You Think Flying Is Bad Now...

Something has to give as airlines adjust to $130 oil and brace for a record yearly loss. Not all of the majors will survive

by Dean Foust and Justin Bachman

To fully appreciate the impact that soaring oil prices have had on the nation's beleaguered airline industry, consider that U.S. carriers will likely spend $60 billion on jet fuel this year—nearly four times what they paid in 2000. Because of the spike in fuel costs, airlines now lose roughly $60 on every round-trip passenger, a slow bleed that puts the industry on pace to lose $7.2 billion this year, the largest yearly loss ever.

Not surprisingly, Wall Street has become so dour about the industry's prospects—can you say federal bailout?—that the combined market capitalization for the six major legacy carriers and Southwest Airlines has fallen to just over $17 billion. That's about what ExxonMobil (XOM) books in revenues every two weeks. "The U.S. airline industry, as it is constituted today, was not built for $125-per-barrel oil," Gerard Arpey, the chief executive of American Airlines parent AMR (AMR), told shareholders on May 21.

Consolidation Is Likely

While the industry is no stranger to losing money—or reorganizing under bankruptcy, for that matter—experts nonetheless believe that the current crisis has the potential to profoundly reshape the industry in coming years. That means not only far fewer carriers than at present, but forcing the survivors to rethink every facet of how they operate, from ticket pricing to the very way they fly. "The problem right now is that no one knows where the price of oil is going to fall down," says Darryl Jenkins, an aviation expert at Ohio State University. "Right now you're just in kind of the worst of all possible situations. Your planning becomes 'What do we do to lose the least amount of money?'"

If oil prices remain in the triple digits—above the $80-to-$90 break-even level for most airlines—it will accelerate the shakeout that is already occurring in the industry. While many carriers have in the past exploited bankruptcy as a competitive maneuver to cut costs, experts believe that any carrier that falls into Chapter 11 going forward will likely have to liquidate. That would probably include one or more of the major airlines. "I think the real risk this time is not Chapter 11, but [Chapter] 7—liquidation," says a senior executive of one major airline. "What happened to Pan Am? TWA? Eastern? I think there's a real risk here that some airlines just go away."

A court-overseen bankruptcy also could help smooth the industry's transformation if creditors decide the environment is too hostile and agree to sell off valuable assets. Historically, airlines have attracted sufficient funding to operate while restructuring, and new capital when they exit. It's not clear that current market conditions—high oil prices and credit-squeezed lenders—would support that playbook. Airlines with the financial muscle to step in—think Southwest (LUV)—would be interested. Southwest historically has avoided major acquisitions and considers them a steep risk but clearly recognizes potential opportunity in a bankrupt rival. "It just gives the acquiring carrier a tremendous amount of flexibility to impose change that would otherwise be very difficult," says Southwest CEO Gary Kelly, whose company has remained profitable because of long-term fuel contracts.

European Buyers

Analysts say liquidations could well leave an industry consisting of two dominant carriers, most likely the combined Delta (DAL)-Northwest (NWA) and perhaps a combined American (AMR)-Continental (CAL), along with a couple of discount players like Southwest. "I think the industry is going to look more like Europe—a couple of far-flung carriers and then a bunch of little guys," says Roger King, airline analyst for CreditSights, a New York-based institutional research firm.

Experts also believe that the oil crisis will eventually prompt Washington policymakers to drop their long-standing resistance to foreign ownership of U.S. carriers, leading to the first generation of truly global carriers. "The U.S. airlines badly need more capital to survive, and the only players with the resources to buy in are the [cash-rich] European carriers. Why would Congress object to that?" asks Robert Mann, an industry consultant in Port Washington, N.Y.