Oil, plain and simple, drives the world's economy.

Oil prices, plain and simple, have been a pain for U.S. airlines.

The price of crude recently surpassed the $65 per barrel mark, and the U.S. commercial airline industry faces likely losses of $5 billion this year. At least one and perhaps two legacy carriers will file for Chapter 11 bankruptcy protection before Oct. 17.

Although the major regional carriers have been sheltered from the impact of soaring fuel prices due to the provisions of their code-share agreements, the jury is still out if the regional carriers will get stung by the higher prices. Economists tell Regional Aviation News that eventually there will be a day of reckoning for the regional carriers, but there is little consensus when that day will ever come.

"At some point, the majors will have to decide if the subsidy they provide to a regional carrier is worth [it]," said David Swierenga, an economist with AeroEcon.

On the other hand, Ray Neidl, an analyst with Calyon Securities, doesn't believe the guaranteed profit margins contained in the code-share pacts between the legacy carriers and the regional airlines will be reduced much further. "In bankruptcy, we believe the legacy carrier would become more dependent on its regional partners and would not want to destroy their borrowing capability for regional aircraft by lowering guaranteed margins much further," he said.

In the last six months, the industry has seen financially strong regionals invest in legacy carriers in order to ensure they can continue to fly. Republic Airways [RJET], Mesa Air Group [MESA], SkyWest [SKYW] and Trans States have all purchased aircraft to be flown for a bankrupt partner, United Airlines [UALAQ].

The Economy

Business and pleasure travel is expected to pick up pace in the next six months compared to last year, said Nigel Gault, an economist at Global Insight that specializes in the travel industry.

In the third quarter, Global Insight expects the U.S. economy to grow at a very healthy 4.4 percent, Gault said. During the second quarter, the nation's gross domestic product grew by 3.4 percent - slightly slower than the 3.8 percent growth rate in the first quarter. "The economy is going to do quite well for the rest of the year. There is evidence in the last month that the economy is actually picking up speed."

With business activity picking up, Gault said business travel should do well.

In addition, personal travel should also be up as consumer spending remains strong and employment continues to grow. Real wages for most American workers have actually grown for the first time in a long time, he noted.

"The main cloud over the travel industry has to be oil prices. At the moment, it hard to say how high prices could go," Gault said.

To the surprise of many, the prolonged high prices have not had the impact on the economy that many experts had predicted.

"It has gone to this level without doing any serious damage to the economy," Gault said. "For the travel industry, it does not seem to have yet made a big dent in what the consumer is willing to do, even with gasoline at $2.42 a gallon. There will be a point where the consumer will cut back, but we don't seem to have reached it."

The traveling consumer may be tolerant of higher gas prices, but the airlines face a competitive situation that makes it difficult to pass on the higher fuel costs. The fare increases that the airlines have been able to pass along over the past year have been "reducing the damage, but not covering the fuel bills," he said.

"The worst thing that could happen is for the fuel prices to stay high and the economy slips into a recession," Swierenga said. "The airlines would be faced with the double whammy of higher costs and decreased revenue."

As 2005 began, Swierenga predicted that the airlines would collectively lose $4.5 billion to $5 billion. "I need to push the forecast to the $5 billion mark. I had calculated that the industry would break even with jet fuel prices at $1.20 a gallon. Prices are now at $1.75 - we have long way to go to get there," he noted.

If the price of fuel were to stabilize in its current range, Swierenga said carriers would have to learn to live with the higher cost structure, which would mean significantly higher fares. Even though Swierenga had earlier predicted a decline in fuel prices for the year, he now sees no reason for prices to come down with the continued high demand triggered by the growing economies in the Far East and continued bottlenecks in the production system. "There is no leeway that suggests prices are coming down. If demand slacks off or more production capacity comes on line, that would clearly suggest prices should come down, but I don't see that happening."

The Southwest Effect

Southwest Airlines [LUV] is not only the consistently profitable airline, it has the power to set the fares in many markets.

With its strong balance sheet, Southwest has been able to buy fuel hedges. This hedging cut the carrier's fuel and oil costs by $196 million in the second quarter, and Southwest is 85 percent hedged for the second half of the fiscal year at an equivalent price of $26 per barrel.

"Southwest doesn't have to pass on higher prices, or it can pass them on only by small degrees," Gault said. "Everyone else has to live with that and follow the lead."

Swierenga said Southwest doesn't feel the pressure to raise its prices while the carriers that compete with Southwest and other low-fare carriers need to raise their prices, but can't, to earn a profit.

Southwest's pricing power is evident even in markets it does not serve. Travelers are attracted to destinations served by Southwest and may spurn resort locations not served by a low-fare carrier, he noted. "It influences the selection of vacation destinations," Swierenga said.

But even as the price of fuel continues to climb, Swierenga said that reality will eventually force Southwest to raise its fares. Next year, Southwest has 65 percent of its expected fuel bill hedged with $32-per-barrel contracts.

The Weak Legacies

The industry's earnings are now tied to fuel prices. "Companies have made great strides to get their costs under control, particularly their labor costs. There have been big improvements in productivity," Swierenga said.

Despite the rise in revenues due to high traffic volumes, and 10 total fare increases (in the $5 to $10 range) this year, most carriers will break even in the third quarter due to the higher fuel prices. However, break-even is not good enough. "This is the time they are normally building up their reserves to make it through the next six months of really tough times. If the barns are not filled up to carry them through the lean period, it will be tough," Swierenga said.

Delta Air Lines [DAL] is a prime candidate for bankruptcy.

"I think Delta should have filed a long time ago," said Daryl Jenkins, a visiting professor at Embry-Riddle Aeronautical University.

"I don't see how they can avoid it," said Ron Kulmann, an airline consultant with Unisys R2A. The new bankruptcy code, which takes effect on Oct. 17, does not give corporations the same flexibility to shed pension obligations that exist under the current law. "That has to have a powerful influence on whether to play by the rules that you understand, or by those where you don't know what will happen," Kulmann said.

Earlier this month, Delta delayed its second quarter filing with the U.S. Securities and Exchange Commission as it negotiated with an undisclosed third-party that would process its credit card charges. The current processing contract expires on Aug. 29 and the potential new vendor is requiring a substantial cash reserve on hand as the contract begins.

"Even though most industry insiders seem to believe bankruptcy is a sure thing," Neidl said, he believes that it "can be avoided - though the window of opportunity is rapidly closing. The carrier faces more pressure from encroachment from low-cost carriers than other legacy carriers, with the possible exception of US Airways [UAIRQ]. If cash levels fall significantly below $1.5 billion with little prospect of additional funds from asset monetization, we believe the company will be forced to file for bankruptcy."

Jenkins thinks Delta should sell its wholly owned regional subsidiaries Atlantic Southeast Airlines (ASA) and Comair.

"I guess the problem is who would your market be. Airline prices are very depressed. You certainly will not get what you would have gotten a couple of years ago," he said.

A number of regional players want to grow and would be ready buyers of either ASA or Comair, Jenkins added.

Neither Jenkins nor Kulmann believe a Delta bankruptcy will lead to a liquidation.

If Delta were to reorganize under Chapter 11, it would have little impact on its regional code-share partners, they said. "I am trying to think of a Chapter 11 that has impacted operations, and I can't think of any," Jenkins said.

As United's and US Airways's partners have learned, regional carriers can survive, and perhaps event thrive, with a bankrupt partner.

SkyWest, Mesa and Republic have expanded their relationships with United as the carrier has shifted more of its domestic flying capacity to its regional partners.

The situation may not be as clear at Northwest Airlines [NWAC] and its AirLink partners, Pinnacle Airlines [PNCL] and Mesaba Aviation [MAIR]. Unlike Mesa, Republic or SkyWest that have diversified their client base, Pinnacle and Mesaba fly for Northwest alone. Furthermore, Northwest owns a small piece of each carrier.

Despite the lack of diversification, Jenkins said he does not believe a Northwest bankruptcy would impact its two regional partners.

Kulmann believes Northwest will file a bankruptcy petition, but Jenkins does not.

Northwest is determined to cut $1.1 billion for its payroll. It mechanics may strike instead of grant the company the pay cut. Northwest has been taking steps to weather any possible strike and it is prepared to fire the union members and hire replacement workers. "Northwest has positioned themselves to get what they want one way or another," Jenkins noted.

"I don't see how they can weather significant operational difficulties," Kulmann said.

Even before the strike deadline, Northwest on Aug. 10 used two planes provided by Champion Air, a charter company that flies Boeing [BA] 727s, because an unusually large number of Northwest mainline aircraft were out of service. The move provoked its pilots, who last year agreed to the company's give-back request, to file a grievance.

"We believe the carrier will try to work through the strike and, barring government interference, it will be successful in replacing the union with sharply lower-cost outside contractors," Neidl said. "The main question is whether the company will maintain the cooperation of the pilots."

The situation at Northwest and at other financially troubled network carriers may cause regional carriers to "question where they fit in," Kulmann said. "If there is a significant failure, they could become [major domestic] carriers in their own right. I don't think there is any question if they would continue to exist. They provide a necessary link in the transportation system.

"The majors are flying more international routes and more of the domestic flying has been turned over to regional partners. The regionals could be asked to pick up more of the slack," Kulmann added.

Independence Air

Kulmann, Jenkins and others point out that in the future, a regional carrier could function on its own. They point to Independence Air [FLYI] as the example. However, they quickly add that the near-bankrupt Independence is not a good role model.

Independence lost $202 million in the first half of 2005 as it struggled to fly a network of 50-seat RJs and Airbus 319s. The carrier burned through its cash reserves so that it ended June with $66 million on hand as it faced $53 million in second-half payments. Its cash burn in the first six months was $192 million.

Standard & Poor's revised its credit watch to negative as the company talked of the need to file for Chapter 11.

"I have been very disappointed in their operations over the last year," Jenkins said. "If they can keep their schedule trimmed, they seem to be getting traffic. There is a lot more strength this year in pricing. They now need to pay attention to pricing."

Neidl said that with oil over $60 a barrel FlyI "will face potential bankruptcy and even possible liquidation this fall."

Six months ago, analysts were using the term liquidation in the same sentences with US Airways, but now the tune may have changed.

US Airways likely will merge with America West Airlines [AWAC] to exit bankruptcy this fall. The shareholders of both carriers are set to vote on the deal in the coming months.

"I have yet to see a case where taking on a failing company - and not just in the airlines - makes a strong company," Kulmann said.

"I know why US Airways wanted the deal," Jenkins said, "but I am not sure why America West did the deal."

>>Contacts: David Swierenga, AeroEcon, (703) 255-3315; Nigel Gault, Global Insight, (781) 301-9093; Daryl Jenkins, Embry-Riddle, (540) 364-6913; Ron Kulmann, Unisys R2A, (510) 729-6806; Ray Neidl, Calyon Securities, (212) 261-4057.<<