PILARSKI SAYS… Can dismal science lead us to optimism?

Increasing capacity does not have to be bad news, just follow economics

As featured in Airfinance Journal Column PILARSKI SAYS

Airlines are finally making real money, just like businesses should. In the US, majors made record profits. Often this is linked in headlines to the price of oil: “Cheap fuel helped Delta set record profits.” Ticket prices coming down and traffic going up are related to increased airline profitability. We hear the same sentiments worldwide. Even Lufthansa and Air France, which have not been doing so well recently, recorded significant profits.

The International Air Transport Association, commenting on the sudden surge of airline profits, summarized the situation in the following way: “[There is] softening in global economic growth but there is no sign of adverse impact on RPKs [revenue passenger-kilometres].”

Similar sentiments can be heard globally. For example: “The Canadian economy is technically in recession, but Air Canada reports strong de- mand.” All this does not imply that the traditional strong link between a country’s economy and traffic is broken. In Brazil, for example, airlines are losing money because of the deep economic recession. To understand what is happening, we have to tie a number of factors together: traffic, state of the economy and oil prices.

Mathematically, the relationships are straightforward. Profit is revenue minus cost, with revenue being the product of traffic and yield (ticket prices). Lower oil prices automatically lower costs. The revenue side is more complicated. Traffic is tied positively to the economy and negatively to yields. Assuming lower oil prices stimulate the world economy, they should lead to higher traffic growth. They also should lead to lower yields, further stimulating traffic. The product of lower yields and higher traffic cannot be theoretically forecast.

Lower costs lead airlines to increase capacity and lower ticket prices. Interestingly, this message is misunderstood, misinterpreted and irrationally feared. Let us start with straightforward economics. Price is a function of demand and supply, which together determine an equilibrium price and quantity produced. Even if demand is the same as oil prices fall, the supply curve shifts right because airlines can now produce the same quantity of ASMs (capacity) at a lower price. This results, theoretically, in higher quantity produced at a lower price (more traffic at a lower ticket price), exactly what is happening around the world right now. Following simple economics, this is the only rational outcome that should have been predicted as oil prices fell last year.

So why do some people believe, or want to believe, that this will not happen (lower oil prices leading to increased capacity and lower fares)? One group does not believe oil prices will stay low. As a matter of fact, when oil prices started to fall the industry waited to act until the lower oil prices became a fact. Most chief executive officers of major airlines expressed doubt, as stated by Doug Parker of American Airlines, in February 2015: “Oil has been over $100 for four years and it has been under $100 for four months… we are going to operate American as though we are still operating with $100 oil.

Michael O’Leary of Ryanair, on the other hand, quickly understood what was happening and acted. The reality of lower oil prices is sinking in and most airlines accept this fact now.

The second element is highly related to the peculiar thinking of some Wall Street analysts. Their almost religious belief is that airlines historically did not make money because they sinned by increasing capacity, causing a decline in fares and monumental losses. Hence, to them any suggestion of an increase in capacity, no matter what reason, is almost sacrilegious and produces violent condemnation.  My view is that when oil prices went permanently down, it was a rational development for airlines to increase capacity and lower fares. Yes, it brings back memories of past airline industry mistakes.

Many analysts pine for “capacity discipline” and take suggestions that airlines behave rationally in light of oil price declines as an invitation for disaster. The future, though, can be much brighter.  Lower oil prices must lead to higher worldwide traffic benefiting manufacturers and airlines, assuming they do not repeat past mistakes. Terrorism and other external events notwithstanding, lower oil prices can be a boon for aviation.

So, what will happen? Must lower ticket prices and higher capacity necessarily lead to airline losses? Does increasing capacity equal abandoning discipline, leading us towards the abyss? Not inevitably in my view. Previous capacity increases led to price wars and disaster. This does not need to happen. True, airlines behave very differently in good versus bad times. When times were tough – such as when oil prices were sky high – airlines behaved more rationally. When things were good, they often engaged in destructive and unwise behaviour.

It does not need to happen now when capacity increases are not an irrational prelude to price wars but a rational response to a changing demand-and-supply relationship. Economic principles are not the enemy – bad airline practices are. Increasing capacity may lead to very good times if airlines follow economics.

As featured in Airfinance Journal Column PILARSKI SAYS