Countervailing Cost Currents
As airlines frantically seek savings, there’s good news and bad.
It’s a central tenet of airline economics: All else being equal, more capacity means lower unit costs. But cost control by expansion doesn’t work if all those extra seats fly empty.
As the 2020 Covid pandemic stretches into its ninth month — tenth for some Asian airlines — lots of seats are flying empty. And many more would, had the industry not grounded or retired one-fifth of all the planes flying at the start of 2020. The industry’s fleet count is more precisely down 21% from January, according to IATA. But that greatly understates the contraction. Planes that are still flying are flying less. Larger planes account for an outsized portion of those idled. So in ASK terms, which measures both seats and distance, industry capacity is down not 21% but 62%.
That’s a problem. It means airlines are producing less for every dollar they spend, since many of their spending obligations are fixed — they won’t drop just because you fly less. Fuel is an exception. It’s a cost that does vary by capacity. Some aspects of labor costs are variable too. Many costs associated with buying or leasing aircraft, however, are indeed fixed. Same for lots of overhead costs. Worldwide, IATA estimates that about 50% of the industry’s cost base is fixed or semi-fixed, at least in the short run.
As a reminder, the Covid crisis is a revenue crisis, not a cost crisis. In fact, industry costs are falling dramatically now that there’s an oversupply of everything from fuel to labor to aircraft. But conversely, the diseconomies of scale from shrinking are frustratingly inflationary.
Airlines are simply lucky that fuel is cheap. And if it stays cheap, the recovery will be a whole lot faster and easier when demand does start to revive. Forecasts about when carriers can return to profitability are heavily dependent on this factor. Recovery from the 2008-09 financial crisis, remember, was slowed significantly by three-and-a-half years of $100 oil from 2011 to mid-2014.
Labor costs, by contrast, are not a function of luck. Since the onset of the crisis, airlines have placed high priority on not just lowering their labor costs but making them more variable. Airline jobs are disappearing, increasingly so as government wage support policies expire. Employees that remain are swallowing pay and benefit cuts. At least as importantly, carriers are looking to offset their contraction-related unit cost penalties with changes to work rules — asking employees to work longer hours for the same pay, for example, or to accept seasonal work. Where possible, companies are offering voluntary leave options — agree to depart in exchange for some severance benefits, maybe health insurance for a time, or travel privileges.
In the U.S., according to Airlines for America (A4A), scheduled passenger airlines employed 460k full-time equivalent workers on the eve of the crisis in March. The number in August was 49k fewer. But that’s with federal wage subsidies still active. A4A foresees employment dropping another 41k by December. American alone, after subsidies ended last month, furloughed 19k of its workers. Others have avoided furloughs only after getting unions to accept various cost-saving measures. Airlines, all the while, have indirectly cut jobs by reducing outsourced work, for everything from maintenance to management consulting.
The labor carnage is everywhere. Almost 4k job cuts at Air New Zealand. More than 4k at Singapore Airlines. Almost 9k at Cathay Pacific. Air France/KLM, a company notorious for strikes, has already axed its workforce by 10%, with more cuts coming. In KLM’s case, the Dutch government nearly refused financial aid when the carrier looked like it couldn’t secure sufficient labor concessions due to pilot resistance (they’ve since relented). When it’s not the government in the industry’s corner, it’s sometimes the bankruptcy courts. Other times, the crisis is providing so much negotiating leverage that airlines are able to extract massive concessions from suppliers with only the mere threat of bankruptcy.
As they prioritize labor cost cutting, airlines are no less critically hammering down their fleet costs. That typically means renegotiating lease agreements, frequently with terms that variabalize a portion of the airline’s obligations (through so called “power by the hour” agreements linked to utilization). Carriers are cancelling and deferring plane orders to reduce their near-term capital spending. They’re retiring old less-efficient planes previously kept around only because pre-crisis flights were so full and demand so robust. Some airlines are telling banks and bondholders that they simply can’t repay all the money they borrowed pre-crisis, most of it for acquiring planes. Often, lenders are agreeing to some form of relief.
But despite the many examples of debt relief, airline industry debt is going up, not down. Because it’s not merely the debt they assumed pre-crisis that’s a problem. A bigger problem is all the new debt they’re amassing just to stay alive during the crisis. Fortunately, credit is widely available and interest rates rather low. And there are other avenues still open for obtaining emergency funds, including the aircraft sale-leaseback market. Airlines have sold a lot of shares too, and in some cases received government grants, no strings attached.
The cost picture for airlines, in summary, is mixed. In their favor are once-in-a-generation tailwinds like ultra-cheap fuel, plummeting aircraft prices, and unprecedented leverage to renegotiate contracts with all key stakeholders — labor unions, aircraft lessors, suppliers, lenders, and so on. In the meantime, airlines will emerge from the crisis with much newer and leaner fleets, having removed older planes that previously had a high opportunity cost of retiring. But blowing with force in the other direction are huge new debt cost burdens and those diseconomies of scale from shrinking so sharply.
Airlines worry too that airport costs might rise as operators struggle to cover their own costs in a world with so much less traffic. New aircraft cleaning procedures carry a cost, in part measured by increased aircraft turn times. When considering their variable costs, carriers will see not just their fuel costs rise with greater ASK production but also costs associated with selling more tickets and servicing more passengers, i.e. GDS fees and catering expenses. Decisions to reconfigure planes with more or fewer seats would have unit cost implications as well. The industry hopes to satisfy environmental pressures with its own initiatives to cut carbon emissions, i.e. fleet renewal, but heavier taxation on air travel is a salient risk.
Just how effectively can airlines take advantage of the cost tailwinds? Just how damaged will their cost structures be by the cost headwinds? The net effect of these countervailing currents will help shape the winners and losers of the upcoming Covid recovery. Whenever it happens.