per barrel. Since February 22, 2011 the industry has paid more than the equivalent of $120 per barrel for jet fuel. On March 1, 2011 the industry paid the equivalent of $132.17 per barrel for jet fuel including the crack spread of $32.54. For all of 2008, the industry paid the equivalent of $25 per barrel to refine crude into jet fuel. In the last five days of trading the crack spread paid by the industry is nearly $30 per barrel.
That’s a lot of numbers, so let me put this in a way that might shock even the most ardent follower of the airline industry: Today’s cost of just refining oil into jet fuel is roughly equal to the total jet fuel price per barrel paid by the industry every year between 1978 and 2001.
1978 – 2001
The mindset of many airline stakeholders - and particularly labor - is based on the period between 1978 and 2001. Deregulation began in 1978 and 2001 marks the beginning of wholesale industry restructuring. .. which actually should have started 24 years earlier. To put this period into an oil perspective, over the first 25 years of a deregulated industry, the equivalent per barrel price of jet fuel was $28.93. Oil was cheap (more than four times cheaper than in 2011) and it was the basis for the industry to grow too big, too fast. After all, the biggest “uncontrollable cost” was a blip. There was little change in either the price of a barrel of crude or the crack spread.
Based on analysis at MIT's Airline Data Project, between 1978 and 2001, the industry grew nearly 2.5 times in terms of available seat miles. Traffic grew faster than capacity. The great enabler in the growth in addition to the cost of jet fuel was the fact industry yields, or the amount the customer pays per mile, declined by 39% when adjusted for inflation. Domestic yields fell by an inflation-adjusted 41 percent over the same period. In other words, cheap seats. The price of an airline ticket was one of the great consumer bargains. This fact ultimately led the network carriers to refocus their operations on international flying because their high cost structures struggled to conform to the realities of the domestic market economics.
As the industry added capacity, employment grew by nearly 220,000 full-time equivalents. During the same period, the total cost of an employee to the industry declined by eight percent in real terms. I can hear it now, ”no way – my salary is significantly less.” Yes, it is true salary costs when adjusted for inflation have decreased. On the other hand, the cost of pension and benefits paid to airline workers has grown at a rate faster than inflation. The cost of an employee to a company is not based on salary alone.
Over the 24 year period being discussed here, it is true that employee productivity in terms of available seat miles per employee and enplanements per employee increased 44 percent and 30 percent respectively. Much of that is again driven by cutthroat competition driving prices downward in order to stimulate demand. Here is the kicker. The number of available seat miles produced per dollar spent on labor fell by 42 percent. Or, labor is producing more output but the cost of that output is increasingly expensive. This fact alone was unsustainable and the restructuring process was used to address the underlying economics.
Many areas of the income statement were addressed by managements over the period with the most noteworthy being the decision to stop paying legacy commission rates to travel agents. This action alone saves the industry nearly $6 billion dollars per year although we can also say that the savings are largely competed away in the form of lower fares. Food and advertising expenses were also reduced. Each of these cost areas, like labor, is considered controllable costs. Oil is not. What the industry did realize over the period was a 30 percent efficiency improvement in the consumption of fuel.
2002 – Today
As 2001 came to a close, unit costs at the network carriers in the face of free falling unit revenue became the story. US Airways was the first carrier to file for bankruptcy. United was second. And American followed with an out of court restructuring. Each carrier had extremely high overall unit costs relative to the industry as shown by the MIT Airline Data Project. The ADP also shows the three carriers were out-of-market with respect to unit labor costs relative to the industry. The network carriers mentioned simply had costs so high, there was no choice but to seek some sort of a consensual restructuring either through bankruptcy or out of court if they were to live and fight another day. The scary part is, oil was still reasonable during this time. The industry jet fuel price per barrel equivalent as restructuring commenced was $30.07.
While jet fuel prices are uncontrollable, so too is airline pricing, particularly in the U.S. domestic market. Since 2001, the industry has only increased capacity by 2.5 percent as capacity discipline became the mantra. Again traffic grew faster than capacity as inflation adjusted yields fell another 12.5 percent. The nominal level of capacity growth can be attributed to the growth in regional carrier and low cost carrier flying. Since 2001, mainline carriers have shed nearly 24 percent of their previous domestic capacity with nearly one-third of that capacity removed since the 2008 fuel spike.
Capacity cutting was all that was left in the face of high oil prices. When carriers delete capacity, they also eliminate jobs. Since 2001 the industry has shed nearly 155,000 jobs – a period when the jet fuel equivalent price per barrel averaged $73.08. Labor productivity has improved significantly as the network carriers restructured. But as I’ve talked about before, the problem with a seniority-based system is that average costs increase as the less expensive employees are the first to be let go. In 2002, when the restructuring began, the average cost of a full time equivalent airline employee was $74,910. Today, the average cost of a full-time equivalent employee is $83,869. More troubling is the benefit and pension package for full- time employees in 2001 cost $11,560. Today, the cost of that package is $18,195 reflecting seniority as well the country’s inability to reign in medical costs.
So Here We Sit
The history of pattern bargaining - and resultant expectations - between labor and management was created on a basis of $30 per barrel for jet fuel. Today, the cost of jet fuel is the equivalent of $132+ per barrel. Yet labor doesn’t seem to acknowledge the fact that times – and oil prices – have changed. There are 52 airline cases under the auspices of the National Mediation Board and I will wager few, if any, of the labor negotiating teams consider oil a major factor in a future contract. It’s “management’s problem.”
Well, it’s also labor’s. While the industry has been creative in finding new revenue to address the reality of fuel costs, consumer pass-throughs generally lag behind the rise in the price of fuel. The bigger issue, the one labor has trouble admitting, is the size of the revenue pie is finite.
Oil is uncontrollable and therefore difficult to predict how much of the revenue pie it will consume. Cost reductions in many areas of the operation have already been largely realized. And that’s where oil prices become labor’s problem. Employees – rightfully - want their share of the pie, and they’d like to make-up the concessions of the past. The problem is the pre-restructuring high water mark, when oil was around $30, is what labor wants to return to. That’s not possible and it’s certainly not sustainable.
I have heard it said many times, "labor is not going to subsidize the price of oil again". Well, truthfully, labor didn’t the first time. When restructuring began and adjustments to labor costs were realized the price of jet fuel was not the issue. It was declining revenue. After much pain inflicted on virtually every stakeholder group over the past decade, $100 per barrel jet fuel is the new reality. Expectations of returning to the past should be forgotten. I like to use history, but history is useless in evaluating this industry because the fundamentals that now govern the industry’s structure like oil and the economies of China and Germany and Brazil are new and rapidly evolving.
I had someone say to me the other day that shouldn’t we throw away the past and just start again making this apex the new reality? The simple answer is yes.
Reader Comments (14)
$100+ oil may be the new reality, but you cannot expect any workforce to accept wages from 2001. My home heating oil dealer didn't lay off workers when oil prices went up, he just charged me more. The airlines need to charge the actual price of doing business and pay their workers a fair wage. Unions need to wake up to the new reality and give up the long lost dream from the regulated era and the flying public needs to acknowledge that good service from a safe airline might actually cost something more than the bus fare they want to pay.
William, I love when you write stuff like this! Keep it coming, as you are securing my financial future!
When young people come to me and ask if they should fork out a high five figure sum for an education, another mid to high 5 figure sum for flight training, and years at pay levels that would make a fast food restaurant manager blush, I point to blogs such as yours. When they ask if the professional pilot profession has a future and if things will get better after the huge paycuts, the loss of pensions, the destroying of quality of life, I point to blogs such as yours. I tell them not to believe me, but to take a look at what the people who run airlines have to say about your future compensation.
So the cost of business goes up for all the participants, and labor costs need to become a hedge for high commodity prices? I love it William! So what I should tell the future professionals of the industry? That in addition to the great personal and financial risk of becomine a professional pilot, add the risk of the commodities market because if oil goes up, you're not longer entitled to increases in compensation in the eyes of airline management? I couldn't make up stuff better than this!
William, I hope in a few years from now you won't be up in front of Congress with your buddies May and Cohen and a sampling of airline CEOs complaining about how you can't find young people who want to become professional pilots. You and your peers are making a nice little bed for yourselves (and me!). As a highly experienced professional pilot with years to go before retirement, the bed you are making for me is going to be warm and snuggly. There's nothing nicer than being on the correct side of supply and demand curve. However, I hope you and your peers are ready to sleep in that same bed (but not next to me) when you're setting the parking brake on a lot of jets for lack of warm bodies to fill those seats.
In closing, Wiilliam, I have a request. Please, please, please, write a blog about how pilot compensation in the U.S., after a decade of losses, is WAY too high! I mean, what you've written so far is fanatastic for me, but I need something more speicfic. I know you hate pilots as a management guy, so it would be very easy for you to write. Thanks!
$100/barrel oil becoming the norm instead of the exception seems like a reasonable conclusion. I don't think that makes a difference to the various airline unions however. The unions want to go back to pre-9/11/2001 wages and I seriously doubt they will stop trying for that until the number of people in the unions that were on the payroll prior to 9/11/2001 substantially decreases.
Just out of curiosity, what happens when crude spikes to @250 bbl? I would hope that wouldn't happen, but do the airlines simply ask for more concessions?
You seem to have somewhat of a limited capacity to understand that there has been plenty of bad behavior and unrealistic expectations on both sides over the years. That being said, do you recall how it temporarily became the sole objective of several legacies to adopt the LCC model....even though they were in no position to do so? Do you recall how airline managers didn't seem to mind artificially devaluing their product in a race to the bottom? The idea of raising revenue was met with some very uncreative and ineffective planning and was quickly discarded as mgmt simply threw up their hands and said "it can't be done.....and besides, we have a better way to cut costs. We'll just get it from the pilots/mechanics/F/A's, etc etc."
Continually beating the "its the unions fault" drum is old, hollow, and doesn't reflect the reality of the situation.
Why is it that you expect those labor groups to subsidize the cost of a ticket? Why do you expect the mechanics to gleefully work for the same rates as your local auto shop? (Actually in many cases, your auto mechanic makes MORE than the aircraft mechanic)
Oh, those pesky unions. Why aren't you conspiring with the guvna in Wisconsin right now?William?
In your "analysis" you talk about the finite revenue pie. Could you include in the facts you report how the CEOs and other senior leaders have fared over the same period of time with regard to their share of the pie? After airline bankruptcies labor emerged with terminated pension programs; higher health care costs; lower salaries (for those who still managed to hold onto jobs) and higher productivity. How did CEOs and other senior leaders fare? Quantifying the stock awards and options at no or low cost and the financial windfalls realized should not be hard to compute since most of this is public information. How is that pie distributed as a comparison? Ten times the average worker? Three hundred times?
You mention pattern bargaining,. I challenge airlines to engage in interest based bargaining. I suspect that CEO interests would not be quite as well represented as they were under bankdruptcy laws.
This notion that airlines cannot control domestic pricing is absurd. The revenue associated with the ala carte menu of services has brought millions in revenue to airlines. Revenue from checked baggage; accelerated miles; premier lanes for security screening; more leg room is proof positive that airlines can and do control domestic pricing.
Airlines that went bankrupt also have enjoyed tax credits as a result of bankruptcy. Yet the mantra continues to be bad bad labor; bad bad regulation.
Finally, if medical costs are unsustainable by AMerican business,,,,they ought to be pressing the governement for realistic health care reform that allows American business to compete globally.
After reading, I’m left wondering how one arrives at the conclusion that the potential revenue of a given industry is a finite amount. And that any change in cost structure is therefore a zero sum game. To follow Mr. Swelbar’s economic logic, when the price of oil rises, the value of the skill sets necessary to safely maintain and operate commercial aircraft must decrease. Hmm.
Let’s take that economic logic and use some equally simplistic examples to superimpose it on the industries of consulting and academia, each with which Mr. Swelbar is somewhat aligned.
In the first example. A consultant is approached by the leadership of ValueLost Airlines and asked to bid on a price for helping them analyze their labor costs per unit of production. The consultant should use which of the following methods to determine his price:
A.) His fee should be an upfront retainer plus expenses. In addition, after one year, he should receive 20% of the value of any sustained efficiencies he uncovered; as measured by the attributed dollar value in increased operating margin.
B.) His fee should be as determined in A, above. However, since there is a revolution in Scotland seeking secession from the crown, the cost of scotch in the executive suite has risen substantially in the past year. Therefore he must deduct the highly volatile cost of this primary commodity in the industry of executive-decision-making from his bid. In other words, the VALUE of his skill set must be reduced because consulting revenue is finite, and it is being decimated by the cost of scotch.
In the second example, a tenured academic working on the Dilbert Data Project at an esteemed institution of higher learning has determined that his endeavors provide great perceived value to the Dilbert Executive-Decision-Making industry, as well as his sponsoring institution and his graduate students. (Accolades and apologies to Scott Adams.) Accordingly, he approaches his institution asking for a raise. The academic should use which of the following methods to determine his new level of pay:
A.) His salary should be increased 20% above that of the standard tenured professor of his seniority due to the added value he has provided to the cited array of stakeholders.
B.) His salary should be as determined in A, immediately above. However, he is aware that tuition inflation in higher education is already through the roof. Fewer students can pony-up the tuition cost of higher education. State sponsored 529 plans can’t keep up with promised returns and must charge maintenance fees to make up for losses. Federal loan dollars are being cut. And the 21st century global economy has put such downward pressure on personnel costs that newly minted graduates are staring at decades-long amortization schedules for recovering the cost of their tuition. Therefore, even though he is delivering more perceived value than ever before, in his professional opinion, he will nevertheless request that his salary should actually be reduced – because there is only so much tuition revenue to go around and the revenue stream is under unsustainable stress.
I will concede that neither method ‘A’ nor ‘B’ is correct in every situation. However, if you believe that method ‘A’ is correct in most situations, then you have one of many entering capabilities for what it will take to prosper as an executive leader in the 21st century economy. If you believe method ‘B’ is correct in most situations … well, hold on to your hourly day job and hope for an executive team that believes in method ‘A’. And don’t work for Mr. Swelbar.
To be fair, although I disagree with much of what Mr. Swelbar has to say, I do agree on a few things. Most notably, although he seems to have a myopic focus on labor costs as a sort of perpetual piggy bank, he does make apparent that volatile cost change must be embraced as a constant for going forward. But where he sees diminished labor costs as the go-to defense against this volatility, I see the prize of commercial success going to the enterprise that can maintain an offense for growing consumer value in the marketplace DESPITE volatile change in costs. Accordingly, the (T)ruely sustainable solutions for affecting profitable commerce will require ingenuity, creativity, and innovation. Not merely some rehash of the same old solutions.
In other words, the onus is on executive leaders (like board members of air carriers) to become accountable for performing at a whole new level. If they cannot lead in the realms of ingenuity, innovation, and creativity, then they cannot grow market value in the 21st century. And if they cannot grow market value, then they cannot grow revenue above the finite amount that Mr. Swelbar seems to believe exists. Accordingly, they need to be shown method ‘B’, in each of the examples above, for determining their executive compensation packages. But if they can create market value DESPITE the enormous challenges posed by the 21st century global economy, then they are welcome to select method ‘A’.
If anyone needs an example of the type of leadership I have in mind, Google S T E V E J O B S. Then try to imagine him saying; “Sorry, no way to grow market value, the price of chips and rare earth are each too high and there is only so much revenue to be had in personal electronics. Everyone from design to assembly to customer-facing will have to give up their pensions and 40% of pay or we’ll take our demands into bankruptcy court.”
Airline economist Swelblog, you really are stupid! New reality? You take a 50% paycut and lose your retirement then we'll call it a new reality!!!! How about raising fares to cover costs? That's what ever other business does. Ever thought of that, idiot? And if the traveling public doesn't like it, then let'em drive 2 days to Florida each way.
Plenty of data points in support of your essay in the comments, Mr. Swelbar. Entitlement, raise ticket prices, management greedy and dumb, fair wages (with no mention of workrules or benefits), etc.
Is it feasible for unions (which want to maximize dues paying members) to deliver improved compensation to their members (which requires productivity improvements, reducing dues paying members); or is that an impossible paradigm shift for those historically backwards looking entities (focus on perceived historical injustices or "golden ages")?
I note many cherry-picked facts here, all in line with the very successful war that the Airline Transport Association privately declared on airline labor in the late '90s.
Sadly, airline labor has not shared in the extraordinary gains of their own productivity. Indeed, they have totally missed out on those gains! To say "the number of available seat miles produced per dollar spent on labor fell by 42 percent" is most disingenuous. It ignores the fact that available seat miles obviously do not increase with inflation, but that employee wages/costs must increase by nearly 3% every year, for 24 years, just to maintain the status quo, without any real gain!
Further, while fringe benefits, especially health care costs may have increased; many of those benefits have been decimated. Pensions were robbed; employee shared payments for healthcare have increased; and many other benefits have just disappeared.
Regardless, to try to base employee costs on the cost of oil is absurd. They are unrelated, just as is the cost of airframes, engines, or catering is to oil.
Although now retired, I entered the industry in 1979. I have seen it all. I also know when to wave the BS flag. And I am raising it here and now!
The real solution is for fares to go up - drastically. Of course this couldn't happen right away, as it would destroy demand. But airfares have not reflected the price of transporting passengers in about 30 years.
As I read it, I don't think William is trying to say that labor costs should be a hedge for fuel prices. But in a high input cost scenario like we have now, airlines executives certainly have to ask the question, "How much should a flight attendant/mechanic/pilot earn?"
It is my opinion that many airline workers have been grossly overpaid when one factors in the legacy benefits like pensions and retiree medical. Clearly those days are nearing and end, at least for workers hired since the middle of last decade.
And of course geopolitics is neither controllable nor predictable. If Saudi goes we'll be hankering for the days of $150 oil. But in all of these scenarios airlines have to look at their costs and mitigate where they can. That's the responsibility of an airline's leadership to its owners, the shareholders.
Hey malcontent, "grossly overpaid", as compared to whom? All the Wall Street crooks or the idiots in Washington? Right! Obviously you're clueless. The pensions and retiree medical????? What are you talking about? They've been gone for almost 2 decades. Except for all the idiot Politicians and just about the entire public sector. School District employees all make more and have way better benefits and only work 182 days a year. And they're all at home every night in their own beds.
A reply to malcontent, above.
“The real solution is for fares to go up – drastically.”
It’s fair to say that not even students of high school economics would disagree. If fares do not reflect the COST of transporting passengers and freight for a sustained period of time, then they must be raised to ensure the longevity of a going concern. But this begs the question: What is the PRICE elasticity of demand for the air transportation market? Or, put another way, at what PRICE will an increase result in a net loss in REVENUE due to the reduced demand it causes? Because this critical dynamic defines the price ceiling of air fares, I am always disappointed to hear ‘experts’ and executive leaders in the air transportation industry discussing PRICE versus COST without ever citing the elasticity threshold. Do you, or they, even know where it lies?
“It is my opinion that many airline workers have been grossly overpaid…”
Quick! What was the average unit cost (in total compensation) of a FA/mech./pilot at a major carrier on September 11, 2001? Now, what was it on the same date in 2005 and 2010 - in real terms AND indexed for ASM’s in 2001 as a baseline? I’m merely trying to determine what metrics you used to base your opinion. If you didn’t use the numbers requested, then perhaps you are measuring air carrier compensation using some yardstick that is less quantitative. Or perhaps you are using some comparative measure that is external to the industry. If so, what skill set values in another industry are equivalent to a lead A&P mech for a transcontinental aircraft carrying 400 people? How about the cockpit crew?
“…especially when one factors in the legacy benefits like pensions…”
Quick, name all the air carriers that have transferred the cost of their defined benefit pensions to the PBGC over the past five or six years? (And at perhaps 25% of their value to the recipients.) Your statement indicates you are simply not aware of these transactions. Next, name all of the currently operating carriers that have never even had defined benefit pensions for their line workers.
“The responsibility of an airline’s leadership (is) to its owners, the shareholders.”
We all know we could debate that statement all day long. While it is true that this has been the status quo that helped to build the worlds greatest free and capitalistic society, it is ALSO true that it is the very cause of collective bargaining, workers rights, OSHA, etc. So it is way past time that executive leaders stepped up to the understanding that while SHAREholder value is a necessary economic standard, disregarding STAKEholder value can have dire consequences on the performance and longevity of an enterprise. And it seems that this has never been truer than in the volatile global economy of today. Effective executive leaders must balance all three of these dimensions, and more. History has demonstrated that the true leaders among them can, and that too many can’t.
Not a rhetorical question: if most airline management was recognized and paid for performance, would they even still be employed?
For a guy who cut his teeth on this profession by being a Flight Attendant you sure do bash labor as being the all encompassing problems that beset the airline industry.
Even Wall Street says there is no blood left to squeeze out of the employees yet you still beat that drum over and over and over........ Get some new material.
Listen up when it hits 2:40
http://www.cnbc.com/id/15840232/?video=3000007338&play=1
Hummmm let's see this morning at breakfast I decided I want to be a Flight Attendant at an airline. Four weeks later I am a Flight Attendant at an airline with no money out of pocket.
Just try and do that as a mechanic or a pilot. Fund it yourself and it will take years. Go ask mom & dad for the cash with the family house underwater and both of them working two jobs just to keep the wolves at bay. Let Uncle Sam pay for it and we'll see you in eight years after a lovely all paid tour of the Middle East.
You being a shill for the ATA I assume the alway lower labor cost mantra will continue until everyone is working for free. Go tell that to your friendly mechanic hanging in a cherry picker at the top of the rudder in a ORD snow storm. That job spinning wrenches Monday through Friday (holidays off too) at the local Lexus dealership is looking better and better.
Keep this up and Air India will have continuing service on to OMA because the only ones who will have labor cost that is acceptable to your masters will be third world countries who will be laying over in East LA at the Days Inn with the entire crew sharing two rooms and thinking this is a great layover.