Monday, August 22, 2005

Hardball At 30,000 Feet

Hardball At 30,000 Feet

This fascinating article describes how Southwest Airlines is using its foresight (and financial hedging) to bankrupt the rest of the airline industry.

Essentially, Southwest correctly predicted the rise in oil prices, and managed to lock in 85% of the fuel required for 2005 operations when oil was $26 per barrel. Now, of course, oil is over $60 a barrel.

Rather than using this hedge to fatten its profits while raising prices, Southwest has chosen to use it club its competitors like so many baby seals. Southwest's pricing is so aggressive that without its hedge, it would have lost $116 million during the first half of this year. Of course, it does have its hedge, and thus reported healthy profits of $235 million.

Other airlines are not so lucky. By keeping prices down, Southwest has forced other airlines to match. The result? Red ink.

"An increase in airfares could offset the rising fuel prices and restore some airlines to profitability, but don't expect any large price increases anytime soon. Southwest Airlines is the price leader for the U.S. airline industry. They set price levels that other airlines must match to be competitive. No other airline can substantially raise fares unless Southwest goes along, but Southwest has little incentive to raise air fares. It is in their best interest to keep fares at a level where they can be solvent and all other airlines are unprofitable. The longer Southwest is able to keep fares at today's levels, the quicker its competitors will shrink, retreat from city after city, declare bankruptcy, or possibly even liquidate. This is a war of attrition and Southwest will win as long as its fuel costs are substantially lower than other airlines."

Obviously, Southwest isn't the only airline that could have taken this hedging strategy. But it is the only one that was smart enough or foresighted enough to do so.

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