Why Southwest matters, even if you don't fly them

Have you wondered why airlines choose to implement new fees (like for checking bags) and increase others (like for booze) and not just raise basic fare levels by the $10, $25 or whatever they needed this time to cover the cost of fuel?

Patrick Illing, preparing to board a flight in Newark, N.J., to Los Angeles, said if airlines need to cover higher fuel costs, they should raise fares, not fees on bags.

"This way it's a little sleazier," he said.

Well, the sleazy airlines have raised fares - over a dozen times this year. But the airlines have also reached resistance raising them higher in many markets due to what I call the "Southwest Airlines Effect."

Southwest is the one and only airline that's expected to post a profit in 2008, while other airlines are in the process of hoarding cash to weather what's becoming a "perfect storm" of dramatically increasing fuel prices and the slowing down of the economy. Both are major whammies for the airline industry and the two together? Let me just say I'm glad I'm not working at an airline these days...

So what's Southwest's secret?

Besides great management team and a clear vision of what their product is and who their customers are, Southwest's secret lies in their fuel hedging strategy. The airline hedged nearly 70% of it's 2008 fuel needs at $51/barrel of oil (as a point of reference, oil closed just over $138/barrel on Friday). Other airlines have between 20-30% of their fuel needs hedged. Southwest has 55% of 2009 hedged and 30% in 2010. The resident hero at Southwest is Treasurer Scott Topping who started hedging programs in 1999.

Fuel is, without a doubt, the highest single cost component for any airline. With Southwest paying less than half of their competitors, they are operating with a serious cost advantage. And most expect that advantage to last through 2010. Southwest has chosen to hold fare levels low in the markets they serve and they are flexing their competitive advantage big time.

How do other airlines deal when Southwest has such a significant cost advantage?

In two basic ways. One, they raise fares disproportionately where Southwest doesn't compete with them (and let me thank my lucky stars Southwest flies to my city). Some intel:

Tom Parsons, publisher of BestFares.com, said that travelers flying between two cities where there is no competition from Southwest would pay about $340 more round-trip than they did just six months ago.

"The difference today between flying on a short-haul route where air fares are offered only by one of the top six major airlines are reaching ridiculous dollar numbers compared to short-haul routes served by low-cost carriers such as Southwest," Parsons said.

Second, they've come up with a bright idea of tacking on new fees. If they can add new "revenue streams" outside of the fare level, they can get more revenue while still pricing even to Southwest. It's estimated that American's new baggage policy will add $320 million to the airline, impacting about 20% of their total customers (AA says 50% don't even check a bag and frequent fliers and international flights are exempt from the first bag fee).

Actually, there's a third way...get out of Southwest's way. Drop capacity in the markets (or drop markets) where you just can't win. Conceding defeat is hard of an airline - but it's a helluva lot easier when you're bleeding cash. The effects?

Herb Kelleher, the iconic co-founder of Southwest Airlines...said flying could become something that only business travelers or the affluent can afford, much as it was in the 1950s and '60s.

"You may see a lot less air service across the United States, and that's really a shame," Kelleher said. "We are heading back in that direction."

So why does an airline need to price even to Southwest?

Because you probably won't fly them if they don't - and an empty seat costs an airline more than a seat sold at a low price even if it didn't cover the costs. Get it? As most costs are fixed per plane (fuel, labor, etc.) they lose less with any sale versus no sale.

Airlines have to fight for each customer, and sure, some airlines can price a bit higher if they have more flights, better nonstops, little TVs, etc. But it won't be that much more. So, as Southwest holds fares low - the other airlines are likewise "forced" to hold their fares near that level where they compete with Southwest.

So Southwest matters as even if you don't fly them they are keeping all airlines' fare levels low in the markets they fly - and if you carry on your own bag you can enjoy the fare without the added fees. Will that low fare contribute to the bankruptcy or even death of your favorite airline? Some predict Southwest may be the last airline standing. I'm personally not that dire about it, but I do predict some thinning of the US airline ranks. I'm not naming names but I certainly wouldn't want to be a small carrier without a big-pocketed and risk-taking investor these days...

Southwest Airlines reaps benefits of fuel hedging strategy [LA Times]
Airlines ponder how far they can push customers [Portfolio]
Southwest on the attack in feisty new ad campaign [Finding Dulcinea]