Even with oil price decline, analysts see major airlines flying un-friendly skies

By Paul Deckelman

New York, June 29 - Oil prices may have backed away over the past two sessions from the historic closing highs above $60 per barrel which they hit on Monday, at least temporarily heartening holders of airline bonds and shares - but until that retreat from those peak levels can be considered more sustained, those securities could again run into turbulence.

And analysts note that sky-high fuel prices are only one of the factors that the CEOs and CFOs of the airline companies have to worry about these days, on top of things like pension obligations, labor costs and big debt service burdens.

The executives of the major hub-and-spoke network carriers like AMR Corp., the parent of American Airlines, Delta Air Lines Inc., Northwest Airlines Corp. and Continental Airlines Corp. have an additional worry - the growing success of such low-cost carriers as Southwest Airlines Co., Jet Blue Airways Corp. and AirTran Airways in grabbing an increasing share of their traditional business.

Given all of those additional problems, even with the relatively small retreat in oil prices seen Tuesday and Wednesday, the so-called "legacy carriers," continue to fly in anything but the "friendly skies" - a phrase popularized years ago as an advertising slogan by another of their number, UAL Corp. subsidiary United Airlines, which is now trying to restructure itself in the bankruptcy courts. United has company in Chapter 11 in the form of reorganizing fellow legacy carrier US Airways Group Inc., which is scheduled to merge with low-cost carrier America West Airlines.

Whether the price is $60.54 per barrel of light, sweet crude for August delivery, as it was at the close of trading Monday on the New York Mercantile exchange, or whether that has come down a bit, to $57.26, as was the case by Wednesday afternoon, it still translates into too-high fuel prices - and "oil is the second-biggest cost factor as far as operating costs go, and the high fuel costs are having a devastating impact on the industry," said airline industry analyst Ray Neidl of Calyon Securities.

He speculated that "if oil was to come down 20% [which would put crude at around $48 per barrel], you might actually have some of these carriers returning to profitability" - but he added that this probably isn't going to happen any time soon, which is why "most analysts are predicting losses this year and next year for most airlines."

Airline analyst Roger King of CreditSights, a New York-based research firm, estimated that jet fuel currently costs around $1.70 per gallon - slightly less than the $1.75 level where it stood at the end of March and early April, but well above the $1.40 area seen in mid-May - and even at that time, the airlines, which were then in the process of reporting their numbers for the first quarter of the year, were lamenting the havoc that escalating fuel prices were playing with their bottom lines.

Besides being linked closely, though not exactly, with the price of crude, jet fuel prices, King noted, are also a function of refinery demand. It is, he said, a matter of "who has most demand on the refineries?

"Generally, refineries are set up to produce gasoline, and that's their best product - they don't sell as much jet fuel as gasoline. So when they figure out how to break up their oil as it comes in, into what the best blend of final products is, jet fuel [frequently] takes a back seat," he said.

With a shortage of domestic refining capacity - there has not been a totally new refinery opened in the United States since 1976; since then the industry has been getting by via piecemeal additions to existing facilities - and with refineries currently running at about 95% capacity, according to industry estimates, there is little room for bumping up total jet fuel output much beyond current levels, ensuring prices will stay high.

Legacy carriers mostly unhedged

Against such a backdrop, the CreditSights analyst noted, the advantage goes to those airlines which had the foresight - as well as the financial ability - to lock in fuel supplies at more moderate prices.

King pointed out that at least as of the first quarter, Southwest, easily the most financially solid of all of the domestic airlines, was 85% hedged at $26 per barrel crude. Alaska Air was about 50% hedged for the year at $30 crude. America West was about 45% hedged against some kind of heating oil option, AirTran had about a 28% hedge for the year, and JetBlue was 22% hedged at $30 crude.

Among the legacy carriers, however, King said that the major old-line carriers in general - and Delta and Northwest in particular - are "basically unhedged, so it leaves them weak relative to Southwest and the others. There's actually more hedging going on with the low-cost carriers than with the major carriers, I guess because they're more entrepreneurial, and also because they have better balance sheets, so their counterparty risk is less. Delta probably could not get a reasonable hedge offer right now if it tried."

While Northwest had a hedge on in the first quarter, "that's gone now. American was slightly hedged in the first quarter, that's gone, and Delta, Continental, United and US Airways have none."

Pension troubles

While fuel prices, as the second-biggest airline expense, are a big part of the carriers' current financial woes - together they have lost billions of dollars since the industry went into a tailspin following 9/11 - they are not the only thing dragging the carriers earthward. Perhaps the biggest millstone around the industry's collective neck is the pension obligations that the older carriers have to the thousands of employees who kept them aloft in previous decades, but who are now retired, as well as to current employees - many of them veterans of several decades of service, who anticipate receiving their retirement benefits after they make their respective last flights.

Delta's chief executive officer, Gerald Grinstein, and his opposite number at Northwest, Douglas Steenland, recently testified before Congress on the need for some kind of federal help on the pensions - otherwise, each executive said, their carriers could find themselves joining United, US Air and a smaller industry player, low-cost operator ATA Airlines, in Chapter 11.

"All the legacy carriers need pension relief, even though American and Continental weren't there" at the congressional hearing, Neidl said. "I still think there's a fair chance they [i.e. Delta and Northwest] can avoid bankruptcy - but come this fall, it's going to be the real test," since fall is a traditionally weak quarter for the industry, with the peak summer vacation travel season over and the end-of-year holiday travel season weeks away on the horizon.

Grinstein and Steenland went before the Senate Finance Committee on June 7 to seek support for a measure, sponsored by Sen. Johnny Isakson, R.-Ga., and Sen. Jay Rockefeller, D.-W.Va., that would let the airlines to freeze current pension benefits and move workers into "defined contribution" plans, such as 401(k) plans. The bill also would give the carriers 25 years to provide funding for benefits already promised.

But their reception was chilly, with the committee chairman, Sen. Charles Grassley, R.-Iowa, complaining that the carriers are in their current plight because the airlines "promised benefits that were too rich, and they and their unions refused to rein in those benefits even after it became painfully clear that the companies could not afford them."

Another committee member, Sen. Jim Bunning, R.-Ky. - a Hall of Fame major league pitcher before he entered politics - fired a verbal bean ball at the executives by bluntly demanding to know "why we should reward lousy management?"

Even so, Grassley - who said 25 years is way too long for the airlines to stretch out their pension funding - indicated that he might support a more modest reform that could help the carriers.

The pension issue was revisited on Capitol Hill last week, when the House passed a measure forbidding the Pension Benefits Guaranty Corp. from using any appropriated money to help bail United out of its billions of pension obligations - but both Neidl and King noted that this was essentially just political posturing with no real impact, since PBGC, as an insurance fund, gets almost all of its money from premiums paid by companies having pensions, not from appropriations.

Delta's excessive debt

King takes a relatively grim view of Delta's prospects, even if Congress were to give it a hand on the pensions.

"They might have to file even if they get some kind of benefit on their underfunded [pension] liabilities, because they have a lot of debt and not enough cash flow." The Atlanta-based carrier, he said, "has too much debt, adjusted for leases and for underfunded pension liabilities, for any reasonable cash flow."

He says Grinstein is trying mightily to keep Delta out of Chapter 11 - for instance, by renegotiating the covenants on its credit facilities from General Electric Corp. and American Express Corp., "so they probably won't go into default on those covenants," and by trying to reduce the amount of outstanding 7.70% notes that the company will have to pay off on Dec. 15 by giving some holders equity in a series of private exchange transactions, the latest one earlier this month. King called the latter tactic "nibbling away, bondholder by bondholder," and predicted that "eventually, they'll get most of that taken out by equity." He also pointed to Delta's efforts to line up vendor financing, and to wring further savings out of its cost structure.

Even so, in view of the company's poor fundamentals, he likened such efforts to "just pushing the deck chairs further towards the back of the boat."

Delta may buy itself some time, but "eventually, all that debt's going to catch up to [Grinstein]," maybe in 2006.

"They're going to have to go [into Chapter 11] anyways, eventually, unless gas drops like crazy and fares go up. There's [only] an outside chance of a miracle happening."

Northwest "further away"

Northwest, he said, "is a little further away from [having to make a bankruptcy] decision. They have more cash relative to their size. They still have to work on getting their labor costs down, which Delta is much further along on."

Northwest is currently locked in bitter negotiations with the union representing its mechanics. The airline tried to end its talks last month, complaining that the mechanics had not acknowledged the need for concessions, and only went back to the bargaining table at the urging of the National Mediation Board.

The airline seeks $1.1 billion in permanent savings from its employees, but so far has only gotten its pilots to go along. It seeks $176 million in cuts from the mechanics, who for months refused to make any concessions, but the union reversed course last week and offered $143 million, which the airline spurned as inadequate. Although the two sides are still formally talking and no strike date has been set yet, Northwest fired a shot across the union's bow with its declaration Monday that it was ready to keep flying even in the event of a strike.

Neidl opined that "the union is not in a position to accept what Northwest is offering. They [the airline] would probably want to outsource most of those jobs. I think there's a real chance of a strike. It's going to be tough for the union to swallow what the company wants and needs."

United "still losing money"

Besides the relative financial weakness of Delta and Northwest, King saw areas of concern in the two currently bankrupt carriers, United and US Air.

Even though it seems to have been successful in its efforts to off-load its heavy pension obligations onto the PBGC, "United is not out of bankruptcy yet, so anything can happen. Anything is possible in a bankruptcy until the final deal is stamped - and that's not for a long time."

He noted that earlier in the week, the Elk Grove, Village, Ill.-based Number-2 U.S. carrier "tried to borrow more money on the DIP loan and actually extend it to the end of March 2006 - even though all last fall, [UAL CEO Glenn] Tilton said he was going to try to come out this summer. He's probably not going to come out 'till next summer - if even that."

Tilton recently told the Chicago Tribune that he expects to emerge from bankruptcy later this year and return to profitability in 2006, but King scoffed "he's dreaming. They just extended the DIP. You really can't come out of bankruptcy unless you have a viable business - and they're still losing money.

"They're going to have to figure out a way to make money. Whether they'll have to cut more costs or prune a lot of their business back that's not profitable, I don't know yet. But they still haven't proved that they can make money - mainly because of high fuel costs."

US Air merger difficulties

As for US Air, he said that its planned merger with America West is fraught with problems, most notably, in the merging of the seniority lists of the two companies, particularly when it comes to the pilots. That, he said, will result in US Air's generally older, better-paid pilots being bumped up to the top of the list while America West's mostly younger, less-expensive pilots are likely to be bumped downward, and some may even be furloughed as the combined company cuts routes and grounds about 50 planes from its merged fleet to remove capacity.

Ultimately, he said, "they're the last people you want to give the hit to, because they're the ones that are making America West a fairly profitable low-cost operation. So merging the lists is going to be a problem."

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