[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
CURRENT SITUATION AND FUTURE OUTLOOK OF U.S. COMMERCIAL AIRLINE
INDUSTRY
=======================================================================
(109-32)
HEARING
BEFORE THE
SUBCOMMITTEE ON
AVIATION
OF THE
COMMITTEE ON
TRANSPORTATION AND INFRASTRUCTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
__________
SEPTEMBER 28, 2005
__________
Printed for the use of the
Committee on Transportation and Infrastructure
_____
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WASHINGTON : 2006
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COMMITTEE ON TRANSPORTATION AND INFRASTRUCTURE
DON YOUNG, Alaska, Chairman
THOMAS E. PETRI, Wisconsin, Vice- JAMES L. OBERSTAR, Minnesota
Chair NICK J. RAHALL, II, West Virginia
SHERWOOD L. BOEHLERT, New York PETER A. DeFAZIO, Oregon
HOWARD COBLE, North Carolina JERRY F. COSTELLO, Illinois
JOHN J. DUNCAN, Jr., Tennessee ELEANOR HOLMES NORTON, District of
WAYNE T. GILCHREST, Maryland Columbia
JOHN L. MICA, Florida JERROLD NADLER, New York
PETER HOEKSTRA, Michigan CORRINE BROWN, Florida
VERNON J. EHLERS, Michigan BOB FILNER, California
SPENCER BACHUS, Alabama EDDIE BERNICE JOHNSON, Texas
STEVEN C. LaTOURETTE, Ohio GENE TAYLOR, Mississippi
SUE W. KELLY, New York JUANITA MILLENDER-McDONALD,
RICHARD H. BAKER, Louisiana California
ROBERT W. NEY, Ohio ELIJAH E. CUMMINGS, Maryland
FRANK A. LoBIONDO, New Jersey EARL BLUMENAUER, Oregon
JERRY MORAN, Kansas ELLEN O. TAUSCHER, California
GARY G. MILLER, California BILL PASCRELL, Jr., New Jersey
ROBIN HAYES, North Carolina LEONARD L. BOSWELL, Iowa
ROB SIMMONS, Connecticut TIM HOLDEN, Pennsylvania
HENRY E. BROWN, Jr., South Carolina BRIAN BAIRD, Washington
TIMOTHY V. JOHNSON, Illinois SHELLEY BERKLEY, Nevada
TODD RUSSELL PLATTS, Pennsylvania JIM MATHESON, Utah
SAM GRAVES, Missouri MICHAEL M. HONDA, California
MARK R. KENNEDY, Minnesota RICK LARSEN, Washington
BILL SHUSTER, Pennsylvania MICHAEL E. CAPUANO, Massachusetts
JOHN BOOZMAN, Arkansas ANTHONY D. WEINER, New York
JIM GERLACH, Pennsylvania JULIA CARSON, Indiana
MARIO DIAZ-BALART, Florida TIMOTHY H. BISHOP, New York
JON C. PORTER, Nevada MICHAEL H. MICHAUD, Maine
TOM OSBORNE, Nebraska LINCOLN DAVIS, Tennessee
KENNY MARCHANT, Texas BEN CHANDLER, Kentucky
MICHAEL E. SODREL, Indiana BRIAN HIGGINS, New York
CHARLES W. DENT, Pennsylvania RUSS CARNAHAN, Missouri
TED POE, Texas ALLYSON Y. SCHWARTZ, Pennsylvania
DAVID G. REICHERT, Washington JOHN T. SALAZAR, Colorado
CONNIE MACK, Florida JOHN BARROW, Georgia
JOHN R. `RANDY' KUHL, Jr., New York
LUIS G. FORTUNO, Puerto Rico
LYNN A. WESTMORELAND, Georgia
CHARLES W. BOUSTANY, Jr., Louisiana
JEAN SCHMIDT, Ohio
(ii)
SUBCOMMITTEE ON AVIATION
JOHN L. MICA, Florida, Chairman
THOMAS E. PETRI, Wisconsin JERRY F. COSTELLO, Illinois
HOWARD COBLE, North Carolina LEONARD L. BOSWELL, Iowa
JOHN J. DUNCAN, Jr., Tennessee PETER A. DeFAZIO, Oregon
VERNON J. EHLERS, Michigan ELEANOR HOLMES NORTON, District of
SPENCER BACHUS, Alabama Columbia
SUE W. KELLY, New York CORRINE BROWN, Florida
RICHARD H. BAKER, Louisiana EDDIE BERNICE JOHNSON, Texas
ROBERT W. NEY, Ohio JUANITA MILLENDER-McDONALD,
FRANK A. LoBIONDO, New Jersey California
JERRY MORAN, Kansas ELLEN O. TAUSCHER, California
ROBIN HAYES, North Carolina BILL PASCRELL, JR., New Jersey
HENRY E. BROWN, Jr., South Carolina TIM HOLDEN, Pennsylvania
TIMOTHY V. JOHNSON, Illinois SHELLEY BERKLEY, Nevada
SAM GRAVES, Missouri JIM MATHESON, Utah
MARK R. KENNEDY, Minnesota MICHAEL M. HONDA, California
JOHN BOOZMAN, Arkansas RICK LARSEN, Washington
JIM GERLACH, Pennsylvania MICHAEL E. CAPUANO, Massachusetts
MARIO DIAZ-BALART, Florida ANTHONY D. WEINER, New York
JON C. PORTER, Nevada BEN CHANDLER, Kentucky
KENNY MARCHANT, Texas RUSS CARNAHAN, Missouri
CHARLES W. DENT, Pennsylvania JOHN T. SALAZAR, Colorado
TED POE, Texas NICK J. RAHALL II, West Virginia
JOHN R. `RANDY' KUHL, Jr., New BOB FILNER, California
York, Vice-Chair JAMES L. OBERSTAR, Minnesota
LYNN A. WESTMORELAND, Georgia (Ex Officio)
DON YOUNG, Alaska
(Ex Officio)
(iii)
CONTENTS
TESTIMONY
Page
Baggaley, Philip, Managing Director, Corporate and Government
Ratings, Standard and Poor's Ratings Service................... 11
Kiefer, Mark, Associate Principal, CRA International, Inc....... 11
Matesanz, Maria, Senior Vice President and Team Leader,
Infrastructure Finance Team, Public Finance Group, Moody's
Investors Service.............................................. 11
Morrison, Steve, Professor and Chair, Department of Economics,
Northeastern University........................................ 11
Sokel, Stuart R., Director, Deutsche Bank Commodities Group..... 11
PREPARED STATEMENTS SUBMITTED BY MEMBERS OF CONGRESS
Carnahan, Hon. Russ, of Missouri................................. 48
Costello, Hon. Jerry F., of Illinois............................. 49
Oberstar, Hon. James L., of Minnesota............................ 70
Porter, Hon. Jon, of Nevada...................................... 72
PREPARED STATEMENTS SUBMITTED BY WITNESSES
Baggaley, Philip................................................ 37
Kiefer, Mark.................................................... 51
Matesanz, Maria................................................. 58
Morrison, Steve................................................. 63
Sokel, Stuart R................................................. 00
ADDITION TO THE RECORD
Air Carrier Association of America, Edward P. Faberman, Executive
Director, statement............................................ 75
CURRENT SITUATION AND FUTURE OUTLOOK OF U.S. COMMERCIAL AIRLINE
INDUSTRY
----------
Wednesday, September 28, 2005,
U.S. House of Representatives, Committee on
Transportation and Infrastructure, Subcommittee
on Aviation, Washington, D.C.
The committee met, pursuant to notice, at 2:00 p.m., in
room 2167, Rayburn House Office Building, Hon. John L. Mica
[chairman of the subcommittee], presiding.
Mr. Mica. I would like to call this hearing of the House
Aviation Subcommittee to order.
Welcome everyone today.
The topic of today's hearing centers on an important
subject: the current situation and future outlook of the United
States commercial airline industry. We only have one panel
today so I am going to let the panelists go a little bit longer
and talk about eight minutes. We have assembled hopefully some
of our Country's best minds on the subject and we will hear
what the professionals have to say.
The order of business will be opening statements by
members. I will start and then we will hear from the panelists.
I do have a request. We have Ms. Schmidt, a member who has
requested to participate in our hearings. The normal procedure
is I will ask for unanimous consent for you to participate and
in doing so, also you will be the last to be heard or last to
offer questions. So, welcome. I ask unanimous consent to allow
Ms. Schmidt to participate in today's hearing.
Mr. Costello. Without objection.
Mr. Mica. So ordered. Thank you and welcome.
We will start with my opening statement. Today's hearing
will focus on the current situation and future outlook of the
United States commercial airline industry. Looming changes in
our Federal bankruptcy law and fuel prices helped send Delta
and Northwest into bankruptcy earlier this month.
Unfortunately, this is just the tip of an iceberg of challenges
that America's airline industry has experienced over the past
four years.
The airline industry in the United States lost some $32
billion during this time period and it may face an additional
$9-$10 billion loss which is projected for this year, 2005. An
economic slowdown, declining business travel, increased
competition from low cost carriers, the 9/11 terrorist attacks,
the SARS epidemic and rising fuel costs have all contributed to
the industry's unprecedented losses. After surviving all of
these challenges, despite these great obstacles, in the last
quarter, American, Continental, United and several discount
carriers reported small operating profits.
Until yesterday, when US Airways emerged from bankruptcy to
merge with America West, almost half the capacity of the
airline industry was flying in bankruptcy. Most legacy carriers
have made cuts in labor, operational and also their
administrative costs. Unfortunately, their only other option to
bring about further reforms has been bankruptcy.
While the airline industry is no stranger to bankruptcy,
having so many major carriers in bankruptcy certainly does get
everyone's attention and it has. Historically, airlines have
failed at a much higher rate than most other types of
businesses. The airline industry has the worst financial
performance of any of our major business sectors. While the
industry has enjoyed some profitable years, airline operators
as a whole have lost money since deregulation in 1978.
This instability has been attributed to the highly cyclical
demand for air travel as well as the structure of the industry,
which has very high fixed costs and few barriers to entry. Some
argue that the industry's current problem is over-capacity and
the bankruptcies, to the extent that they reduce capacity, will
help solve the problem. While such capacity reductions may
offer temporary relief, history has shown that the growth of
airline industry capacity has continued unaffected even by
major liquidations.
According to the Government Accountability Office, only
recessions, which curtail the demand for air travel, and the
September 11 terrorist attacks appear to have caused the
airline industry to reduce its capacity. This indicates that
other airlines quickly replenish capacity to meet demand. Low
cost carriers, in particular, are continuing to take delivery
of new aircraft and expand their capacity. For example,
Southwest Airlines continues to grow at an 8 to 10 percent
annual rate and Jet Blue at almost 30 percent annually. In
addition, there are 17 new entrant airlines currently awaiting
certification by the Department of Transportation.
One bright spot for legacy carriers is the continued
profitability of international routes where there is less
competition from low cost carriers. In adjusting to their new
economic realities, legacy carriers have made flying abroad a
priority and sometimes they shift aircraft from domestic to
international flights and start new service to foreign
destinations as we have seen. For example, Delta's plan for
recovery included reducing mainline capacity by 15 to 20
percent and increasing their international flying by 25
percent.
Under President Bush, negotiators from the Department State
and Transportation have reached agreements with countries such
as India, Vietnam and Mexico as well as others to open
international routes to U.S. carriers. These efforts are
important and hopefully will be of assistance to our legacy
carriers.
The airlines' financial woes may also impact our airports.
Sometimes their financial problems do go beyond just the legacy
carriers. Airports that serve as secondary hubs for financially
weak airlines are particularly at risk because reductions in
connecting passenger traffic can end up leaving a void too
large for other carriers to fill. For example, flight schedules
have been reduced by US Airways at its Pittsburgh hub and more
recently by Delta at its Cincinnati/Northern Kentucky hub,
leaving these airports with decreased revenues.
An airline's withdrawal from a hub can also leave an
airport over-extended relative to its remaining passenger and
revenue base. They take on pretty significant obligations and
we see the results for these airports. For example, when US
Airways withdrew from Pittsburgh, that airport was left with a
financial responsibility for the new terminal building that it
had built specifically for US Airways operations. In addition,
Fitch Ratings recently revised its outlooks for the Detroit,
Minneapolis and Memphis Airport bond ratings from stable to
negative based on their concerns that the risk to financing at
those airports may increase during Northwest's bankruptcy.
I think this also poses an issue for this Subcommittee and
our efforts to improve infrastructure at various airports
across the United States and we are putting hundreds of
millions and some billions of dollars in improving the
facilities and airports themselves. This does raise some
serious issues that our Subcommittee needs to address.
For our hearing today, we have assembled a panel of airline
industry, financial experts and academic professionals. I look
forward to hearing the views of our witnesses. We don't have
any associations here. I do welcome any associations that want
to submit for the record. We will leave the record open for a
period of two weeks so they may submit commentary on this
important hearing and their recommendations.
With those lengthy but necessary comments and caveats, I
would now recognize the outstanding Ranking Member of this
subcommittee, the gentleman from Illinois, Mr. Costello.
Mr. Costello. Mr. Chairman, thank you and thank you for
calling this hearing today. I also welcome the witnesses that
are here. I will submit my statement for the record and
summarize it.
As you indicated, since the terrorist attacks of 2001, we
have seen the airline industry lose about $32 billion,
staggering fuel prices, thousands of people have lost their
pensions and health care and in the last two weeks, Northwest
and Delta both have filed bankruptcy. I have no doubt that
thousands more will lose their pensions and health care in this
coming round of the bankruptcies that were just filed. With
close to 50 percent of our domestic aviation capacity in
bankruptcy up until yesterday, we need a frank assessment of
the short and long term condition of the industry.
It is difficult to gauge how much the industry's current
conditions can be attributed to September 11. We all know that
legacy carriers were in trouble before September 11. The legacy
carriers, in my judgment, failed to adjust their business plans
to economic trends that began long before September 11,
including business models that depended on extracting a premium
fare from business travelers.
In fact, the premium fare for business travelers amounted
to a significant amount of revenue for the legacy carriers.
When the economy started to tighten in 2000, the business
traveler shifted and went from the legacy carriers to the low
cost airlines. Indeed, low cost carriers are a significant
force in the aviation industry today with a combined domestic
Origin and Destination (O&D) market share of about 30 percent
up from 23 percent just a few years ago.
In addition, the aviation industry and the Nation as a
whole is faced with record high fuel cost which has stymied
growth. According to the ATA, the Air Transport Association,
the industry's jet fuel expenses could increase by $9.2 billion
in 2005 alone. The ATA also projects industry-wide net losses
this year of approximately $9-$10 billion.
Some have suggested ways to save the airline industry. ATA
has called for a repeal or the suspension of certain taxes and
fees, a move, in my opinion, that would wreak havoc on our
Aviation Trust Fund and does not take into account the fact
that other modes of transportation and consumers are also
suffering from high fuel prices. In fact, the amount paid in
fuel taxes for 2005 is expected to be $600 million, well short
of the $10 billion projected net industry losses. We should not
make such policy decisions in a vacuum.
Some current and former airline CEOs and others have
suggested other ways to save the industry. Robert Crandall, the
former Chairman of American Airlines, wrote an op ed recently
in the Wall Street Journal suggesting that the bankruptcy laws
need to be changed. He suggested, ``You say, look, if you fail,
you liquidate.''
In addition, Mr. Crandall and others have suggested that we
have too much capacity in the system. Crandall states, ``The
capacity never comes out. It takes all the guys that haven't
gone bankrupt and drives them into bankruptcy.'' He and others
have suggested that in addition to changing the bankruptcy
laws, we should remove perceived barriers to consolidation. In
fact, ATA agrees that consolidation and capacity reductions are
needed. Yet, it is still not clear to me that any one of these
proposals or all of them together will provide the much needed
fix for this ailing industry.
I hope that our witnesses today will address those issues.
In addition, I hope that the witnesses will talk to us about
what this subcommittee or what the Congress should be doing in
the future for the industry. When we get into questions, I will
be interested in knowing not only how you feel about the
proposal from ATA about the temporary suspension of the fuel
tax, about the capacity issue and also interested in knowing if
the Congress did nothing substantial for the industry, what
would happen in the long and short term.
Last, in addressing all of these issues, the suspension of
the current fees and taxes, current bankruptcy laws and
capacity issue, I hope to hear what solutions you provide and
will suggest to this subcommittee.
Mr. Chairman, again, I appreciate you calling this hearing.
I welcome the witnesses and look forward to hearing from them.
Mr. Mica. I thank the gentleman.
Mr. Coble?
Mr. Coble. Thank you, Mr. Chairman. I will not take the
five minutes.
I commend you and the gentleman from Illinois for having
scheduled this hearing and express appreciation to the
panelists for their attendance.
The future outlook of the United States commercial airline
industry is an area of our commerce that needs thorough
examination. I like to avoid use of the word ``crisis'' because
it is so obviously laced with pessimism. There are many people
and colleagues who believe that the U.S. commercial airline
industry is standing in the shadow of a critical situation.
Someone said to me the other day airports are what bus
stations were four decades ago, 45 years ago. By that, I think
he meant the obvious overcrowding, wall to wall people.
Oftentimes when you go to an airport today, and I am not
pointing accusatory fingers at anyone, but a cancellation or a
delay in flight almost becomes the rule rather than the
exception.
I appreciate your scheduling this, as I said, because we
need to examine this before it does become a crisis.
I yield, Mr. Chairman.
Mr. Mica. I thank the gentleman.
Ms. Norton?
Ms. Norton. Thank you, Mr. Chairman, for trying to stay
ahead of the curve on the airlines and it is very difficult to
do but I appreciate the hearings, and this is not the first, on
the state of our commercial airline industry. It is kind of
like a physical exam, only the airline industry has had to take
these physical exams often.
When two major airlines, not the ones most traditionally
troubled, now find themselves in bankruptcy, it is very hard to
know where to go from here or what to think of the industry as
a whole. This much we know. This industry, even more than every
other industry in the Country as a whole, did not need two
hurricanes, Katrina and Rita, and especially not Rita which has
put very special pressure on all of our resources, gas and fuel
resources.
I am concerned that the fuel crisis which does not seem to
abate is putting great pressure even on the lower cost
airlines. You remember at our last hearing there was particular
interest in whether all of them would become low cost and maybe
somehow the industry would be saved that way. I heard the
President say people should not take trips they don't need to
take. Of course the airline industry wants you to take as many
trips as you can.
It is one indication of how the airline industry, every
economic change appears to negatively affect the airline
industry. Conservation, for example, does not appear to be any
kind of solution there, although there is much to be said for
why the Country ought to have an explicit conservation policy
which might then free up some energy for industries like our
airline industry which certainly can't do that.
I just think we need to talk to folks out there and notice
that these are not Government witnesses, so that we can get the
best information and the best thinking we can at this time.
Again, I thank you, Mr. Chairman, and yield back.
Mr. Mica. I thank you.
Mr. Ehlers?
Mr. Ehlers. Thank you, Mr. Chairman, and thank you for
having this hearing.
I would just like to comment. Everyone knows the airlines
are in trouble and are having serious problems. It is perhaps
no an appropriate business model as it has been traditionally
practiced, but I encourage us also to look on the positive side
and what a tremendously positive impact the airline industry
has had upon this Nation over the past half century.
I recall my first flight in a jet airplane, a 707, in the
late 1950s, early 1960s, and that was an incredible experience.
Little did I realize that the first of over a million miles of
travel I would perform on jet airplanes. It has transformed
American life, it has brought families closer together with
more frequent visits, it has changed the very nature of the
Congress.
When I first took office, one of my predecessors, former
President Ford, commented to me that when he was elected in
1948, he moved to Washington with his family and they went home
twice a year, the August recess and the Christmas recess.
Today, most members of Congress go back to their districts
every week and have maintained much closer ties with the public
and I think have been much more responsive to the public as a
result of that.
Air travel has been a very positive thing for the
integration of this Nation, of bringing people together,
developing better understanding and we have to make sure
whatever we do as we discuss these issues we recognize what a
strong, positive effect that has been and that we work together
to maintain a strong airline industry which can continue to
keep the bonds of our Nation firm, but not only that, but give
us opportunity to visit other lands frequently and become
better acquainted with other countries and therefore, make us a
better country in dealing with the problems of the world.
I yield back the balance of my time.
Mr. Mica. I thank the gentleman.
Mr. DeFazio?
Mr. DeFazio. Thank you, Mr. Chairman. Thank you for the
timely hearing on this issue.
My goal in debating this issue over the years has been to
see that we continue to have a system of universal air
transport which serves not only major hubs or profit centers in
the United States' large urban areas, but also medium and
smaller sized cities. I am concerned about whether continuing
total deregulation, a hands-off attitude with perhaps some
liquidations in the industry of so-called legacy carriers, is
going to provide that sort of service to the traveling public,
not only to leisure travelers who seem to be the target model
of many airlines, but to the business travelers.
We are moving toward a very inefficient system where more
and more corporate travel is being done on fractional
ownership. I was riding with a fellow from a not particularly
large company out of Eugene last week, crammed into a 50 seater
from Phoenix to Eugene. He was waxing about how as soon as they
could justify it on the books, which he thought would be real
soon, they were buying a private jet.
So it is that desire to drive out all the people who used
to pay or were willing to pay a premium for access to that kind
of a system and just run a low budget system which may or may
not have international links of any good significance for
leisure travelers who don't quite pay for their cost of
transport. That doesn't seem like a sustainable model.
There are other issues raised or touched on by the
testimony. It seems that the so-called rents attributable to
the refiners have tripled in a year. That is interesting.
People are wondering why is jet fuel so expensive. Well,
because our refinery capacity has been squeezed down to the
point where it is just about adequate to demand and the
slightest burp allows an Exxon-like jacking up of the prices
saying oh, my gosh, we just can't meet the demand, we will have
to jack up prices. The head of the largest refinery in America,
Valero, said the system was working real well for them. Their
stock is up 263 percent a year.
We want to blame the environmentalists and the regulatory
system. It wasn't the environmentalists or the regulatory
system. It was the lack of a regulatory system that allowed the
mergers, the closures and the downgrading in refining capacity
and nothing has been built. Even when George Bush offered to
make military bases available with no environmental
restrictions, the industry said no, we are not really
interested. We are doing well where we are. So we have to look
at those sorts of things.
I am concerned about the idea that somehow we should let
the market squeeze and squeeze and squeeze and squeeze until we
get all the costs out of the system. I think the recent Jet
Blue incident points to the problems there when planes are
maintained in El Salvador by people who may or may not be
qualified mechanics, who may or may not be using approved
parts, who may or may not be enlisted in terrorist networks
because we can save money by maintaining planes in El Salvador.
Meanwhile, mechanics here are put out of work who are doing a
good job, who were regulated, who were overseen, that is good
for the system. That is squeezing out the inefficiencies.
That is pretty essential, your plane can land and you will
live, your plane can't land and you won't live. Most Americans
are willing to pay a slight bit more to know their pilot and
the mechanic are trained and qualified and the plane doesn't
have unapproved parts on it.
I am concerned about how we are squeezing and pushing the
system. I am not sure that cutthroat competition will give us
the service the American people need, particularly many small
and medium sized cities, and it is not going to give us the
safety that we need, particularly with an Administration that
is so derogatory of government and regulation that led us to
the point where we no longer even have a functional Federal
Emergency Management Agency let alone an FAA that has enough
people to oversee the maintenance work being farmed out more
and more.
I think there are a lot of questions raised by this model
and I hope the panel can respond to some of these points and
tell us why it is so great that most carriers are flying full
and still losing money.
Thank you, Mr. Chairman.
Mr. Mica. I thank the gentleman.
Mr. Ney?
Mr. Ney. Thank you, Mr. Chairman and the Ranking Member. I
will be brief.
I want to thank you for the hearing. I think it is
important. The airline industry is important. We have seen that
through Katrina. I have to credit the brave pilots of Jet Blue
last week and the plane they safely landed with 140 people on
there.
Also mentioned before were the bankruptcies and an issue I
would like to know about is if some of the bankruptcies occur,
what happens with the pensions versus those who didn't go into
bankruptcy. Is there a level playing field? Does that have
future repercussions? I think that is important.
Also the airlines are being asked to have cost saving
measures or to increase customer service which I know they want
to do, I still think that has to be analyzed. There are delays,
baggage lost. On a personal note, and I am not going to say the
airlines but I will take it up privately, but our office books
my flights through CATO, the service we have, and then I had to
change it so I called myself and had a lengthy conversation,
about 20-25 minutes.
I arrived at the airport where they asked me to produce my
employee ID because I was booked employee rate. Thank goodness
I didn't accidentally travel on employee rate, and that would
have given people things to look at of, how did you get the
employee rate traveling to Washington. I didn't have an
employee badge, obviously, and then I asked, where did I call.
I can't remember whether it was India or Ecuador but I called
somewhere overseas. The past couple of times I have called
there.
If you talk to the employees, they will tell you that this
may be cost saving to outsource to India or Ecuador or wherever
it was outsourced to but at the end of the day, they said there
are hundreds of mistakes they see coming in as a result of this
outsourcing.
I would like to know has anybody ever looked, in the quest
to save money, does outsourcing overseas come back to haunt the
very airlines that are trying to save money? I don't know if
small issues like that are looked at or not but I think it
should be because saving a dollar but costing the airlines a
lot may not be good for them.
Again, would the bankruptcies result in reduction in
services, cities served and the fate of the thousands of
airline employees? I think it is a topic of utmost importance
to the citizens of the United States.
Again, I want to thank the Chair and the Ranking Member for
the hearing.
Mr. Mica. I thank the gentleman.
Ms. Millender-McDonald?
Ms. Millender-McDonald. Thank you, Mr. Chairman and the
Ranking Member, for holding this very important hearing.
I would like to say to the committee, Mr. Ehlers, a
physicist, after his positive stand on this hearing today, it
was very enlightening, however, the issues facing the U.S.
airline industry are indicative of the challenges that face all
of us. Many of the issues that we will be discussing today,
hopefully, will be issues confronting our national economy in
some capacity and that would be pension reform, bankruptcy
reform, rising fuel costs and a changing and evolving
marketplace.
So I would like to commend our leaders, both the Chairman
and the Ranking Member, today for putting in front of us such a
distinguished and focused panel. The panelists before us now
are not industry representatives, but I am told from leading
financial institutions that offer an outside perspective with
an investor's eye, and that is good.
As we prepare to reauthorize the aviation bill, this
hearing is an excellent first step and I commend the Chairman
and the Ranking Member and look forward to hearing from these
experts on what the next step for the airline industry could
be. Of course I would like to know what the impact of the most
recent wave of bankruptcies will have on the airline industry
as a whole, to what point it will bring us and there are
arguments made that major network carriers are unprofitable now
because their business models are no longer functional.
These are some of the issues that I would like to hear from
you regarding our airline industry. As the Chairman and the
Ranking Member have stated, the industry has lost over $32
billion and it is projected they will lose an additional $9
billion to $10 billion. This is astounding. We do understand
our airline industry is flying in bankruptcy, so it is not a
healthy industry.
I look forward to hearing from all of you today, outside of
the bronchitis that I have. Thank you, Mr. Chairman and Ranking
Member.
Mr. Mica. Thank you.
Mr. Kennedy?
Mr. Kennedy. Mr. Chairman, Ranking Member, I want to thank
you for holding this hearing today and I want to thank all the
witnesses for attending.
We are currently experiencing a time of financial crisis
with the commercial airline industry. As a representative from
Minnesota's Sixth District, this concerns me. As you know,
Northwest Airlines based in my home State of Minnesota declared
bankruptcy two weeks ago. The airline industry is an enormous
economic engine in Minnesota. Northwest Airlines represents
approximately 80 percent of the flights to of the Minneapolis-
St. Paul Airport, they employ thousands of Minnesotans and tens
of millions of passengers fly into and out of Minnesota each
year.
The pensions of tens of thousands of Minnesotans are
foremost on my mind. Over the past four years, U.S. commercial
airlines have lost over $32 billion collectively and it is
estimated that the industry will experience another $10 billion
in loss in 2005.
We all know that skyrocketing fuel prices have become a
burden on everybody, individuals, families and businesses.
Northwest Airlines is no exception. In 2003, Northwest spent
$1.6 billion on fuel. It is estimated that the airline will
spend $3.3 billion on fuel in 2005. When fuel costs are
combined with the climbing cost of pension plans, the results
are a perfect storm. Over the next three years, Northwest must
contribute $3.3 billion to its pensions plans in order to meet
their obligations. The airline has already missed a $65 million
payment to the fund.
Northwest is only the latest of a string of airlines which
have sought bankruptcy protection for these same reasons.
United Airlines and USAir's decisions to terminate their
pension plans gave those airlines an enormous competitive
advantage as they plot to emerge from bankruptcy protection.
United's shortfall of $9.8 billion and USAir's shifting of
further billions in liabilities not only puts the Pension
Benefit Guarantee Corporation at risk, but cuts the guaranteed
benefits for thousands of employees and retirees. Statistics
like this explain why until yesterday almost half the capacity
of U.S. airlines is flying under bankruptcy protection.
Mr. Chairman, we must continue to work with the airline
industry, its workers and retirees to find solutions to this
crisis. I look forward to the testimony of the witnesses today
and I am hopeful that we can determine how to go forward to
protect the ticket buying public, workers, retirees and the
airline industry as a whole.
I yield back the balance of my time.
Mr. Mica. Thank you.
Any other members of the Subcommittee seek recognition? If
no other members of the Subcommittee seek recognition, we will
recognize Ms. Schmidt from Ohio.
Ms. Schmidt. Thank you, Mr. Chairman, for allowing me to
participate in this important review and outlook of our
Nation's commercial airline industry.
I know I am not the only member of Congress with
constituents who have been directly affected by the serious
difficulties facing many of our commercial airlines. Delta
Airlines, which filed for Chapter 11 bankruptcy on September
14, has its second largest hub in my local area at the
Cincinnati-Northern Kentucky International Airport.
According to a 2005 study by the University of Cincinnati,
the airport contributes $4.52 billion annually to the Ohio-
Kentucky-Indiana tri-state economy and supports more than
55,000 jobs through the region. Delta accounts for about 83
percent of the passengers at the airport annually.
When I was sworn in on September 6, I was notified by Delta
of its intention to accelerate its overall transformation plan
which includes realignment of Delta and its subsidiary,
ComAir's services at the Cincinnati-Northern Kentucky
International Airport. Locally, this will result in the loss of
nearly 1,100 jobs in my area. A week later, as I mentioned,
Delta and its subsidiaries filed for Chapter 11 bankruptcy.
I am a strong believer in competition and free enterprise.
I am also concerned at what appears to be difficult economic
conditions including pension costs and the rising cost of fuel
that confront virtually every airline in our Nation. A vibrant,
safe and reliable airline industry is vitally important to our
Country.
I look forward to learning more about the outlook of our
airlines at today's hearing.
On a personal note, as I flew up here yesterday morning,
one of the flight attendants came to me and thanked me for
serving and said that she loved working with Delta, was willing
to take another pay cut in order to keep her job and was very,
very worried about her pension, and asked for my consideration
on that. I am just bringing that to this committee's attention.
Thank you once again, Mr. Chairman, for the opportunity to
participate and for holding this most important hearing.
Mr. Mica. I thank the gentlelady.
If there are no further opening statements, we will
recognize our panel of witnesses today. As I said, we have
assembled some of hopefully the Country's leading experts on
this topic. We have Mr. Mark Kiefer, Associate Principal, CRA
International, Inc.; Mr. Philip Baggaley, Managing Director,
Corporate and Government Ratings, Standard and Poor's Ratings
Service; Mr. Steve Morrison, Professor and Chair, Department of
Economics, Northeastern University; Mr. Stuart R. Sokel,
Director, Deutsche Bank Commodities Group and Ms. Maria
Matesanz, Senior Vice President and Team Leader, Infrastructure
Finance Team, Public Finance Group, Moody's Investors Service.
Welcome to all of you.
As I said, normally we go five minutes. We won't run the
clock in the normal fashion. We will let you go seven or eight
minutes. We want to leave time for questions. We will start
with Mr. Mark Kiefer of CRA International, Inc. Welcome and you
are recognized.
TESTIMONY OF MARK KIEFER, ASSOCIATE PRINCIPAL, CRA
INTERNATIONAL, INC.; PHILIP BAGGALEY, MANAGING DIRECTOR,
CORPORATE AND GOVERNMENT RATINGS, STANDARD AND POOR'S RATINGS
SERVICE; STEVE MORRISON, PROFESSOR AND CHAIR, DEPARTMENT OF
ECONOMICS, NORTHEASTERN UNIVERSITY; STUART R. SOKEL, DIRECTOR,
DEUTSCHE BANK COMMODITIES GROUP; AND MARIA MATESANZ, SENIOR
VICE PRESIDENT AND TEAM LEADER, INFRASTRUCTURE FINANCE TEAM,
PUBLIC FINANCE GROUP, MOODY'S INVESTORS SERVICE
Mr. Kiefer. Thank you, for the opportunity to appear before
you today to hear my comments on this very important subject.
I have a Power Point presentation for you although I would
ask that my prepared statement be made a part of the record.
Mr. Mica. Without objection, the entire statement will be
made a part of the record.
Mr. Kiefer. I will speak directly to the issues that
brought us all here today, namely the current situation facing
the U.S. commercial airline industry, the impact of the recent
bankruptcies and high fuel costs, and also the outlook for the
future of this industry.
I do believe it is fair to characterize the current
situation in this industry as the greatest crisis it has faced
in its nearly 100 year history. We have heard from several
members of the Subcommittee the number, $32 billion in losses
since 2000 and I agree with the assessment, that loss is
expected to reach $40 billion by the end of this year.
At the same time, the millions of shareholders among the
American public that own these publicly traded companies have
experienced over $24 billion in losses in the market value
because of the steep declines in the prices of their shares. We
have also heard that five of the ten largest airlines in the
industry have entered Chapter 11 to this point since the year
2000.
At the same time, well over 100,000 jobs have been lost in
this industry since that time and just recently, in concert
with their announced bankruptcies, Delta and Northwest have
announced the likelihood of additional layoffs. Pay and
benefits have been cut very substantially. You may recall
before their bankruptcy, Delta pilots negotiated pay cuts of
over one-third, and significant cuts in benefits. The failure
of the pensions at United and USAirways have resulted in the
largest pension default in U.S. history. Those airlines that
continue to have pension plans now have unfunded liabilities of
over $14 billion.
The effect of this crisis is felt not just in the airline
industry itself, but in other sectors of the economy. Those
institutions engaged in aircraft finance are having to accept
less favorable terms just to have any business from the airline
industry, aircraft manufacturers and parts suppliers are facing
canceled or foregone orders or delayed orders for their
equipment, and as mentioned, the current environment has caused
a potential funding shortfall in supporting the FAA and its
infrastructure because that system is funded through taxes and
fees paid by the carriers, a large portion of which are based
on air fares.
Not all of the news is bad. I would share the optimism of
Mr. Coble in this regard. The low cost carriers are very
profitable and growing. Southwest has had 57 consecutive
quarters of profit, Jet Blue has had 18. They have weathered
this storm remarkably. In fact, the resulting low fare
environment has produced tremendous benefits to consumers
because they are paying lower prices as a result.
I would like to talk a bit about how we got here and add to
the comments that have gone before. I think there are three
basic factors that have contributed to the current situation.
Business travel has undergone a fundamental reorientation since
2000. At that time, a weakening economy had already begun to
dampen travel and business travelers were becoming increasingly
intolerant of very expensive tickets.
After September 11, 2001, there was a disproportionate drop
in business travel as many corporate travel departments
restricted travel altogether. As a result, there is much more
cost consciousness among the traveling public but among
business travelers as well.
We have heard there have been an unprecedented combination
of challenges that have buffeted the industry since the year
2000, the economic slowdown, the events of September 11, the
outbreak of SARS, the war in Iraq and the dramatic increase in
fuel prices now at a historic high at least in nominal terms.
At the same time, advances in technology have reshaped the
demand for travel. Improvements in teleconferencing and related
facilities have made it less necessary for business people to
travel. At the same time, the growth in online ticket sales has
created much greater, really unprecedented price transparency
so that business travelers are more easily able to seek and
find lower cost alternatives to the traditional legacy carrier
business model of charging much higher fares. At present, low
fares are not the exception but really the rule.
The other important contributing factor in that regard is
that low cost carriers have become an integral and significant
part of the industry. Their market share has almost tripled in
the last ten years and is expected to constitute about one-
fourth of the domestic industry by the end of this year.
The largest domestic airline in the United States is
Southwest Airlines at this point. Jet Blue and Air Tran are now
classified as major carriers by the Department of
Transportation, earning more than $1 billion in annual revenue.
Most of the cities served by legacy carriers are served by at
least one low cost carrier. At the same time, legacy fare
carriers face low cost competition in most of their city fare
markets.
As a result of this significant market penetration, low
cost carriers are now able to dictate price in many markets. It
is important to point out the low cost carrier business model
is not really predicated so much on low cost, but on low fares.
These carriers were designed from the beginning to charge low
prices and their low cost structure is a result of that
imperative.
At the low cost carrier prices, legacy carriers simply
cannot make money with their higher cost structure. The chart
you see before you reflects a measure of the operating
profitability of Southwest and Jet Blue compared to the major
legacy carriers. You can see in the last calendar year, there
was a remarkable difference in that regard.
I would submit to you that deregulation of the industry in
1978 has finally caught up as it were with the legacy carriers.
The legacy carrier cost structure is even today to a
significant extent, a remnant of the regulated era where routes
and fares were regulated by the Civil Aeronautics Board and in
effect, cost increases could be passed on to customers through
higher fares. This made possible higher wages and lucrative
benefits such as pension plans. In effect, there was to some
extent a disincentive to reduce costs because the profits were
in effect a function of costs.
Until recently, legacy carriers faced only limited price
and route competition on a national scale. The legacy carriers
competed mostly with other legacy carriers and hub dominance
and limited competition for nonstop service are a feature of
the hub and spoke networks that the legacy carriers employ. In
the current market environment, the high labor costs which were
possible under the regulated environment have become
unsustainable such that the unfunded pension liabilities now
exceed $14 billion.
You can see from this chart just how much they have grown
in the last four years. That is a reflection in part of the
poor investment performance of these plans. At the same time,
the rising cost of health care, which we have talked and heard
so much about, has produced large unfunded liabilities in the
post-retirement insurance benefits offered by many of the
legacy carriers.
I would submit that conversely, low cost carriers are
ostensibly post-deregulation carriers. They have been designed
from the ground up to compete on price and their cost structure
is fundamentally different, fundamentally lower and their
operating model likewise is designed for low cost.
I would quickly add that I think with respect to the impact
of the recent bankruptcies, I think we will see further wage
reductions at Delta and Northwest, elimination of the pension
plans are likely. Going forward, I think the other legacy
carriers that have not yet gone into bankruptcy will have no
choice but to eliminate their pension plans as well should
Delta and Northwest do so.
I think the low cost carriers are indeed vulnerable because
of higher fuel prices but finally, I would say new aircraft on
the horizon promise greater increases in fuel efficiency and
significant growth in air travel is forecast which I think will
return this industry to financial health in the long term. I
think the prospects are very good in the long term.
Thank you very much for the opportunity to appear before
you today.
Mr. Mica. Thank you.
We will wait until we have heard from all the panelists to
start questions.
Mr. Baggaley with Standard and Poor's Ratings Services,
welcome, and you are recognized.
Mr. Baggaley. Thank you.
Good afternoon. Thank you for the opportunity to testify
today.
I am the Managing Director with Standard and Poor's Ratings
Services and Senior Credit Analyst for the airline industry.
Please see my written testimony which I ask be included in the
record.
Mr. Mica. Without objection, so ordered.
Mr. Baggaley. This afternoon I hope to provide some
perspective on the airline industry's problems by addressing
three related topics: first, what are the principal causes of
the U.S. airlines' current financial problems; second, how are
airlines responding to that situation; and third, what broader
changes might improve the industry's prospects.
First, why are most airlines reporting losses and bleeding
cash in a strong economic environment? Numerous factors have
contributed to the problem and Mr. Kiefer mentioned some of
them. I would say that three stand out in the current
environment: very high jet fuel prices, intense price
competition in the domestic market; and heavy debt and pension
burdens.
Fuel prices are the most serious concern at the moment. Oil
prices have increased sharply over the past year and the future
outlook is for an extended period of high prices. Added to that
is limited refining capacity which has widened the normal price
difference between oil and jet fuel. Exhibit 1 of my written
testimony shows the movement of oil and jet fuel prices this
year with the levels of January 1st set to equal 100. You can
see the heavier line, jet fuel prices, jump above the lighter
crude oil line over the past month due to damage to refineries
in the wake of Hurricane Katrina.
The Air Transport Association estimated recently that the
U.S. airlines will spend $30.6 billion on fuel in 2005 compared
to $21.4 billion in 2004 and double 2003's $15.2 billion. These
and other years are shown in my Exhibit 2.
Even low cost airlines are under pressure. Southwest
Airlines would be operating around break even without its fuel
hedges and Jet Blue recently warned that it could report
losses. Standard and Poor's last week placed our ratings on Jet
Blue on credit watch for a possible down grade.
Most airlines don't have the credit profile that would
allow them to hedge fuel prices without putting up cash
collateral, thereby depleting their reserves of cash. In any
case, hedges cannot undo current price levels, only protect
against further increases. Airlines are trying to raise fares
in response. However, unlike railroads, trucking companies and
shipping lines, airlines don't have corporate contracts that
allow for automatic fuel surcharges. Rather, they must try to
raise fares, a move that requires all the major players to go
along or the attempted fare increase will fail.
The second major cause of the airlines' financial problems
is intense price competition, particularly in the domestic
market. Exhibit 3 in my remarks shows domestic yield and
revenue per available seat mile. Both measures turned sharply
downwards starting in 2001 and have improved little despite
several years of economic recovery. The rapid spread of low
cost airlines and excess seat capacity have prolonged the
pricing weakness.
Over the past year, airlines have managed to raise their
fares somewhat in response to high fuel costs. However, if high
oil prices cause the U.S. economy to slow, that momentum
towards higher fares will likely stall.
The third big financial problem for the airlines currently
is debt and pension deficits. Airlines tend to operate at
higher leverage than manufacturing companies even in the best
of times. Starting in 2001, the legacy carriers had to borrow
heavily to fund losses and maintain adequate cash reserves even
with Federal aid. On top of that, pension plans that were fully
funded in the stock market boom of the late 1990s fell into
deficits when share prices and interest rates fell. Exhibit 4
in my remarks shows the effect for Delta Airlines.
What have airlines been doing in response to all these
problems? First, airline employees have been asked to take
substantial pay cuts, trim their benefits and in some cases,
lose their jobs. Exhibit 5 in my remarks shows broad expense
categories for AMR, parent of American Airlines, in 2002 and in
the second quarter of 2005. Over that period labor costs
declined from 41 percent of total expenses to 32 percent.
Exhibit 6 shows the dollar value of the labor concessions and
of significant other cost initiatives and the large negative
effect of higher fuel costs that offset much of that progress.
The final question that I posed at the outset of my remarks
is perhaps the most important one. Are there broader trends or
changes that could provide an answer to the industry's
financial problems? I will consider three such possibilities:
bankruptcies, mergers and reductions in capacity. Obviously,
bankruptcy signals financial failure but it also gives an
airline tools to correct that situation. Exhibit 7 shows
selected financial data for United Airlines in 2002 when they
entered bankruptcy and from the forecast in their
reorganization plan.
Three items are shown. First, there is some reduction in
debt, mostly through canceling unsecured obligations. The scope
for cutting secured debt and leases is rather less unless
United wants to turn back planes to their creditors, some of
which they have done. Second, the pension deficit was
eliminated by terminating the defined benefit plans. Lastly,
United's forecast shows much lower labor costs by 2006.
Bankruptcy makes it easier for an airline to secure labor
concessions because ultimately the Bankruptcy Court can impose
them.
Delta and Northwest will face similar opportunities and
constraints as they proceed through Chapter 11. Bankruptcy can
help an airline improve its financial prospects, but the
struggles and continued losses of United and the fact that
USAirways paid a second visit to the Bankruptcy Court shows
this is no panacea.
Mergers are a second change often suggested as a cure for
airline problems. Such combinations do allow the merged airline
to capture more passengers but diversion of traffic is by its
nature a zero sum game. What the merged airlines gain, others
lose. Furthermore, these mergers have tended to drive up labor
costs because union cooperation is needed for smooth
integration.
For example, United's proposed acquisition of USAirways in
2000 led management to negotiate an expensive pilot contract
that later helped push the airline into bankruptcy. For these
and other reasons, the track record of airline mergers has been
discouraging.
Fortunately, mergers in the current environment may fare
better, particularly if the acquired company is in bankruptcy.
Consider America West acquisition of USAirways just completed
yesterday. USAirways had already lowered its operating costs to
levels approaching those of America West. As a bankrupt
company, USAirways had the flexibility to rid itself of
aircraft and facilities not needed in the combined airline, and
America West managed to attract significant outside investment
and loans to bolster its cash reserves.
The merged company will still face difficulties in
integrating its two labor forces over the next several years.
Also, outside forces such as high fuel costs could certainly
cause a renewed financial crisis. Even so, acquiring a bankrupt
but potentially viable airline appears to avoid some of the
pitfalls that have plagued previous mergers.
From the perspective of the airline industry as a whole,
the main benefit of airline bankruptcies and mergers is that
they can reduce overall capacity. This should is often
suggested improve the balance of supply and demand and allow
for increased fares to cover added fuel expense. One of the
most frequent criticisms of the bankruptcy process is it has
allowed struggling airlines to survive to the detriment of
their solvent competitors.
There is no doubt that liquidation of a major airline in
bankruptcy would allow the survivors to raise prices somewhat,
however, whether that revenue gain is sustainable would depend
on where the parked aircraft end up and whether the surviving
legacy airlines have competitive cost structures. If the
liquidated airline's planes simply change hands or if low cost
airlines still have a huge cost advantage, then the revenue
benefits would likely erode over time. In other words,
consolidation, whether through bankruptcy, liquidations or
mergers, will help the industry only if accompanied by
withdrawal of planes from the U.S. market and by competitive
cost structures at the survivors.
To conclude, let me summarize my answers to the questions
posed at the beginning of my testimony. First, the dire
financial condition of most U.S. airlines is due principally to
high fuel costs, intense price competition in the domestic
market and heavy debt and pension burdens.
Second, legacy airlines have undertaken significant steps
to trim their losses but these have so far been insufficient to
restore profitability, largely because of the fuel prices.
Lastly, bankruptcy, restructuring and mergers have the
potential to improve the industry's financial health, but only
if accompanied by reduced capacity and most important, by lower
operating costs.
Thank you for your attention.
Mr. Mica. Thank you for your testimony.
We will now hear from Dr. Steve Morrison, Professor and
Chair, Department of Economics, Northeastern University.
Mr. Morrison. Thank you. It is my pleasure to be here
today.
I should note that the statement I submitted was co-
authored with my longtime collaborator, Cliff Winston. When I
say ``we'' in the testimony, I am referring to he and I.
Mr. Mica. Thank you, and we will include the entire
statement in the record without objection.
Mr. Morrison. The airline industry has always been a
cyclical one because the demand for air travel is sensitive to
the level of economic activity and carriers must invest in
capacity well before they know the level of economic activity
and demand. In the current down turn from 2001 to 2004, the
U.S. airline industry lost $13 for each of the nearly 3 billion
passengers it flew resulting in the $32 billion number we have
heard several times here today but the causes of the current
financial state of the airline industry are more complicated
than mere cyclicity.
What the industry is experiencing is unprecedented and is
due to a confluence of factors which have exacerbated the
longstanding and underlying challenge that carriers have of
aligning capacity with demand over the business cycle. To
understand the current situation better, we need to look at
what has happened during the last several years to some of the
key components that determine an airline's profitability, the
number of travelers, the fares those travelers pay, the price
of fuel, wages and salaries of employees being of particular
interest.
As far as the number of passengers goes, the good news is
the traffic in 2004 exceeded its previous peak in 2000 before
the down turn began. I should note that month to month traffic
turned down in February 2001 before the recession began in
March 2001. The recession ended in November 2001 so this
situation goes well beyond cyclicity as I said.
Although the industry is cyclical, year over year traffic
declines are relatively rare and the latest down turn is
unprecedented in that it took four years for traffic to
rebound, but traffic did rebound. The question there is why.
One is the GDP is growing, about 3 percent a year since the end
of the recession.
Another reason is more travelers are feeling that flying is
safe enough for them to travel by air, but perhaps most
important, is that airlines responded to the drop in traffic by
significantly reducing fares. That is good news for travelers
and bad news for airlines. Fares have fallen by 25 percent from
2000 to 2004 after adjusting for inflation. This substantial
decline in fares has only occurred one other time in the U.S.,
namely right after World War II when capacity restrictions were
eased.
Because of the dramatic decline in fares, the rebound in
traffic masks underlying changes in passengers demand for air
travel. Our back of the envelope calculations suggest that air
fares in 2004 generated 17 percent less traffic than those same
low fares would have generated in 2000. Demand has changed.
This raises the question of what has caused this change in
passengers underlying willingness to pay for air travel.
Plausible reasons are that the airlines product has
changed. Increased security leads to earlier arrival at
airports and longer trip times. To quantify this with another
back of envelope calculation, if passengers now arrive at the
origin airport one half hour earlier than previously, then
under plausible assumptions, travel would decline by 7 percent.
Fuller planes, now over 75 percent full on average, the
highest since right after World War II, make travel more
unpleasant. An alternatives to air travel, teleconferencing and
rail travel at least in the northeast corridor, have become
more attractive options. In addition to these considerations,
the traveling public, especially the formerly lucrative
business travelers are less willing to pay fares many times
higher than their fellow leisure travelers.
Fuel, we have heard a lot about fuel. In addition to
unanticipated reductions in travel demand, the industry is
vulnerable to unanticipated increases in costs. Jet fuel makes
up 10 to 30 percent of airlines costs and its price can
fluctuate widely which can have a significant effect on airline
profits.
Relative to the price of jet fuel that prevailed in 2000,
the last so-called good financial year for the airline industry
and one in which the price of fuel was relatively high by
previous historical standards, in 2003 and 2004, the industry
lost an estimated $8 billion due to the higher price of jet
fuel. Given the higher prices in 2005, especially the post
Hurricane Katrina price spike, the industry is estimated to
lose even more.
Before discussing labor costs, it is important to note the
change in the competitive environment of the industry. Since
deregulation low cost carriers have expanded more or less
steadily to the point where in 2004 low cost carriers competed
on routes between metropolitan areas that accounted for over 50
percent of the Nation's domestic air travel. This increased
competitive presence by low cost carriers has put increased
pressure on legacy airlines to reduce their fares and costs.
I should add here that the surprise here is that it has
taken so long for low cost carriers to have this role.
Advocates of deregulation looked at the performance of
Southwest Airlines in Texas and PSA in California and saw that
as the model that would prevail in the Country and it may well
be the case but it has taken 27 years for that to happen.
Labor represents the biggest single category of airline
costs, about 28 percent. Legacy airlines were, by definition,
those that existed during the period when airlines were
regulated. In the regulated environment, there was what
economists call rent sharing as unionized workers and others
sought and received a share of the profits that the regulated
firms earned. Low cost carriers adopted a different style of
labor relations that resulted in lower pay and/or higher worker
productivity than legacy carriers were able to achieve with
their work force.
Legacy carriers have been cutting costs where they can and
since labor is the largest category of airline costs, it has
been the target of cost cutting and enhanced productivity
through negotiation as well as in bankruptcy as the legacy
carriers seek to reduce costs to compete with low cost
carriers.
As a result of these demand and cost shocks, the U.S.
airline industry finds itself with more capacity, high cost
capacity in particular than can be profitably supported at the
fares passengers are willing to pay. This problem will be
rectified if when demand increases, costs are reduced or high
cost capacity leaves the industry. Competition among carriers
will reduce such capacity and may well lead to at least one if
not more carriers to contract, undergo liquidation or be
absorbed by another carrier.
Successful carriers, those that are cost efficient and
responsive to passenger preferences, will be poised to pick up
any slack. Indeed, travelers will gain if legacy carriers make
the required changes to be effective competitors in the new
environment or are replaced by lower cost carriers.
We looked at competition between carriers through the year
2000 that low cost carriers tended to enhance traveler welfare
much more than legacy carriers. That sounds obvious but there
are factors other than fares that affect traveler welfare like
frequency of service. This is an important finding because it
indicates airline markets are working in the sense that those
carriers that enhance traveler welfare are rewarded with higher
profits.
Some have argued that our bankruptcy laws need reforming
because carriers operating under Chapter 11 are able to
artificially reduce their costs and thus drag down healthier
carriers. In previous work, we found the effect of bankrupt
carriers competing against healthy carriers was mixed. For some
bankruptcies competing against bankrupt carriers were helped,
competing against a weakened competitor and others, healthy
carriers were hurt by such competition. On net, the effects did
not merit reevaluation of current policy.
The current situation with nearly 50 percent of carriers in
bankruptcy could well be different but analysis that we have
done so far suggests that is not an area in which to look for a
solution.
Thank you.
Mr. Mica. Thank you for your testimony.
Now we will hear from Mr. Sokel, Director of Deutsche Bank
Commodities Group. Welcome and you are recognized.
Mr. Sokel. Good afternoon.
My name is Stuart Sokel. I am a Director at Deutsche Bank
in New York City. Having spent the last 14 years in the oil
trading industry, my testimony today will attempt to provide
insight into the logistical and economic forces currently in
place today.
Without a doubt, high energy prices are having a major
impact on the Nation's economy and it is imperative to
understand the core issues which are significantly affecting
the United States' commercial airline industry. I invite
questions and comments at any point should further clarity be
required.
In brief, the oil market today reflects a composite view of
global macro economic strength, environmental concerns and
demographic changes, all of which have contributed to
dramatically higher energy prices over the past year. Most
Americans are keenly aware of how limited refinery capacity in
the United States, a point that has been pronounced due to the
damage wrought by the hurricanes in the Gulf Coast region has
meant higher refined product prices. This point only gives a
partial explanation and I believe it needs greater scrutiny.
To start, let us remember what has taken place in the world
since 1998. At precisely the same time that a number of
emerging market countries, for example, India and Thailand,
were rapidly expanding domestic refinery capacity, a financial
crisis in Asia coupled with over capacity from OPEC pushed oil
prices to levels that seem like a mere memory today. Ten dollar
oil was just another session away and many respected
journalists and pundits alike predicted the end of reliance on
oil, Middle Eastern or otherwise. Thus, there was no perceived
financial pressure for airlines to change their operating
procedures.
In retrospect though, this period was a mere blip on the
trend line of growth that has taken place in the world today.
Today, the major United States airlines are competing for the
same marginal barrel of jet fuel that Singapore Airlines,
Quantas and British Airways need for their own fleets.
Seven years ago, domestic passenger demand in India and
China alone was a mere pittance compared to today. In addition,
the environmental regulations of lower sulfur gasoline and
diesel fuel in Europe and the United States have only served to
take the jet fuel market into further deficit given the
continuing difficulty of refiners to adopt to changes in
product specification. In short, the situation would appear to
be dire and it becomes critical to develop a strategy that
serves the industry in the coming years while addressing the
immediate need to remain solvent.
To start, we have to acknowledge that the lack of
investment in refiner and terminal capacity over the past 30
years will not likely suffice for the next 30 years. To be
critical of the oil industry, however, neglects a very
important point. I would like to address one of Congressman
DeFazio's points. The logistical hurdles of building a new
refinery coupled with the questionable return on investment
given history poor margins did not exactly provide the
integrated companies with any major incentives.
It is true that the stock of Valero, for example, has risen
260 percent though I forget the precise number. However, from
1985 to 2000, if you had been managing an equity portfolio,
similar returns would not have been made. So it is a recent
phenomenon that the oil and gas sector in terms of the equity
market has rewarded the sort of returns we have seen over the
last one to two years.
This point may be small consolation for the aviation
industry but it does provide a bit of historical context to the
current dilemma. In order to remedy the supply bottlenecks, the
coastal areas of the United States will need investment in the
downstream sector. By that, I mean the refinery sector and will
also need support from the Congress in order to educate an
electorate which seems very comfortable with the notion of
affordable oil as long as the infrastructure is not in their
specific backyard.
Storage facilities need to be in close proximity to high
volume airports and major markets. Such projects will need to
be environmentally and economically sound but without a
reasonable commitment from all interested parties, the burden
of supplying jet fuel will fall exclusively into the hands of
market forces which will lead to a continuation of higher
prices in years ahead.
I should point out currently it is very likely that a
carrier flying into LAX airport is utilizing jet fuel supplied
from a Korean refiner given the nature of the physical
arbitrage that we see in the oil industry today.
Management of energy risks is an area that many carriers
have neglected in recent years and unfortunately the blame may
be spread around in no short order. Most of the airlines which
did hedge for the current fiscal year have not hedged their
exposure for 2006 and beyond.
In addition, a large percentage of the hedges were placed
in crude oil as opposed to their actual exposure which is jet
fuel. In trading jargon, this differential is commonly referred
to as basis risk. Given the potential for jet fuel to out pace
the rise in crude oil prices, in effect, that is precisely what
has happened this year and the market expectation is that this
will continue.
Anecdotally today, the price of jet fuel has risen by seven
cents a gallon and by virtue of the Air Transport Association's
statistics, each penny increase in the price of a gallon of jet
fuel drives an additional $190 million in annual fuel costs for
the United States airlines.
For airlines that did not hedge or for those which
liquidated hedges due to court ordered instruction, the outlook
remains very severe given the current forward price of
approximately $2 per gallon for 2006. I understand that the
forecast by United Airlines for their 2006 jet fuel costs is
roughly $1.50 per gallon.
It is fair to say that Wall Street can be critical of
hedging activity which is unprofitable or deemed to be
speculative as exemplified by certain refiner activity.
However, the incremental cost of fuel and labor will continue
to play the largest role in the future outcome of the industry.
While labor costs cannot be hedged, oil prices certainly can be
managed in the same manner in which companies monitor their
foreign exchange, interest rate and credit exposure.
There is an adage in financial markets which states the
only thing that can cure high prices is high prices. The
airline industry however suffers from the burden of having to
pay high prices without the flexibility of necessarily
receiving higher fares. Historically, carriers have been loathe
to pass on higher fuel costs in the form of any additional
tariff for fear of being undercut by competition. This has led
to a vicious cycle within the industry, an important matter
left for an airline industry expert to discuss as opposed to an
oil trader.
From my perspective, however, the potential solutions
aforementioned are sound and will allow the forces of supply
and demand to act to the advantage of consumer and industry
alike.
Thank you very much.
Mr. Mica. Thank you.
Now we will hear from Maria Matesanz, Senior Vice President
and Team Leader, Public Finance Group of Moody's Investor
Service. Welcome, Ms. Matesanz. You are recognized.
Ms. Matesanz. Good afternoon. I am Maria Matesanz and I
manage the team at Moody's that rates debt issued by U.S.
airports. Thank you for inviting me to speak today.
Moody's Investors Service is the oldest bond rating agency
in the world. We have been rating bonds since 1909. Today we
have more than 1,000 analysts in 19 countries around the world.
Our ratings and analysis cover approximately 10,000
corporations and financial institutions, more than 20,000
municipal debt issuers, over 12,000 structured finance
transactions and 100 solvent issuers.
In Moody's view, the main and proper role of credit ratings
is to help enhance transparency and efficiency in debt capital
markets by reducing information asymmetry between borrowers and
lenders. We believe that this benefits the market by enhancing
investor confidence and allowing borrowers to have broader
access to funds.
Moody's does this by publishing forward-looking rating
opinions publicly, freely and broadly and by publishing credit
research about debt securities and their issuers. Our credit
ratings are opinions about the future probability of full and
timely repayment of debt obligations such as bonds, notes and
commercial paper. Our opinions are communicated to the market
through a symbol system originated almost 100 years ago which
rank orders relative credit risk on a scale with nine broad
categories ranging from AAA to C.
My comments today will focus on the impact of airline
bankruptcies on U.S. airports. Moody's has ratings on 166 debt
issues at 114 publicly owned U.S. airports. The median airport
rating is A2. This contrasts sharply with the median rating of
B3 for airlines.
Airlines have had a very unprofitable number of years as a
result of extremely low air fares, high labor costs and
increasing fuel costs. The combination of low fares and the
growth in capacity by both the legacy airlines and the low cost
carriers has resulted in very strong passenger and revenue
growth at airports and stable outlook for airport sector
issuers. In most markets, passenger volumes have now exceeded
pre-9/11 peak levels and many airports are experiencing flight
delays due to capacity constraints.
In Moody's opinion, credit quality in the airport sector
has stabilized due to the maintenance of solid liquidity
levels, growth in non-airline concession revenues, management
control over operating and capital budgets and the strength of
the underlying origin and destination service area economies.
Moody's analysis focuses on these factors as key explanatory
variables for the increasing gap between the median airport and
the median airline rating.
Air transportation remains an essential service in our
economy and Moody's believes that because of the difficulty in
building new airports and the long lead time needed for
environmental approvals, existing airports will generally be
able to pass justifiable operating and capital costs on to
airlines and passengers despite financial turmoil in the
airline industry. Given the strategic importance of hub
facilities for legacy carriers and their large investment in
local facilities, certain hubs may even benefit from route
restructuring by their dominant carrier.
For example, when Delta chose to de-emphasize its Dallas-
Ft. Worth hub last year, Atlanta Hartsfield Jackson saw
significant increases in its connecting traffic. Likewise, when
American scaled back its hub at Lambert St. Louis, Chicago
O'Hare saw an increase in connecting traffic. We define a hub
as having more than 30 percent connecting passengers.
With three of the six legacy airlines in the U.S. now
operating in bankruptcy, our focus is on identifying those
airports that may suffer financial stress as a result of cuts
in service, reductions in passengers and revenues as well as
those airports that may suffer a rejection of key airline
leases. Airlines operating in bankruptcy generally continue to
pay airport rates and charges and in most cases do not
radically downsize their operations. These are two important
offsetting factors that help buffer the impact of an airline
bankruptcy on the ability to generate revenue at an airport.
Our analysis will continue to weigh the credit impact of
the bankruptcy filing of an airline on the ratings of its hub
airports. We will also consider such credit fundamentals as the
size and economic health of the origin and destination base,
the financial strength of the airport and the operating
agreements for airlines at each facility.
Hub airports served by airlines in bankruptcy often have
agreements that allow the airport to charge the airlines fees
to recover all operating and debt expenses. The so-called
residual agreements often include a credit for all non-airline
revenue such as parking and rental car fees and food and
beverage concessions as an offset to airline charges. While
some airlines may not wish to pay increased fees, Moody's
believes that the opportunity to serve many of the larger local
markets and the higher fares in some of these markets would be
an incentive for the remaining or new carriers to increase
service and continue to pay the agreed upon rates and charges.
While the bankruptcy filings of Delta and Northwest are
partly the result of certain pressures common to all airlines
such as high fuel costs, rising labor costs, low yields in the
aftermath of Hurricane Katrina, the circumstances surrounding
each filing differ significantly and the resulting impact on
airports may be different. Both airlines will look to regain
their long term business viability by seeking to lower their
costs in a variety of areas. Some of these, for example, labor
costs, are neutral to airports. Strategic decisions about route
structure and capacity reductions on the other hand can have a
significant operational and financial impact on airport credit.
Airports may also be affected by the legal strategy the
airlines adopt regarding their airport leases. Airlines may
choose to reject comparatively expensive or older leases,
especially at airports they are also considering for service
cuts. On the other hand, and as we have seen time and again,
airlines are likely to affirm other leases at airports they
deem strategically vital to their network.
In conclusion, we continue to focus on those airports that
in our view lack one or more of the credit strengths that
support the divergence in credit quality of airports and
airlines. In Moody's opinion, the increased risk that the
airline restructuring process implies will be borne by those
airports with less favorable routes, a high reliance on
airline-derived revenues, a service area that is below the
median in terms of generating demand for air travel, below
average liquidity levels and limited ability to cut airport
operating costs and/or scaled back capital programs.
Thank you again for the invitation to testify. I would be
happy to respond to any questions.
Mr. Mica. Thank you and thank all the panelists. It took a
little time to get through but we don't have any other
witnesses today and we wanted to hear from each of you involved
in looking at the industry and give you an opportunity to make
presentations.
I have a few questions. Unfortunately, there is a
conference going on so we have lost at least half of the
membership but I want to go ahead since you have been patient
and continue with the hearing.
My question for each of you, first of all, is do you expect
additional bankruptcies in the short or the near term and the
long term? Mr. Kiefer?
Mr. Kiefer. I would have to say I am optimistic at the
prospect of American and Continental, the two major legacy
carriers that have thus far avoided bankruptcy. I am optimistic
at the prospect of them avoiding bankruptcy. Certainly in the
near term, there is not a likelihood of that. Their cast
positions are such that it is not likely in the near term.
I think in the long term, American was among the first of
the major legacy carriers to negotiate major concessions with
their union early on in this crisis. Continental has probably
the reputation as the best labor relations among the legacy
carriers and I think the combination of those two things
implies they are likely to be able to negotiate further
concessions in order to avoid bankruptcy.
However, as I mentioned, should Delta and Northwest elect
to terminate their pension plans or convert them to defined
contribution plans, American and Continental will find
themselves to be ostensibly the only major legacy carriers
remaining that offer pension benefits. I think those costs will
prove unsustainable to those carriers in the long term. So
their ability to negotiate those potential reductions in
benefits and costs will be a key factor in their avoiding
bankruptcy in the long term.
Mr. Mica. You answered part of my next question. Let me
give Mr. Baggaley a chance.
Mr. Baggaley. In the near term, I think the most likely
bankruptcy candidate is an airline you are familiar with in
this area, Independence Air. I don't expect that American or
Continental are likely to file unless there are further shocks
to the system such as a further major increase in fuel prices
or terrorism.
Over the longer term, I think I would agree with Mr. Kiefer
that the pressure of the benefits and pensions might cause them
to file for bankruptcy. I would expect what they would try to
do is negotiate outside of bankruptcy to at least reduce those
benefits. Their pension deficits are not nearly as large as
those of Delta and Northwest, so they are not under quite as
much pressure.
Mr. Mica. Dr. Morrison?
Mr. Morrison. I should add that my study of the industry is
not at the firm level and my fellow panelists may be much
better informed than I am, but I will say it wouldn't surprise
me to see another bankruptcy.
Mr. Mica. Mr. Sokel?
Mr. Sokel. I think if the situation in terms of high jet
fuel prices continues in the next fiscal year, it is difficult
to see how you wouldn't have additional bankruptcies unless the
additional costs of operation were passed on to the flyer
because at this point, it strikes me that most of the major
carriers have very little sense of what the outlook really is
in the sense that if they had to hedge at this precise moment.
I don't think any increases in refinery capacity are going to
meet the short term needs of the industry.
Mr. Mica. Ms. Matesanz?
Ms. Matesanz. I would defer answering that question to our
airline analyst at Moody's and I would be happy to report back
his views.
Mr. Mica. I have a question for you and you are sort of our
airport expert. Did you say the airport bonds were at what
rating?
Ms. Matesanz. The median rating for airport bonds is A2.
Mr. Mica. And airlines were B2?
Ms. Matesanz. B3.
Mr. Mica. Do you see any change in that rating for airports
as a result of the current bankruptcies or financial problems
that we have seen over the most recent period of time?
Ms. Matesanz. The median rating is something that moves
very, very slowly.
Mr. Mica. So it would take a while to impact that?
Ms. Matesanz. Exactly, and we don't see any radical changes
in the profile of the sector. We have a stable outlook on the
airport sector as a whole.
Mr. Mica. What should Congress do and Mr. Kiefer, you said
the pension was the big enchilada.
Mr. Kiefer. I think with respect to the question what
should Congress do, with respect to the pension benefits I
suppose one piece of guidance I would offer is that I think it
is likely if not certain in the long term that pensions will no
longer be a feature of the U.S. airline industry. The low cost
carriers have never had them and never will. I think any
efforts at pension reform ought to be aimed at preserving
benefits for existing employees rather than trying to maintain
them for potential future employees because I think they are
likely to go away in that regard.
Mr. Mica. Mr. Baggaley?
Mr. Baggaley. Standard and Poor's has a policy of not
recommending for or against any public policies. I would just
make a note as to the pensions.
Mr. Mica. You have also provided the charts on AMR that
reflect also industry. They cut labor.
Mr. Baggaley. That was $1.8 billion.
Mr. Mica. Right. They are getting hit in the shorts here
with the fuel and they have cut some of their overhead.
Mr. Baggaley. There were various other cost reductions on
the order of $2.2 billion, so one can see just how much of
their progress has been wiped out by the rise in fuel prices.
Mr. Mica. Again, pensions would still be sort of the big
enchilada in obligations and fuel?
Mr. Baggaley. Actually, the largest portion of American and
other airlines' obligations are secured debt and leases.
Pension deficits are significant but they are a minority of the
total.
Mr. Mica. The only way you can restructure those would be
through bankruptcy or negotiation?
Mr. Baggaley. Yes.
Mr. Mica. Dr. Morrison?
Mr. Morrison. I mentioned in my testimony that an extra
half hour early arrival at the airport is estimated at 7
percent.
Mr. Mica. Seven percent. That was interesting. I am going
to use that because I am trying to get them to do in-line
systems and some other things, faster screening.
Mr. Morrison. That is my suggestion precisely. It seems to
me that in the scheme of suggestions, it is relatively
uncontroversial.
Mr. Sokel. I am not entirely sure what can be done in the
short term and the longer term. The Congress should look into
the initiative offered by the Kuwaitis with regards to their
offer to build a refinery within the United States because it
would seem it is a bit of robbing Peter to pay Paul at the
moment.
Mr. Mica. Interesting. Ms. Matesanz?
Ms. Matesanz. Again, I would limit my remarks to the impact
on airport credit and would be happy to provide an answer.
Mr. Mica. So you don't see a big problem and you don't see
that Congress has to step in at this point?
Ms. Matesanz. Again, with respect to the airlines, I would
defer answering that question.
Mr. Mica. Right, but I meant airports.
Ms. Matesanz. As far as airport credit, again, our outlook
is stable for the sector. While airline bankruptcies are
something that we look at closely, particularly for hub
airports, we look at a whole host of other factors that
airports have under their control such as the ability to offset
airline revenues with other sources of revenue, the ability to
cut their operating and capital budgets, their ability to
attract other carriers to those markets through efficiencies in
their own operations as offsets to the credit impact of an
airline bankruptcy on their own operations.
Mr. Mica. I thank all of you for your comments. We don't
have jurisdiction over fuel prices, we don't have jurisdiction
over the four cent jet fuel tax and we don't have jurisdiction
over pensions, but I think it is important that we review the
impact of all of these on the airline industry and if
necessary, take steps where we can assist, but don't underwrite
a failing business operation or model. I have been sort of the
tough guy on the block on this because I think that subsidies
would only temporarily delay the inevitable as far as the
airline business is concerned.
Last, I thought we were doing a pretty good job in
increasing fares and the airlines have increased fares from
February to some time this summer about eight times. That has
helped some of them see at least a minimal operating positive.
I think one of you said all failed to institute price increases
as a competitive area they won't touch. They have done that.
Does anyone want to comment? I just don't see any other way for
them to survive if they don't increase their fares.
Mr. Kiefer. I think one thing that is important to point
out is if we observe any recent fare increases that in addition
to being very cyclical, this business is also quite seasonal.
Fares typically, both for domestic travel and international
travel, will increase in the summer because that is a higher
demand season. That may be something we are observing there.
I would offer one other further comment to the prior
question. I think it is important when Congress looks into this
issue and when you are thinking of what you may do about it, to
think of this issue in the broader industry context which is to
say that some of the same factors that are causing the large
financial losses in the industry, the low cost competition and
so forth, are also affecting the ability of the system to fund
its future infrastructure needs.
I think issues like the proposed fuel tax holiday or
proposals that may soon be on the table to restructure the
Federal Aviation Administration and so forth need to take into
account not only the current but the long term financial health
of this industry. Those proposals that might threaten that
should be considered in that light.
Mr. Mica. Thank you. I agree with that.
Mr. Baggaley? Anyone else?
Mr. Baggaley. Historically, it has been very difficult to
pass through fare increases in the domestic market but this
year the pattern has changed somewhat. As you said starting in
February, there have been a series of increases. I think the
level of fuel prices reached the pain threshold even for the
low cost carriers and they went along with these fare
increases.
The bankruptcies of Delta and Northwest will probably
result in some further withdrawal of capacity and probably out
of the Country because there are other areas where there is
strong demand and that should help that a bit further.
Mr. Morrison. It is safe to say that fares over the longer
term have to rise but it is hard for them to rise in the
current environment with the capacity that is there. Unilateral
action by one carrier won't do it and we generally frown on
collusive behavior which might be in their collective interest
but not in the interest of passengers.
Mr. Mica. Mr. Sokel?
Mr. Sokel. I suspect the problem is that the rate of fare
increase doesn't match the rate of the jet fuel price increase
ultimately.
Mr. Mica. Mr. Costello?
Mr. Costello. Mr. Baggaley, you addressed the issue of
capacity in your statement. In fact, you refer on I think the
last page of your testimony to that where you say
``Consolidations, either through bankruptcy or liquidation or
mergers will help the industry but only if it is accompanied by
the withdrawal of planes from the U.S. market and by
competitive cost structures.'' What do you mean by that? In
other words, regardless if you have mergers, if you have
bankruptcies, whatever takes place, we have too much capacity?
Is that what you are saying?
Mr. Baggaley. Capacity is a partial problem. If you look at
the percentage of seats filled, it is actually quite high and
to the extent that some planes of a high cost carrier are
simply moved out, low cost carriers will expand to fill the
void.
The thing that gives some hope for the current situation is
that with strong demand overseas, some of these planes will be
redeployed there and the legacy carriers are lowering their
costs to be closer to the low cost carriers. Over capacity is a
problem but it is not the sole problem and some of the changes
that have been suggested as potentially helping the industry
work only if it is accompanied by cost reductions.
Mr. Costello. You also say that broader trends and changes
could heal the industry. Elaborate on that.
Mr. Baggaley. They could help somewhat but I think the
industry is going to be financially stretched for the
foreseeable future. The best case scenario is that the legacy
carriers lower their costs, are modestly profitable in the best
of times but still highly leveraged and at risk in a down turn.
The best case is not terribly bright but it is certainly better
than the worst case.
Mr. Costello. The hub and spoke system, is it still an
effective model for the legacy carriers?
Mr. Baggaley. The hub and spoke system can generate more
revenue and there are some very successful carriers overseas
who use it. Also some of the low cost carriers use it, so it is
not pure dichotomy between a Southwest model and an American
Airlines or United model. The problem is that the extra
revenues generated by the system have been shrunk by the low
cost competition and that still leaves them with the higher
costs. So they have been trying to shift more of their flying
overseas, shift more to local markets and lower the costs at
which they operate the hub and spoke system.
All the low cost carriers, they don't have international
operations, they don't have regional feeders so if we are to
serve the Country, there is a place for a hub and spoke system
but it has to operate at lower costs.
Mr. Costello. Mr. Kiefer, I mentioned in my opening
comments about the argument that the legacy carriers are
operating under a business plan that may no longer be
effective, in particular the business traveler, the premium
ticket price made up in the past a major portion of the revenue
going to the legacy carriers. I am wondering if you agree with
that and if so, what changes will have to take place in the
legacy carriers business plan in order for them to get back
into the market?
Mr. Kiefer. I think I would agree with it at least in part
which is to say that the composition of the traveling public
that now exists is fundamentally different than it was four or
five years ago. There is much more price consciousness and so
it is true if the business model is predicated on the ability
to charge much higher fares on business travelers, it is
proving problematic. I think there are business travelers
willing to pay those higher fares out there; the problem is
there are simply not enough of them to sustain the legacy
carrier's profitability.
At the same time, however, legacy carriers do offer certain
premium services such as first class, airport clubs and so
forth which are attractive to business travelers and provide
benefits that are desirable to the extent I don't see them
going away in the long term. They also offer international
services which as we discussed because of their continued
regulation largely do have much higher profitability than
domestic services and so forth. I don't think the business
model is completely broken but I think it is much more
difficult to apply in the current environment.
With respect to the operating model to address some of the
comments of Mr. DeFazio earlier, I think the hub and spoke
system likewise provides some very significant benefits to the
traveling public. It allows the connection of far more origins
and destinations than would be possible with strict point to
point service, it allows the connection to international
gateways which is vital to the air transport system and
finally, perhaps most importantly, it provides connection for
small communities to the air transport network that simply
might not be possible otherwise. So I think it has a lot of
benefits that will probably keep it around for some time.
Mr. Costello. You also mention in your testimony that the
low cost carriers are quite vulnerable to some of the
challenges that face the legacy carriers, obviously high fuel
costs being one. What other challenges do you see for the low
cost carriers and what does the future look like for the low
cost carriers?
Mr. Kiefer. I think certainly fuel is the most significant
of those challenges. Southwest hedges a significant 85 percent
this year at I think $26 or $28 a barrel. Those hedges will
subside in the next few years. They are only hedged I think
about 28 percent on average. I could be corrected on that but
for the other low cost carriers.
I think the other big issue is labor costs. Ironically,
just as we have talked about the very significant cuts in wages
and benefits that the legacy carriers have instituted, if
anything, low cost carrier wages are likely to increase. I
don't ever see them instituting pension plans or post-
retirement, health insurance but it is likely that pay for
those carriers, particularly as they grow and continue to be
profitable, will increase. Labor being upwards of a third of
the total operating costs of the carriers, that will begin to
bear on their future profitability.
Mr. Costello. Mr. Sokel, it is my understanding that a
large percentage of the airlines hedges were in crude oil as
opposed to their actual exposure which is jet fuel. Why was
that?
Mr. Sokel. I think there are a few reasons. The first is
that there was the perception at the CFO level within many of
the carriers that WTI, which is the benchmark in the United
States, is the liquid most actively traded index and therefore
because it is liquid and because it is screen based, New York
Mercantile Exchange based, there was a belief that this would
seem to be a benchmark that was more suitable versus something
that was strictly traded over the counter.
The problem in that perspective is that it doesn't
recognize accurately the fact that in times of extreme demand
or supply restriction or both, such as we have now, you can
have this increasing basis risk and companies that are only
hedged in crude oil lose out on this increase in price in the
actual product. I think another reason is that once one airline
hedges in WTI and another reports that they are hedging in WTI,
it almost becomes the standard for the industry.
Without going into specifics, I would debate that the jet
fuel index as traded in the over the counter market is very
liquid. It takes a little bit more of an understanding of how
it is traded and what the basis is but clearly the difference
between hedging in jet fuel or heating oil or crude oil
probably makes the difference on the bottom line of tens of
millions of dollars.
Mr. Costello. Final question for the panel. Just a brief
response, if you will.
The Chairman asked the question about what Congress should
be doing. I would ask, as I made mention in my opening
statement that Mr. Crandall and others have asked, regarding
the issue of bankruptcy, what he thinks should be done as far
as the bankruptcy laws are concerned, capacity issues and so
on. My question is, what if Congress does nothing? What if we
take no action whatsoever with the issue of bankruptcy, with
capacity, with fees and taxes, what happens to the industry?
Mr. Kiefer?
Mr. Kiefer. I think as I stated earlier, there are
additional job losses that are likely, there is the real
prospect of additional loss of pension benefits for significant
numbers of employees and I should point out in the case of
pilots, this is a very substantial reduction in benefits from
perhaps as much as over $100,000 a year in benefits being
reduced to less than $30,000 a year in benefits.
Having said that, I think inevitably if Congress does
nothing, I do believe this industry will right itself in the
long term and perhaps additional consolidation whether it be
liquidation or even just the renegotiation of benefits will
ultimately provide for the long term financial health of the
industry.
Mr. Costello. Mr. Baggaley?
Mr. Baggaley. If fuel prices gradually decline, that can be
partly covered by fares, I think the legacy carriers will
struggle through. They will shrink, some of them will merge and
as I indicated earlier, they will be financially weak, but
still flying. If there are further price shocks or other
outside shocks, I could certainly see some major carriers
shutting down in bankruptcy.
Mr. Costello. Dr. Morrison?
Mr. Morrison. What if Congress does nothing? I am an
economist so the perspective that I take is one of is there a
market failure that needs correcting? I am unaware of a market
failure in the sense that economists mean it, that needs
correcting. I would agree with my colleagues as to what would
happen in the absence of action.
Mr. Costello. Mr. Sokel?
Mr. Sokel. If Congress does nothing, then the average
American can expect to pay a lot more for their privilege to
fly. In absence of that, you will have increased bankruptcies.
Mr. Costello. Ms. Matesanz?
Ms. Matesanz. Speaking from the standpoint of the airport
sector, the capacity issues that are strained by the hub and
spoke model are something that need to be focused on as far as
facilitating airport expansion at those airports that are
capacity constrained already. That is an area that potentially
need some more study and some more scrutiny as far as how to
expedite the building and development of additional capacity to
support the efficiency and fuel economy by extension of the
airport tenants that serve the airports.
Mr. Costello. Mr. Chairman, I have another question or two
but my time is up and there are other members here. Hopefully,
we can come back.
Mr. Mica. Mr. DeFazio?
Mr. DeFazio. Thank you.
Mr. Kiefer, you seemed to indicate a little sensitivity to
the concern I raised about connectivity of the system. It
obviously can profit the system if it works properly in dealing
with small or mid-sized cities.
What I would like to understand both from you and others is
what do you think is a policy role? I am not sure that markets
are enough to continue to serve those areas especially since,
if we want to talk like economists, we don't take into account
external diseconomies, the external diseconomy being the people
who live in the second largest city in Oregon have to drive 120
miles to the airport in Portland because all of the little
planes that now fly out of our market are overbooked. They are
100 percent full.
So it is kind of a problem. You can't get there at night
any more, but other than that, it is working pretty good. That
is happening to people outside of virtually every major urban
hub in America and most of us do not represent major urban
hubs.
If you look at the GAO studies, that is where the big drops
in air fares have come but in a lot of your smaller, mid-sized
cities, air fares have not been as generously discounted into
those markets and the service is crummier.
The question is as a policy maker, what is the vision for
the system? Are we ultimately going to abandon everything but
say SEATAC and San Francisco and LA on the West Coast and I
don't know what it will be in the middle and a few on the East
Coast because that is where the market takes us? So, you have
to drive 400 miles, that is your problem if you want to fly? We
are losing something here.
Does anyone have any ideas on what we should do as policy
makers as opposed to pointing fingers in terms of dealing with
us?
Mr. Kiefer. I think as policy makers, the Congress has
already addressed the issue of service to small communities
through the Essential Air Service Program.
Mr. DeFazio. It is a pretty lame program and I keep asking
people for a better model.
Mr. Kiefer. I just offer that as context but I think you
raise an important point that while at the same time the hub
model allows more frequent service or connects to more
destinations, the small community, often it does so through
perhaps one airline. That is why I think you observe the much
higher prices that you do in your community or elsewhere from
these smaller communities to the large hubs and so forth.
I am not sure I can offer a direct policy prescription for
that issue but I agree with you that it is not to say that
there are not other issues with respect to the hub and spoke
system and its ability to serve small communities because it
does indeed do it perhaps more frequently but more expensively
as well.
I don't see in the long term however, a reduction in the
number of airports that serve passenger traffic or serve it at
any significant volume because air travel is forecast to grow
over time and if anything, the trend has been particularly
through the advent of regional jets and so forth to add more
point to point service to medium-sized airports rather than
service at very large hubs.
So I think the future is not necessarily bleak for the
smaller or medium-sized cities with respect to their air
service, but I agree that it may not be ideal at present and it
may look a little different in the future. As for how to
reinvent that from a policy perspective, I am not sure I have a
prescription for you at this point.
Mr. DeFazio. Thanks. Anybody else have a comment or idea?
Mr. Baggaley. There is an interesting experiment which will
be rolling out shortly and that is Jet Blue, a low cost
airline, will be deploying large 90-100 seat regional jets and
they expect to expand those throughout much of the eastern half
of the Country. If that works and there are some new larger
regional jets that are very efficient and the pilot unions at
the major airlines, the contracts have been changed to allow
that in many cases, you could see a greater seat capacity
available to some of these communities and therefore, lower
fares. They wouldn't be 100 percent booked anymore.
Mr. DeFazio. Mr. Morrison?
Mr. Morrison. The issue of service to small communities is
something I looked at ten years or so ago and the issues may
well have changed or the situation may have changed, but what I
found then was the level of service and the fares charged which
are certainly higher than others, were based on the less demand
and higher costs attended with lower capacity aircraft, that
they are more expensive to fly, there are fewer passengers
flying so frequency is less, service is definitely less but
there are fewer passengers.
As far as some regulatory type solution or a non-market
solution, I know some local communities make contracts with
airlines guaranteeing some minimum.
Mr. DeFazio. My largest city pioneered that, so it is a
market-based way of attracting people.
If we could, someone referred to going to Europe, people
are going overseas. The question is how are fares set overseas.
My understanding is in Europe everybody is charging a fuel
surcharge and somehow that happens.
I guess it is not a market-based system or it is a market-
based system that somehow tolerates getting a premium for
higher fuel costs and so American airlines have to go over
there to operate so they can make money when the planes are
full as opposed to losing money when their planes are full
here. Can you help me out with that? What is the difference?
Mr. Baggaley. The legacy carriers have expanded their
flying to foreign destinations, they are not flying within
those destinations but transatlantic flights, transpacific and
so forth. There are as yet no true low cost carriers serving
many of those markets, so the fares, at least in the summer,
are higher, the planes are full there are fewer participants on
each route, so they are more attractive.
However, that has its limits. In the past, the
transatlantic market airlines have dumped in too much capacity
and the fares have fallen. At the moment that is the relatively
good area.
Mr. DeFazio. On the issue of fuel, Mr. Sokel, I have been
looking at some analysis of what has happened to refining. It
is pretty interesting. You talked about the historically low
rates of return and I grant you from 1999 to 2004, refineries
were making 22.8 cents for every gallon refined.
By the end of 2004, they were making 40.8 cents, almost
twice as much, and this year they are making $1.10 or somewhere
between $1.00 and $1.10. That is up five times. Were you
talking about the 22.8 cents for historically low rates of
return, the 40.8 cents or were you talking about today's $1
rate of return?
Mr. Sokel. I was talking about really prior even to the
22.8 cents because if we go back to the example of what took
place in the mid-1990s and even in the late 1980s, the
downstream sector has been in a period of significant
consolidation probably for the better part of the last 15 years
and it is really only in this last three or four years that
companies such as Valero, Exxon-Mobil, British Petroleum are
showing significant returns in the refiner sector.
Mr. DeFazio. Would you say at $1 a margin per gallon that
would be enough incentive economically to build a refinery?
Mr. Sokel. That is a very interesting question but I guess
if I listen to Lee Raymond or Sir John Brown, it would seem the
logistics of actually building a refinery in a place that is
commercially viable is still a question that needs to be
answered. There are not too many people sitting in this room
who would like to have a refinery or a terminal capacity put
near where they live.
I think it is a combination of things. How much
environmental legislation needs to be passed if it is
particularly in California, in New York, in Florida and in some
of the major markets. I would imagine in the State of Oregon,
it would also be difficult to hurt the pristine vantage point
that people have by putting a refinery there.
Mr. DeFazio. We are looking at several liquefied natural
gas facilities in Oregon. We are connected to the gas lines. We
aren't connected to the gasoline lines except for one very
small pipeline. That is why they tell us we on average always
pay more than Washington and California. So bringing it into
Oregon wouldn't do you a lot of good because you can't get it
out again.
The point becomes as I understand the President's proposal
which may or may not have been serious but he said that he
would work to waive all environmental laws or could potentially
in an executive manner waive environmental laws to put a
refinery on a closed military base which could likely be in one
of those areas.
It seemed there was a resounding silence from the industry
and when you see quotes like Valero's chief operating officer,
a quote in the Post saying, basically it is working pretty well
the way it is. It kind of reminds me a bit more of California
in the days of the former Enron where our plants are down for
maintenance, markets up, so if we run right on the edge of
refinery capacity, when they shut down, we see a little blip.
We went up 30 cents a gallon in Oregon, even though we are not
in the East Coast network, because of Katrina. That was
interesting.
I guess I am questioning whether there is a market here and
whether we need to look at a little bit of disaggregation in
this industry when you look at the concentration. I would be
curious if you think this is adequate that we have gone to the
point now from 34.5 percent being the top five refineries in
1993 to 56.3 percent and 83 percent in the top 10. I am
beginning to wonder whether we have real market characteristics
here or whether we are seeing a little bit of manipulation and
excess rents or price gouging as some of us call it?
Mr. Sokel. I would almost argue that price gouging occurs
more when the price is low in terms of gasoline than when the
price is high because the level of sensitivity is that much
higher when the prices are high. I think there are more than a
number of national oil companies that would love to be able to
put a refinery in the United States if for no other reason than
to have an outlet for their additional crude oil. Whether that
would be Saudi Arabia or Kuwait or the Emirates, and I can name
a host of others, I suppose it has 30 years or thereabouts
since the last refinery was built in the United States, so most
of the executives who have been with these companies for a long
time can't even remember.
Mr. DeFazio. They don't know how to build them any more.
Mr. Sokel. They might have forgotten or if they do, the
building prospects are mostly in the emerging market countries.
That is kind of the perspective that I have. It is precisely in
the countries that are considered emerging markets now where
most of the refinery capacity has increased over the last
decade.
Mr. DeFazio. The interesting thing there is what are the
profit margins over there?
Mr. Sokel. They are good but they are not as good because
of the simple fact that people don't drive in the same way that
they do in the United States.
The one point I would like to make is that in terms of the
waiver of sulfur, that is an interesting proposal from the
President because a number of the refineries in the Middle
East, for example, produce a higher sulfur of gas oil that
currently does not come into the United States in its natural
form. Were sulfur requirements to be removed, a lot of that
product by normal market forces would find its way into the
United States.
Mr. DeFazio. I think there is a problem with the outfall of
burning the higher sulfur fuels particularly with catalytic
converters and other things I don't think we are going to
recommend we step back from.
Mr. Sokel. The problem is, given the environmental
legislation that would be needed to do that, that is probably a
non-starter.
Mr. DeFazio. Thank you.
Mr. Mica. Mr. Larsen?
Mr. Larsen. Thank you.
A little more about hedges. We are doing our part in
Washington State out of the four refineries located from
northern California to Washington State to the border, four of
them are in my district, so we are doing our part on
refineries.
Mr. Sokel, with regards to hedges, Mr. Costello asked a
question about why hedge on crude oil and not jet fuel and it
seems to me in terms of that regard, nothing government did
stopped or prevented or forced people to hedge into the crude
oil market versus jet fuel, that the decisions made by airlines
based upon whatever advice they got, they made those decisions
to go into crude oil and not jet fuel.
Why make that choice versus Southwest Airlines, if I am not
mistaken, has a better hedge in jet fuel versus crude. What is
the decision-making process that takes place within an airline
so we can understand that because it is not something we are
going to be able to address, nor should we interfere in a
market like that.
Mr. Sokel. It is an interesting set of questions. I guess
you could start by saying that unto each individual airline
goes their own rationale of how to hedge, when to hedge,
whether to hedge at all. There are a lot of concerns that go
into the matter, not the least of which is what happens if we
put on a hedge that loses money and Wall Street says, well, we
didn't invest in your company because we thought you were a
good oil traders, we wanted a pure view on the positive
prospects of the industry.
Just to step away from the aviation industry for a moment,
that is exactly what happened recently with Valero. Valero lost
$300 million on their refinery hedges and more than a few
analysts did say to William Grehee, we didn't invest in your
company because we thought you were good oil traders. We wanted
a pure view on the refinery sector. It didn't matter that the
stock price has gone from $40 to $120 in the last year, people
always found something to moan and groan about.
If I can make a comparison with one of the European
carriers that Deutsche Bank does a great deal of business with,
the way they set it up is they try to mirror the hedging
program actually with their route structure. For example, if
they know they are going to be refueling 70 percent in the
northwest European market, that is where 70 percent of their
hedges go. If it is 10 percent in the Gulf Coast or related
pricing to the Gulf Coast, then that is where they would do it.
In terms of the American carriers, I think Southwest is
probably the best example of having instituted a hedge program
at least that in percentage terms goes out to 2009, I believe
between 30 and 40 percent hedged between 2007 and 2009.
Ultimately it comes down to an individual or group of
individuals saying, we really don't think there will be that
much demand for jet fuel relative to crude and we are trying to
place our hedge in something that will at least reflect the
broader price of oil.
Again, the question of liquidity and transparency typically
is one reason because a typical CFO is not only hedging oil,
they are hedging interest rates, currency, so familiarity may
go to the heart of the matter of how hedges are placed and
certainly when they are placed.
Mr. Larsen. In your view, for future planning for
individual airlines, has the econometrics model that has
existed for the price of the barrel oil permanently shifted up,
is the delta steeper now and should they be thinking about
that?
Mr. Sokel. I think it is a very delicate point because
arguably most airlines are now on the more optimistic side of
their view of what jet fuel prices will be for the next two
years. I am a little bit conservative in my view but I believe
you have to estimate the price of jet fuel as to what the price
would be if you had to hedge 100 percent of your fuel today.
Many in this room would argue that is not necessarily
indicative because the analyst community did not expect to see
$70 right now, they were forecasting much lower price and it is
now for next year they are predicting $60 prices, so the
contrarian in me says maybe there will be lower prices just
because everyone now has suddenly gotten onboard that the
prices of energy are high.
Having said all that, an absent a recession, global
reduction of growth, it is hard to see given the global
situation in jet fuel and with global airlines. I did mention
the demand for the marginal barrel of fuel. It is a fungible
market, the barrel of jet from a Korean refiner to LAX airport,
so on and so forth, has its way of when one market is in
deficit, the other market in surplus provides that market but
all that means an increasing demand period, it just means
higher prices for the extended period.
Mr. Larsen. Mr. Baggaley had some comments about hedging
and Southwest. Do you want to comment on any of this?
Mr. Baggaley. Yes. It is certainly the case that many
airline managements are regretting that they didn't try to put
more hedges in place but the biggest difference between
Southwest Airlines and the legacy carriers is Southwest
Airlines is rated A, a solid investment grade credit. They can
do business in setting up hedges with others because counter
parties will take their credit risk.
For most of the legacy carriers, for all of the legacy
carriers, they would have to put up cash collateral and they
are trying to conserve their unrestricted cash. That is their
last line of defense against bankruptcy. So their choices at
this point have narrowed.
Mr. Larsen. Thank you, Mr. Chairman.
Mr. Mica. I thank all of our panelists. I think you have
answered the question of what should Congress do and what if
Congress does nothing.
I guess that is sort of the question. It looks like we are
headed toward some type of assistance with pension reform which
is also spilling now into other aspects and segments of our
economy. Regarding fuel, we must increase refining capacity and
supply on an expedited basis. Not much is going to happen
there. I think we are at sort of a standoff as to what Congress
can do.
I am glad you all raised the four cents and the ticket tax,
and financing the infrastructure. We talked a bit about
capacity of the airlines interns of seats but we also face a
capacity crunch with airlines as far as a place to land planes.
We can only fit so many planes in so much air space and we are
back to the pre-September 11 capacity issues facing the
industry.
I am concerned about the impact of leaving airports and
others holding the bag so to speak, particularly when it is
necessary to continue increasing capacity for more planes to
land. If you can't have more revenue and you can't do more
business, there is not much hope for the future. That is just a
couple final comments.
I appreciate your participation. We may have some
additional questions. Some of our members were called away for
a conference but we do appreciate your insight and sharing your
opinions, your knowledge, your experience with us. Again, on
behalf of the Subcommittee, we thank you for your participation
today.
We will conclude the hearing. There being no further
business before the Aviation Subcommittee, this hearing is
adjourned.
Thank you.
[Whereupon, at 4:15 p.m., the subcommittee was adjourned.]
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