To Save Airlines, Surcharge the Skies

To Save Airlines, Surcharge the Skies

A gloomy outlook for the economy coupled with even higher fuel costs in the near-term endangers the already weak financial condition of the airline industry.

As domestic retail fuel prices surge, the pain at the pump is spreading to the broader consumer economy, affecting consumers indirectly on everything from pizza delivery to air travel. 

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Domestic passenger airlines are taking action by tentatively raising their base fares. After a period of deep losses extending from 2001 through 2005, 2006 signaled a return to profitability of the U.S. airlines. The contention was that higher fares and sustained cost-cutting measures were culminating in this much-needed turnaround. Notwithstanding this positive turn, data suggests that the domestic passenger yields have lagged the skyrocketing jet fuel prices. For the 2003-2007 period, ATA domestic passenger yields grew at a compounded rate of 2 percent, while the domestic jet fuel prices grew at a whopping 25.3 percent a year.

For first three months of 2008, jet fuel prices have already jumped 18 percent. Furthermore, jet fuel expense as a percentage of operating expense for domestic passenger airlines has risen from 13 percent in 2003 to 26.5 percent in the third quarter of 2007.

For 2003-07, fuel costs at United Airlines grew 25 percent annually to $5 billion in 2007 and management expects them to reach $7 billion in 2008.

A gloomy outlook for the economy coupled with even higher fuel costs in the near-term endangers the already weak financial condition of the airline industry. This month, major U.S. passenger airlines including United, Delta and Southwest announced plans to decelerate their growth and cut non-fuel costs to offset higher fuel prices.

Although M&A activity will result in the elimination of redundant domestic capacity, the cost of oil and a weak economy could compel some carrier exits. One victim of such spiking fuel costs is Aloha Airlines, which filed for bankruptcy protection last month.

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Measures like hedging fuel prices offer only a speculative means to control fuel expenses. Domestic passenger airlines raising their fares can only offer a temporary solution against fuel expense. There remains a critical need to implement a rational mechanism that addresses the volatility of fuel costs.

How can passenger airlines counter the unpredictable prices of jet fuel? Other segments within transportation provide a practical solution. The freight industry recovers rising fuel costs above a base rate, by adding a fuel surcharge. Fuel surcharges have been part of the freight pricing strategy for many years, allowing the actual costs to adjust with the crests and troughs in fuel costs.

As the fuel surcharge fluctuates with a government-reported fuel price index, the correlation of fuel costs to price is visible, measurable, and thus generally accepted by shippers.

Although the lag between when fuel is purchased and adjustments in the surcharge can affect a carrier's ability to recover incremental costs, it still provides for some predictability in recover of fuel price increases. For example, in FedEx's fiscal second quarter, fuel surcharges were not sufficient to offset incremental fuel costs, but they did offset such costs in the carrier's fiscal third quarter.

Table 1 illustrates the use of this practice in most segments of the industry such as air express, airfreight, LTL, truckload, rail and ocean freight. For example, the surcharge percentage for air express services is subject to monthly adjustment based on the average price for a gallon of kerosene-type jet fuel.

Despite a higher percent of total cost for fuel (26.5 percent for domestic passenger airlines compared to 16 percent for express carriers like FedEx and UPS), the domestic airlines have not adopted the best practices from freight carriers for the passenger service.

Table 2 illustrates differences in shipping a 100-pound box via Southwest Airlines from New York City to Phoenix and a one-way ticket for a person to fly the same distance. The air freight rate includes a 13.6 percent fuel surcharge applied to the base rate but the airfare does not include a fuel-related fee, which can be substantial as shown below.

Although carriers have applied fuel surcharges in their cargo operations, they have not deployed that approach to passenger operations to recover rising fuel costs. Even with success in applying a flat amount for fuel surcharges on international flights, airlines should convert to an index-based fuel surcharge to gain predictability of recovery of higher fuel prices and gain acceptance from passengers. For example, United Airlines charges up to $150 each way on international travel. For a $625 one-way fare between Chicago and London, the fuel surcharge becomes 20 percent, and thus not consistent with increase in fuel prices, thereby hurting the prospects of consistent recovery of the surcharge.

The airline industry already has a practice of numerous add-on fees for items such as airport fee, security fee and FAA tax. With systems in place to handle accessorial charges, the airlines can recover higher fuel prices by implementing a periodically adjusted fuel surcharge and avoid building ad-hoc increases into their base fares.

Although some pricing strategies of the freight industry have been adopted by the airline industry to promote passenger discipline (e.g.: fees for second checked-in baggage and extra charge for heavier bags), they continue to ignore implementing a system for the more volatile and higher fuel expense. For airlines to profitably navigate through the challenges of rising fuel costs, this approach needs to get off the ground immediately.

Jindel and Pawar are president and research analyst, respectively, at SJ Consulting Group, a transportation consulting firm in Pittsburgh.