Time to Look Forward – Not Back

Historically,www.swelblog.com has taken space this time of the year to reflect on the biggest stories of the year. In this column, I want instead to spend more time looking at issues that will be important in 2011.

First, the look back: 2010 began with me taking sides in the battle for JAL and siding with the ultimate victor, American.  We wrote about the National Mediation Board, wondered aloud whether the labor-friendly Obama Administration would permit an airline strike given the fragility of the economy. We challenged Captain John Prater, President of the Air Line Pilots Association, on multiple fronts, offered a favorable perspective of the controversial Chairman and CEO of United Airlines, Glenn Tilton, and looked at mainline pilot scope and the pilot unions’ associated rhetoric. We challenged Southwest to put its money where its mouth was in the proposed slot swap between Delta and US Airways and noted Continental’s contract offer to its pilots that offered Delta wage rates plus $1 per hour. We laid out why we did not like the proposed United – US Airways merger; criticized the tarmac delay rule, pondered the American and jetBlue tie up at New York’s JFK airport; applauded the United and Continental merger and argued that American and US Airways will be fine in a consolidated world – at least for the foreseeable future.  We questioned why the airline industry was losing numerous battles in Washington, the looming threat from carriers in the Middle East,  the price of regulation in terms of what is a public good and lobbed yet another challenge to now ex-Congressman James Oberstar. We also weighed in on the Export-Import Bank; the Southwest – AirTran merger; the national elections; and questioned the need for the number of commercial air service airports in use today. We explained why pilot picketing and other union activity revealed only part of the labor quandary at US carriers, and predicted that foreign ownership restrictions will be the subject of ongoing debate.

Meanwhile, we only touched on airline profitability – a nice change, but noted with caution as three quarters do not make a trend. The airlines are doing what they should be doing in de-leveraging their balance sheets, with consolidation occurring not just in the mainline sector, but beginning to reshape the regional sector as well.  Oil was less of an issue in 2010, with price volatility muted compared to the prior two years. And the revenue picture brightened, particularly coming off a dismal 2009.  Finally we saw pivotal votes rejecting unionization at Delta, although the jury is still out whether labor’s defeat there was due to something unique to Delta or a broader referendum on a union’s ability to improve the lives of dues-paying members

Thanks to all of you who are regular readers and those who check in occasionally, readership was up significantly in 2010 and I hope you continue to read in 2011.

LOOKING FORWARD:

LABOR:  Labor promises to remain a significant story in the coming year.  There is new leadership at the Air Line Pilots Association; the Allied Pilots Association; and the AFA-CWA to name a few.  While it is hard to predict whether things will change at the largest flight attendant union, AFA-CWA, after multiple terms under Patricia Friend, I am confident that changes in leadership will benefit the pilots represented by both ALPA and the APA.  This is not to say that I expect either of the unions to roll over, but believe that there is much to gain for both sides in a constructive dialogue that was too often absent in the previous union administrations. It is safe to say that the terms served by Captains Prater and Hill did more to set the unions back than advance the pilot profession.

The NMB will remain on my watch list.  We could see action sooner rather than later at American, where Larry Gibbons, Director of the Office of Mediation Services, will now oversee the negotiations that have been underway for several years. Will the NMB become even more political as Gibbons sits closer to the board members than do other members of the team he oversees?  Will the Board play a crucial role in facilitating new and joint agreements at Continental – United?  Will the Board side with the unions in determining whether Delta interfered in the IAM and AFA representation elections as the unions allege? Ultimately, the unions will determine how aggressive they need to be to leverage the support of employees at the merged carriers anxious about recent changes in working conditions and how the seniority list is constructed.

It is clear that the industry will be watching as Delta manages one of the least-unionized workforces, particularly as former union members from Northwest are brought into the fold. One might say that the hard work is now done as the votes have been cast and the election is over.  But I say the hard work is just now beginning.  It won’t be that long until another election can be called.  And the difficulty of the task is highlighted by the civil war between the work groups at US Airways that continues into yet another year.  It seems unlikely that the legal issues dividing the merged pilot groups and pilots and management are near resolution. All eyes will be on United CEO Jeff Smisek and Southwest CEO Gary Kelly to see how they manage culture change at their bigger, more complex carriers.

Finally, look for organizing activity to increase at other airlines.  The losses at Delta will make the unions hungry for increased membership and recent changes to federal election law under the Railway Labor Act make it easier for union to win a secret ballot election.  Already unions are targeting jetBlue and SkyWest –where unions lost past elections under the old rules.  If the Delta vote is a referendum on the former Northwest employees not being content with their union, might there not be opportunities for the International Brotherhood of Teamsters to begin raiding select work groups?

FUEL:  As I write, West Texas Intermediate is trading at $91+ per barrel.  As Southwest CEO Gary Kelly, put it, volatility in fuel prices is the industry’s “No. 1 challenge” and “the single biggest threat to aviation.”

The price of oil is sure to be a story in 2011.  Goldman Sachs, the firm that predicted $200 per barrel oil in 2008, is predicting $100 per barrel during the first half of 2011.  Given growing confidence that economic recovery is finally taking hold and the levels of new industrial production activity in the Asia-Pacific region that often drives market oil prices, $100 per barrel seems reasonable. 

Here at Swelblog, we were among the first to suggest that the best thing that happened to the US and global airline industries was oil at $147 per barrel, which more than anything else served as the impetus to reduce capacity from an industry that had grown too big.  If oil prices continue to climb, it will serve as a discipline on any efforts to add marginal capacity to the system, particularly in the domestic market.  And this time around, a Southwest does not enjoy the same hedge book and fuel cost saving potential v. the industry as it had when oil prices surged in the 2004 – 2008 period. 

Should oil continue its rise, we will begin to see further reductions in small community air service.  For many communities, a fuel surcharge on top of what many believe are high fares will test the price elasticity of even the more inelastic customers - who will take to the highway as their first point of access to the air transportation grid.  This would be a healthy outcome for the industry that is still arguably over-connected.  Rising oil prices – along with regulation imposed costs that will come to fruition in 2011 - should be a catalyst for continued consolidation in the regional sector.

If fuel prices rise, the passenger carriers will likely be successful imposing fuel surcharges to fares, just as the cargo carriers were in the past.  Southwest may not charge for bags, but even they will have to consider fuel surcharges this time around.  That is a big differentiator for the US airline industry in 2011.  What makes this tricky is that the US consumer was long conditioned to paying fares based on industry costs of $30 per barrel in-the-wing jet fuel.  The industry has adapted.  At $95 per barrel the industry begins to be tested yet again.

WASHINGTON:   the Air Transport Association has a new leader in Nicholas E. Calio, a former Citicorp executive with keen bipartisan skills. Calio becomes the new President and CEO of the industry’s trade group on January 1, 2011, hoping to turn the airline industry fortunes after some trying legislative and regulatory losses in 2010.  With new costs and operating constraints posed by rigid new tarmac delay rules, increased passenger compensation for overbooking, a new push to have a total cost of trip (fare and fees) made known to the purchaser, proposed constraints on regional carriers,  changes at the NMB, investigative actions by the FAA, the rejection of the slot swaps between US Airways and Delta, and the loss on appeal of the right of airports to implement congestion pricing, airlines are hoping for kinder, gentler treatment in Washington in the new year.

In a recent media release, the ATA said it was pleased with the recommendations of Secretary LaHood’s Future of Aviation Advisory Committee.  I am assuming this will prove to be a blueprint agenda for Calio and his team at ATA.

And with Oberstar now gone from the House Transportation and Infrastructure Committee, new Chairman John Mica (R-FL) has an opportunity to make some headway on relevant and important issues that threatened to make US aviation a second-tier player in the global industry under the misguided direction of the former chairman.

I am encouraged by the leadership changes taking place in the industry and hope that we can finally have a discussion on issues with a mindset on positioning the industry within the global sphere.

CONCLUDING THOUGHTS

The industry’s work is far from done.  Progress on consolidation, cutting capacity, new technologies and efficiencies, and re-balancing labor costs have dramatically improved the cost structure in the industry, just as anti-trust immunity, open skies agreements and global partnerships have improved revenue opportunities for US carriers. But work must continue on alternative fuels and reducing the impact of aviation on the environment and ensuring that the airline industry is not paying more than its fair share of the tax burden.

There are still barriers to better operations on the labor front as well. Union leaders need to decide once and for all how to address the split between mainline and regional flying all the while securing/maintaining some form of scope protection their members expect.  A good start would be to stop the charade that this is a 76-seat issue.  The mainline does not want that flying because they will not accept the rates necessary to do the flying.  Once again, labor did much to create the problem, now it is time that they figure out how best to fix it.

Finally, it is time to stop playing politics with the FAA Authorization bill and put together a clean bill to address the aviation infrastructure.  Let’s get rid of the pet projects loaded into a bill that should be designed for efficiency.  And airlines and airports need to figure out how to work together.  The debate should not be about an increase in the PFC but the extent to which the industry has a say in how the money is spent.  Just as airlines need to be positioning themselves to succeed in a global industry, airports that add little to no value to the airline map of tomorrow should not be spending precious money building out an infrastructure that may not be used.

Let’s hope that in 2011, we can stop living in the past and look toward a strong future for the US airline industry. We have to get our impediments fixed at home to prepare for the next upcoming competitive battle for advantage in the global market.  For some this next competitive battle will be much tougher to win.

Happy New Year. 

Dear Chairman Oberstar: What Do You Mean This Is Not What You Voted For?

Responding to the news that the U.S. Department of Justice had approved the merger of Continental and United, House Transportation and Infrastructure Chairman, James Oberstar said, “This consolidation of the mainline companies into three or four mega-carriers is not what I voted for in 1978. Nor did anyone foresee three international alliances dominating the global airline market.” 

For a guy that has been in and around the U.S. airline industry for longer than it has been deregulated, Oberstar should know better. Since 1978, the predictions have all pointed toward three network carriers.  The formation of the global alliances also addresses exactly what Oberstar and other members of Congress intended three decades ago… more choices for consumers.  

Don’t take my word for what the goals and objectives of U.S. airline deregulation was intended.  The November 6, 1985 report by the General Accounting Office (GAO) spells them out.  The GAO report was requested by U.S. Representatives Norman Mineta (D, California) and James Howard (D, New Jersey) to assess the effects of deregulation as compared to the intentions and expectations.  The GAO report stated the purpose of the deregulation act was to allow competitive market forces, rather than the federal government, to decide the quality, variety, and price of domestic air service.  It was aimed at encouraging the formation of new airlines, expanding service by existing airlines, and bringing lower fares and better service to passengers. Recognizing free competition might result in some communities losing air service, Congress created an Essential Air Service Subsidy Program protecting service to eligible communities.

The GAO compared economic expectations of deregulation with actual changes in the industry's structure (the number of airlines, each airline's share of traffic, and the ease with which they can begin new service to a city-pair), conduct (behavior in setting prices and levels of service), and performance (profitability, efficiency, and responsiveness to consumer preferences). The report does not address airline safety. 

Now, let’s look at today’s aviation industry keeping the goals of the Airline Deregulation Act of 1978 (ADA) in mind.

The GAO report states five years after enactment, there were more airlines competing.  It also highlights a trend prevalent today.  “With increased competition, the largest airlines have been losing passengers to smaller and new airlines (which often offer lower fares). Nationwide, the percentage of passenger miles flown by the largest airlines (formerly called trunks) fell while smaller carriers combined with new airlines almost doubled their percentage of passenger miles flown.”

I think the number of airlines is less important than understanding the levels of domestic capacity held by the top three, five and 10 largest airlines operating in the domestic marketplace.  I looked at available seat miles by all competitors from 1974 to 2009.  In 1979, the three largest U.S. airlines held 48.6% of domestic capacity; the five largest, 72.3%; and the 10 largest, 93.1%.  In 2009, the three largest U.S. carriers held 43.8% of domestic capacity; the five largest, 61.7%; and the 10 largest, 81.8%.  These numbers exclude code sharing and regional capacity.  If included, the levels of concentration would still be less than the levels of concentration in 1979.

The 1985 report cited trends shortly after passage that still hold true today like. Average fares fell, service improved for most passengers, efficiency improved, consumer choice increased but not everyone benefited and, thirty years later, airlines are still adapting to deregulation.

 While 2010 fares are rising as compared to an abysmal 2009, the long term trend is still decreasing real fares. Domestic networks provide passengers in markets large and small with significant choice and access to virtually any market. Airline efficiency including labor, operations and fuel consumption has improved. It’s true not all markets have enjoyed similar levels of benefits, but that is less about consolidation and more about individual community economies and the price of oil. The industry is not static (some would even say stable) and is still adapting to a series of crises including September 11,  SARS, $147 per barrel oil, the Great Recession, Avian Flu, H1N1, volcanic ash and numerous and onerous regulations and taxes imposed by government as well as new competition in domestic markets and emerging world networks.

The Deregulation Debate Leading Up to Passage of the ADA

Congressman Oberstar, I assume you listened to the learned economists that participated in the debate as to whether passage of the Airline Deregulation Act would prove to be good policy.  I will highlight some of the economic theories espoused during that debate.  If you read carefully, I believe you will find many of the trends prevalent immediately after passage are still intact.

• Analysts expected deregulation to result in a more competitive market structure by removing barriers to entry into individual markets and allowing new firms to enter the industry.
• According to economic theory, a single firm operating in a market invites entry by a competitor if it is inefficient, charges too high a price, or fails to provide the price/service options consumers want. While entry of a competitor forces the existing firm to become efficient and more responsive to consumer preferences in order to survive, economic theory holds potential competition-- the realistic possibility of entry by a competitor-- may be sufficient to produce performance similar to competing firms.
• The report of the Civil Aeronautics Board special staff on regulatory reform concluded the most detrimental effect of regulatory protection on airline industry performance was probably limiting potential competition.
• Deregulation spurred airline competition by increasing their ability to alter route structures, service offerings and fares to attain the maximum competitive advantage. (true today through domestic code-sharing and alliance formation)
• Economic theory suggested the ability of lower cost firms to enter markets and compete on the basis of price would create downward pressure on fares.

The GAO concluded, “Trends in fares and service quality are generally consistent with predictions of deregulation's effects. It appears that increased competition generally restrained fare increases so that fares are now more closely related to costs and are probably lower on average than they would have been if the regulatory policies in effect from 1974 to 1977 had continued. Service generally improved, a result that not all analysts anticipated, with increased departures and seats and more markets receiving through-plane service by scheduled airlines. It is possible that analysts generally underestimated how much air travel would increase in response to lower fare/lower service options. As expected, smaller airlines using smaller aircraft replaced major airlines in some of the smaller, short-distance markets. Convenience improved as more passengers were able to complete a trip without changing airlines. Load factors, expected to increase, have varied, generally staying above pre- deregulation levels but varying too much from year to year to identify a long-term trend.”

The GAO reported in 1985 in the six years following deregulation, the airline industry recorded the worst financial performance in its 45-year history.  High operating losses raised questions about the industry's future performance under deregulation, but analysts had expected some airlines to have financial problems during the transition from regulation. “Airlines that cannot fully adjust to deregulation will continue to have financial problems; more may go bankrupt. Yet, in the long run, airlines that can reduce costs to match fares of lower cost competitors and find new profit opportunities in meeting unfulfilled passenger preferences will survive. In this way, the industry will become more efficient as those less able to meet the challenges of a deregulated environment go out of business.”

The GAO reported financial performance varied widely, suggesting airlines can be profitable in a competitive market.  “Analysts warn that the transition is not yet complete. During this period of adjustment, airlines that cannot adjust to the more competitive environment may be forced to reorganize or go out of business. Once the industry has fully adjusted to deregulation, it should be profitable over time, although some airlines may occasionally suffer losses and even leave the industry.”

Economists and other analysts expected deregulation would increase efficiency in several ways: (1) new, lower cost airlines would enter markets, reducing average industry cost levels (2) airlines would alter their route structures and aircraft mix, seeking to lower per-passenger costs (3) the ease of entry and increase in fare competition would keep pressure on all airlines to keep costs down. In an unregulated and unprotected environment, bankruptcies would occur when less efficient airlines were unable to adapt to the more competitive environment. By giving airlines freedom to profit or fail, competition would help assure only the most efficient airlines survived.

The GAO concluded “changes in fares, service, and profit are consistent with economists' and other analysts' expectations of the effects of increased competition on a formerly regulated industry.”

Perplexed

In your statement, Congressman Oberstar, you say “This action [DOJ approving the United – Continental merger] points strongly to the need to give broader authority over such mergers to the Department of Transportation, allowing DOT to consider such factors as the impact a merger will have on service to communities and customers, as well as the effect the merger could have on the industry as a whole. There must be consideration of whether a merger will inevitably trigger others, ultimately reducing the industry to a few large carriers, each of which is unwilling to compete seriously in markets dominated by one of the others.”

Like you, I agree the Department of Transportation should have broader authority over such mergers because they understand the industry. The Department of Transportation had the wisdom to approve the immunized alliances all the while recognizing the benefits conferred on customers and communities of all sizes.  Whether mergers spur others will always be speculation.  Just like the economic theory surrounding deregulation, which I assume you relied upon to ultimately vote in favor of deregulating the industry, a single carrier operating in a market invites competition. The same is true today. 

To say large carriers are unwilling to compete with one another is simply not true.  Look at some of the recent markets the U.S.’s largest domestic carrier, Southwest Airlines, has entered:  Washington Dulles - a United hub; Denver - a United hub; San Francisco - a United hub; Minneapolis/St Paul - a Delta hub; Milwaukee - a Midwest/Republic hub; New York Laguardia and Newark – a Continental hub. These large markets are homes to all major carriers.

You said “when Congress deregulated the airlines in 1978, we were promised better service, added competition, and more choices for consumers. With the United-Continental merger, our domestic carrier fleet will have shrunk to four network carriers. Moreover, each merger appears to trigger another, as carriers feel the need to get bigger in order to compete with the newly merged airlines. American merged with TWA, then America West merged with US Airways [I ask, would either carrier be here today if they had not merged?], followed by Delta absorbing Northwest, and now United merging with Continental. Can a US Airways-American Airlines merger be far behind?”

Congressman, just look at some of the choices enjoyed by consumers.  They are plentiful and choice continues to be built into the consumer’s decision to buy or not to buy.  One can even argue the consumer is more empowered today than at any time over the past 32 years.  There is a choice to fly on a full-service airline or a low cost, no frills airline; there are choices when ticketing like paying more for a better seat; there is a choice to fly on an airline that charges for bags or one that does not. Under the bilateral regime, airline choices were limited by the number of destinations and frequencies allocated to respective carriers. Today that is not true, and today, alliances give consumers the option of garnering frequent flyer miles and benefits for their entire trip, not just portions of a trip. I could go on but the promise of more choices for consumers in the ADA is alive and thriving.

There are many issues that are considered when thinking about a merger partner in addition to the structure of the market.  But I take you back to the analysis performed that points to the fact that the industry is less concentrated today among the largest airlines than it was in 1979.  Throughout the deregulated period, there have been mergers, there have been failures, there has been opportunistic growth by various sectors of the industry, and there have been significant cuts in capacity in response to the price of oil and the strength of the economy.  In every instance the industry has adapted to change in one way or another, but no fix concentrated the industry more heavily.

Concluding Thoughts and An Ask of You

Congressman Oberstar said, “airline consolidation brings consumers and communities fewer choices and less competition, usually leading to increased fares and reduced levels of service. And that runs directly counter to the promise of deregulation” is confounding.  Confounding in that the opposite is happening today.  Confounding because the Airline Deregulation Act you supported is playing out in the manner in which it was envisioned based on the economic analysis performed by the GAO.  To re-regulate will only make the industry even smaller following the cutbacks since 2002 employing still fewer people all the while disenfranchising small communities from the airline map.  Consolidation activity was prevalent before deregulation as six of the 16 trunk airlines were gone by the time the ADA was passed.  Consolidation at home should not be feared nor should alliance formation.  Each action is about adapting to a new environment and that is precisely what the industry is doing.

When the ADA was passed, trunk airlines were predominantly domestic airlines.  During the past seven years each of the network carriers except one has nearly 50% of their capacity exposed to international markets.  The domestic systems the network carriers operate are most important extensions of their international operations.  These extensions have a domestic benefit to customers as well.  Airlines are consolidating at home in order to prepare to compete globally unlike the consolidation period in the mid-1980s which was domestically focused.  Today’s industry is less about getting to Duluth from Dubuque and more about getting to Duluth from Dubai. That’s the world today, one deregulation helped open up to all of us.

Congressman Oberstar, in your statements surrounding the approval of the most recent two mergers you have not provided a single shred of evidence contradicting the GAO study that dutifully outlined the foundational facts and analysis upon which you cast your vote in 1978.  It would seem that you are basing your comments largely on perception and even making some statements – like US Air merging with AA - that are specious at best.

Congressman Oberstar I have one ask of you.  Reconsider your position on mergers and consolidation.  The United States was once the absolute leader in aviation. That cannot be said today.  We need carriers that have the financial wherewithal to raise the (our) flag in every world region.  The solution you seek in your message will only further marginalize U.S. commercial aviation in a global context. 

A Battle for JAL or the Threat of Competition?

In this post, I’m going to pick sides in the mighty contest for the JAL bride.

But before we begin, let’s dispense with some business.

First, let the record show that I have long been a fan of Delta Air Lines on many fronts, particularly how it went about its merger with Northwest.  I applauded the strategy CEO Richard Anderson led in demonstrating the benefits of an “end to end merger” versus the old model merger with “significant network overlap.” It is interesting to me how Delta is suggesting to the world that getting immunity for a relationship with JAL will be fairly easy.

Second, I was recently asked by to present at a one-day seminar on the subject of anti-trust immunity hosted by American’s legal counsel Jones Day.  I am not retained by American in this matter, but the airline did cover my travel expenses.

My views are my own. And they are based on a very firm foundation of data.

Now, let’s talk about alliances.

The North Pacific Market

In the U.S. – Asia market, the two most important Asian gateways are Tokyo Narita and Seoul Incheon.  And just as airlines compete, gateways compete for the same traffic. Tokyo and Seoul offer services that can facilitate 10.4 million U.S. – Asia passengers a year.  Of those, 10 million passengers can be accommodated by either Tokyo or Seoul, while only 400,000 are uniquely served through Tokyo’s Narita gateway.

Airlines form alliances to partner with other airlines and more effectively participate in traffic flows between world regions. Alliances permit a carrier to leverage its own network across its partner’s network to create benefits that would not otherwise be logistically possible or economically viable. 

Now Japan Airlines is the “it” airline in a global contest to win its favor and woo it from one alliance to another.  The troubled airline’s current partners in the oneworld alliance are determined suitors in their effort to keep JAL happy at home, while Delta is playing the part of home wrecker, posing and making promises that the opportunities are greater for JAL as part of the SkyTeam alliance.

If I am Delta…..

I would be pursuing JAL as well.  Why?  Because Delta has the most to lose from any new competition into the U.S. – Japan/U.S. – North Pacific marketplace.  Why?  Because of the extraordinary rights Delta has to fly beyond Tokyo and Japan and carry traffic that originates in Japan.  Why?  Because the route rights granted to Northwest (Orient) in 1952 came at a time when Japan was dependant on the U.S. in its post war recovery.

The bilateral agreement in place between the U.S. and Japan has been largely unchanged since 1952.   Both sides have thought the pact unfair, but little progress was made until 2009.  To Japan, the bilateral was imbalanced, with too many NRT slots held by U.S. airlines using them to provide local intra-Asian service.  To the U.S., the bilateral was viewed as anticompetitive as it restricted frequencies, favoring incumbents and preventing market-driven price discounts.  Those incumbents are Northwest and United, which bought the rights from the late, great Pan Am.

What complicates the DAL’s JAL play is that Delta in effect already owns most of the rights of a Japanese flag carrier as a result of the 1952 bilateral agreement.  Along with its immunized relationship with Korean Airlines, Delta already enjoys a commanding market position in what promises to be one of fastest growing markets over the next 20 years – the North Pacific.   

Those route rights now held by Delta as a result of its merger with Northwest give the carrier significant market power.  Those route rights have over the past six decades enabled Delta to build a U.S. – Asia network via Tokyo that could only be rivaled by United.

Only now, under an Open Skies pact between the U.S. and Japan, can that incumbent status be truly challenged.

Oberstar and the Fear Mongers Sure are Quiet

As this story unfolds, one thing we’re not hearing is the usual braying from Congress’ self proclaimed, air travel consumer protection cop James Oberstar.  Is it because the situation involves his former hometown airline?  Or is it because the Congressman is just waiting to pounce?  In either case, the man who has previously been quick to try to apply regulatory and legislative “solutions” to the airline industry’s complex challenges is atypically quiet.

As regular readers know, I am no fan of the Minnesota Congressman’s approach to competition in the industry.  But as we approach a situation in which the term “duopoly” will describe inter-alliance competition should Delta and JAL form a partnership in Japan – his silence is, well, deafening.

Today, American + JAL at Tokyo, Northwest/Delta at Tokyo and Delta + Korean at Seoul are competing for U.S. – Asia traffic.  There are 413 city pair markets in that region that involve 19 overlapping Asian markets served by each Tokyo and Seoul that have at least 5 passengers per day each way.  Currently, 83 percent of those 413 city pair markets either originate in or are destined to points behind a U.S. gateway to one of those 19 points beyond the two Asia gateways. 

It is these markets that represent a competitive disadvantage to the non-immunized alliances today – chief among them  American’s oneworld.  These markets also represent true opportunity for the immunized alliances of tomorrow – those, that is, that would now be permitted by the U.S. – Japan Open Skies Accord – and that’s what has the incumbent airlines looking nervously over their shoulders at the prospect of new competition.

Today both STAR and oneworld are limited in their ability to compete for this traffic by a lack of immunity with their Japanese partners.  Northwest/Delta, on the other hand, can coordinate schedules and set fares for traffic connecting over Tokyo Narita (as a result of the agreement negotiated with Japan in 1952) and for traffic connecting over Seoul with its Korean Airlines partner.

In fact, on 98 percent of the 413 city pairs we’re discussing, either Delta/Korean or Northwest/Delta or both “immunized” combinations have a larger share of this critical connecting traffic than does American + JAL. 

This ability to generate traffic and offer passengers a choice of carrier and gateway is just one of the important benefits that accrue to airlines and consumers as a result of a relationship that allows immunized alliance airlines to coordinate schedules and set fares.

Today Delta’s U.S. domestic network is roughly 2.5 share points larger than American’s, yet it is able to connect disproportionately more traffic from the U.S. to Asia.  Network economics suggests that this relationship does not make sense unless one considers the power of immunity.

The Threat of Competition

Today, both oneworld and STAR compete for the same traffic against SkyTeam.  Today there is certain symmetry among the three global alliances for U.S. – Japan traffic and U.S. – Asia traffic.

In the U.S. – Japan market, STAR’s share is 31%; oneworld w/JAL is 38%; and SkyTeam w/o JAL is 30%.  In the U.S. – Asia market: STAR’s share is 34%; oneworld w/JAL, 22%; and SkyTeam w/o JAL, 28%. 

Based on MIDT data American commissioned from Compass Lexicon and analyzed by me, if JAL were to be lured away by SkyTeam, the numbers would look very different.  In the U.S. – Japan market:  STAR, 31%; oneworld w/o JAL, 6%; and SkyTeam w/JAL, 61%.  In the U.S. – Asia market:  STAR, 34%; oneworld w/o JAL, 10%; and SkyTeam w/JAL, 30%.

Delta will likely challenge that analysis, claiming that it should not include traffic between Japan and the U.S. “beach markets” of Hawaii and Guam. I will leave that argument to the lawyers.  But last I checked, one was a U.S. state and the other a U.S. territory and each are therefore governed by the U.S. – Japan bilateral.

In simple terms, the real threat of liberalization in the U.S. – Japan market is the overnight competition Delta/SkyTeam will face from oneworld and STAR for the nearly 10 million U.S. - Asia passengers.  Do the math: If Delta is successful at luring JAL away from oneworld, then SkyTeam and STAR will have a 92% share of the U.S. – Japan market.  In most economic analyses, that share represents a duopoly.  And that should not be the result of market liberalization. But then again, do we have a duopoly on the Atlantic given that oneworld is not immunized there either?

Oberstar and the Fear Mongers have already protested the prospect of limited competition in three alliances hell bent on “gouging” air travelers.  So where are they when it comes to the prospect of just two alliances controlling so significant a share of the Asian market?

Duplicitous Delta and the Source of My Confusion

In late 2006, while Delta was in bankruptcy, U.S. Airways made a hostile offer to take control of the company.  Delta rejected U.S. Airways’ overtures vehemently and was ultimately successful in fending them off. “US Airways’ principle goal in its hostile takeover attempt is to eliminate its key competition,” Delta(Grinstein) said at the time. “In a pro-competitive merger, the two airlines’ routes do not overlap excessively; they are complementary. Joining complementary networks can enhance competition and create consumer benefits that result in lower prices and increased service option.”

Then in late 2007, Delta, on its own terms, began to pursue a merger with Northwest. Anderson argued time and again that the two airlines had “complementary instead of overlapping route systems” that would maximize synergies.

With the two airlines already connected through alliance relationships, Anderson said:  “Alliance relationships are valuable and very difficult to extract yourself from.”  He noted that neither Delta nor Northwest needed to pull out of its existing alliance, which would have “disrupted revenues and required tearing out significant infrastructure and then rebuilding someplace else.” 

Given regulatory restrictions regarding cross border mergers, an immunized alliance is a defacto merger in the sense that it gives the combination the ability to act as one airline in determining service levels, pricing, marketing.

On the surface, the size of Northwest/Delta’s North American network is slightly larger than American’s.  However, the fit of the network is more important than size.  The ability to leverage one network against the other in order to create new city pairs to sell is critical to any network’s success.  American and JAL would make for a true “end to end” combination whereas Delta and JAL possess significant overlap with each other – the very combination it suggested results in an anti-competitive combination.

On the surface, the solution is crystal clear - at least to me: Three alliances across the Atlantic and the Pacific that each benefit from anti-trust immunity and equally competitive tools.  Even if JAL ultimately restructures through bankruptcy, a partnership with American would still provide a true end-to-end partner that Delta itself contends is the very best way to maximize the synergies of a commercial combination.

But the more I study the data, a different picture emerges. Delta’s play for JAL is not about JAL at all.  It is about preserving Delta’s dual flag status in Japan.  For 58 years Northwest/Delta has been tweaking its US network to sync with its Japan-based network – and they have done it well.  Under Open Skies, Delta will realize new and more vigorous competition on many routes where it enjoys little to no competition today.  Self preservation is a strong instinct and I am all for consolidation in this industry.  But I am also for open and fair competition, particularly where all three alliances are concerned. 

Either way, Delta wins.  It wins by delaying anti-trust immunity for each American and United and thus preserving its legacy competitive position.  And it wins by potentially eliminating a competitor (JAL) where redundant flying can be removed. 

Competition loses.  If Delta lures JAL away from oneworld and the U.S. grants the Delta/JAL combination anti-trust immunity, then perhaps Oberstar finally has a position he can defend. Three way alliance competition is robust.  Institutionalizing duopolies in Open Skies markets is something else.

Are Some US Airlines Too Big to Fail? Hell No!

Holman W. Jenkins Jr., writing in the July 8 Wall Street Journal gets it right: "The new administration seemingly won't let companies fail, and won't let them succeed either," Jenkins wrote of Justice Department opposition to antitrust immunity for Continental Airlines and the Star Alliance. Such alliances, he argues, are the industry's "self-help solution" for companies looking "to share losses and preserve capacity in a downturn." By denying that option to struggling carriers, Obama may soon be forced to "add the airlines to the collection of failed industries being run out of the White House."

Sadly, What is Good for One is Not Good for the Other Two

Congress, of course, has a long-held penchant for meddling in the affairs of industries and organizations. This week, the Senate Judiciary Committee Subcommittee on Antitrust, Competition Policy and Consumer Rights spent taxpayer money to hold hearings on college football’s selection process for placing teams in its Bowl Championship Series. So we should not be surprised to see a growing government role in an industry that has managed to lose more than $30 billion over the past nine years.

If government oversight of the airline industry is going to stand in the way of corporate success, then there is no airline too big to fail. So why not let them fail? Airlines are criticized for not being innovative. True - and for the most part their innovations over the past 10 years amount to little more than finding ways to maximize revenue within a system of constraints.

Delta/Northwest is the largest carrier in the world, and even it commands less than a 5 percent share of the global airline market. No other U.S. airline claims more than a 3 percent share. Yet the government continues to treat the U.S. airline industry as if it is a threat to competition and slap the hands of airlines that attempt to improve/augment their business models through partnerships and alliances with foreign carriers.

Antitrust laws are designed to protect consumers from corporate power. Does a well-established trend line of fares falling at rates greater than inflation for three decades demonstrate corporate or industry pricing power? A passenger traveling from Greenville/Spartanburg to Los Angeles has a choice between more than 20 flight combinations to get from California and back.  Does that demonstrate corporate or industry power? Does an industry that makes the price of its product fully transparent to the buyer sound like an abuse of the consumer?

The fact is that most U.S. air travelers still have plenty of choices when it comes to flying – albeit in an industry that still carries more capacity than it needs.

Southwest: The Wolf in Sheep’s Clothing

Let the record show that I have not joined the chorus of analysts and observers who predict rising fares by Fall. The recession holds. Many consumers are tapped out. Enter: Southwest Airlines.

Southwest has a long history of leveraging difficult financial times -- profiting at the expense of competing airlines because it could. It profited because of the chasm in its CASM versus it competitors; it profited because of the chasm in the RASM charged by competitors; it profited because it smartly used its balance sheet to make a wildly successful bet on the future of fuel prices . . . Southwest profited because it could. So this week’s fare sale in which the airline is selling tickets at $30, $60 and $90 says one of two things: either Southwest is struggling mightily with the forward booking curve, or the airline smells blood. I think the answer is both, but more the latter.

Southwest is now the big dog in the US domestic market and a player that must be reckoned with in any discussion of domestic market competition. If the nation’s lawmakers and policymakers continue to equate low fares with sufficient competition and consumer benefit, then deregulation has clearly come full circle.

Southwest is not now the big dog to those in Greenville/Spartanburg, Knoxville or Duluth. But most travelers can get in a car and drive less than a few hours to fly Southwest from these markets or more than 280 others not now served by LUV.

If this is what the regulators and policymakers really want, then that’s what they’ll get. Therefore, there is no reason to think that any airline flying today is too big to fail.

With Southwest adding the dots of the largest population centers where it did not previously fly to its route map, the industry could be at a tipping point. These markets also represent large sources of feed revenue to many legacy carrier hubs, and with Southwest offering fares too low for some legacies to match, this fall and winter may be a long, cold one for the traditional carriers.

Will the government continue to stand in the way of airlines that are desperately seeking new revenues? If so, no bailout will save an airline – not until U.S. airlines are allowed to act like other multinational industries serving a global economy. There already is enough taxpayer money bailing out other industries with similarly troubled attributes – adding airline rescues to the mix would only throw more good money after bad.

Union Rhetoric

What’s behind Congressional opposition to these common-sense alliances? The loudest voice in the room is labor. Even at this financially treacherous time, the industry is split from within, the result in part of union leaders that refuse to recognize economic trends and realities when they don’t serve the union’s objectives. When are the unions going to recognize that the transfer of domestic market wealth from the incumbent carriers at the time of deregulation to the new wave of carriers that followed is largely complete? And that tomorrow’s opportunities do not reside inside the 48 contiguous states?

Now, in the years since airlines sought and won aggressive cuts in labor costs during restructuring, it is increasingly clear to me that continual change/modification to outdated collective bargaining agreements cannot overcome the structural seniority chasms that exist between the legacy carriers and their lower-cost, younger competitors – at least in the domestic market. For decades, as the network carriers have been forced to compete for ways to average down labor costs through protracted bargaining, the low-cost carriers simply use seniority arbitrage to facilitate their growth. And I think we are about to see another run of growth by the LCC sector.

When it comes to the airlines seeking immunity to maximize revenue and, in the case of United/Continental/Air Canada, address certain cost efficiencies as well, the strategy is to maintain as much of the current operation as is financially feasible. Unlike the US steel industry that lost nearly 400,000 jobs because producers in other countries could do it significantly cheaper, blame for the next round of airline job cuts most go in part to the airline unions that have been busy trying to convince the dinosaurs at the Department of Justice and on Capitol Hill that alliances will result in job loss and a further deterioration of wages and working conditions.

Between the time Eastern Airlines and Pan Am died and 2000, the industry’s high-water mark for employment, U.S. airlines added nearly 100,000 jobs. Since 2000, the industry has lost nearly 140,000 jobs - and it should have been more -  mostly because nearly all the airlines and virtually all the existing hubs have been protected in one way or another by patrons on Washington. Indeed, many of the jobs lost from a failure of one or two of today’s carriers likely will be replaced as market positions in the largest cities are filled by new and more efficient carriers.

Let Some Airlines Die – And Then Let DOJ and Congress Rethink

At this point no one US airline is too big to die. Competition remains plentiful whether that competition comes from another ticket counter at the same airport or cheap fares at a nearby airport. Either way, the industry is still too big – with too many network carriers, too many regional carriers and too many hubs.

And, except for a few “up cycles” along the way, revenue has not supported the industry’s growth or size. The time is right for lawmakers to hear the new reality in the industry – one focused not on a false threat of monopolies and price gouging, but the very real threat in an industry so bloated, burdened and inefficient that it fails to provide the very thing a business must: a reliable return for investors and real job security for employees.