Since moving back into the black in 2010, the sustained profitability of North American carriers has been one of the brightest spots for the airline industry.
Amid continued tight capacity discipline, leading North American carriers posted collective profits of over $7 billion in 2011 - though net profits were much lower, in part hit by heavy losses at American Airlines parent AMR. Having striven so hard to reach profitability, there is a determination to retain it, which is evident in their performance so far this year. This was underlined when IATA's eurozone-woes-dominated recent global forecast for 2012 quietly lifted projected North American carrier profits by $500 million.
Costs and capacity remain the focus of carriers in North America. The former is largely a story of fuel and its history as a leading indicator of demand, while the largest airlines continue to maintain bearish attitudes towards the latter as they focus on improving return on invested capital (ROIC).
Fuel is the "largest and most volatile cost" for airlines in the region, notes industry body Airlines for America (A4A). The price of jet fuel has fluctuated from around $120 per barrel at the beginning of January to nearly $140 per barrel in March, before settling to about $110 per barrel at the end of June, according to the organisation's calculations.
This volatility results in varied losses and gains for air carriers. In June, Delta Air Lines predicted it would take an $800 million writedown on its fuel hedges and realise losses of $155 million in the second quarter because of declines in the spot market price of jet fuel.
One way Delta has addressed its fuel bill is through buying the Trainer oil refinery in Pennsylvania from Phillips for $180 million. The Atlanta-based carrier hopes that the refinery deal will result in about $300 million in annual savings once the plant begins operations later this year. However, more than $100 million in upgrades are needed first.
Delta's approach to fuel is innovative, to say the least, and other carriers as well as market analysts are watching closely to see if it will succeed. Others, such as US Airways, have opted instead not to hedge jet fuel and are expected to benefit from the declines in the price of jet fuel in the short- to medium-term. But the downward slide in the price of oil may not be a good thing.
"Historically, large changes in fuel prices have been a strong predictor of economic activity - and underlying demand for air travel," William Greene, senior transportation analyst at Morgan Stanley, said in a recent report. This could mean a decline in passenger demand, which, he says, typically lags behind fuel by three to four quarters. Demand is already slowing. IATA data shows traffic in RPKs increased only fractionally in North America in May, compared with a 1.3% year-on-year increase a month earlier. Traffic is running 1.9% higher for the year to date, but that compares with the 4.1% year-on-year growth seen for the same period in 2011.
But at the same time, IATA notes that carriers in North America have the highest load factors globally, at 83.4%, because of their continued capacity discipline.
Airlines have yet to officially acknowledge a slowdown. In a June investor update, United Airlines reported a 2.1% increase in six-week domestic advance bookings, and Alaska Airlines reported that bookings were up to 3.5% higher through August.
However, one industry analyst notes that continued capacity cuts are a signal to the market that airlines are not expecting good things in the near term.
North America's two largest airlines, Delta and United, plan to shrink capacity by 1% and up to 1.5% respectively this year. Southwest expects to keep capacity flat, while Air Canada and US Airways are predicting modest increases of 1.5% and 1% respectively.
American Airlines has not released its capacity guidance for the year as it moves through the Chapter 11 bankruptcy reorganisation process, but is expected to cut capacity too. These carriers combined carry the vast majority of travellers in the region.
Smaller and low-cost airlines are still planning growth. Allegiant Air, Hawaiian Airlines and Spirit Airlines plan to increase capacity by double digits this year, while Alaska Airlines, JetBlue Airways and WestJet all plan mid-to-high single-digit increases.
However, these increases will have little impact on overall capacity as a result of these carriers' relatively small share of the North American market.
no growth for growth's sake
"Maintaining capacity discipline is a challenge," says Jamie Baker, an analyst at JP Morgan. "US airlines need to make sure they don't succumb to the temptation to grow for growth's sake. The industry can't afford for anyone to fall off the wagon."
Capacity cuts and continued discipline have led to rising airfares, improved margins and higher ROIC at airlines in the region in recent years.
US Airways' continuing pursuit of a merger with American could result in further decreases in the coming years. Details of what a combination of the two airlines would look like have yet to emerge, but it is widely expected that a merger would result in some capacity cuts, as did the mergers of Delta and Northwest Airlines in 2008 and United and Continental Airlines in 2010.
In a recent report, Morgan Stanley estimated that a merger between the airlines could result in a "mid-to-high single-digit" reduction in capacity at the merged entity. Assuming a 9% cut, this would translate into about a 1.6% reduction in overall US passenger traffic, based on 2011 numbers from the US Department of Transportation.
"Consolidation is positive for airline fundamentals in a number of ways," Morgan Stanley's Greene said in the report. He cites more rational fare pricing, labour expenses and capacity trends as being benefits of consolidation.
US Airways expects American to begin discussions on a potential merger following the bankruptcy court judge's ruling on its labour contracts, which is expected in mid-August.
North American carriers are also looking at other ways to address costs and boost returns. Delta received approval from its pilots to implement a dramatic restructuring of its regional fleet that could result in lower costs per passenger in June. Under the plan, it will remove 218 50-seat regional jets, which have some of the highest per passenger costs in the industry, for a total of 125 from its regional fleet by 2015 and will add 70 76-seat regional jets to its contract carrier fleets and 88 117-seat Boeing 717-200s to its mainline operations during the same period.
While this will result in a net increase of 4,716 seats in Delta's combined fleets, the airline hopes that it will result in lower costs per passenger and improved margins.
Other airlines are expected to follow Delta's lead. The tentative agreement that American's pilots will vote on in July would allow the airline to add up to 195 large regional jets - those with 66 to 79 seats - and reduce the number of small regional jets. United is expected to pursue a similar strategy as contracts for 55% of its regional fleet expire during the next five years.
What the focus on cost and capacity boils down to at the region's airlines is ROIC. Alaska has become the industry leader on this metric, reporting an 11.7% ROIC in 2011 and maintaining a company target of average annual returns above 10%. All of the region's carriers are now focused on ROIC, and their respective strategies, which include reducing costs and improving margins, reflect this.