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25–912 PDF 2006

CURRENT SITUATION AND FUTURE

OUTLOOK OF U.S. COMMERCIAL

AIRLINE INDUSTRY

(109–32)

HEARING

BEFORE THE

SUBCOMMITTEE ON

AVIATION

OF THE

COMMITTEE ON

TRANSPORTATION AND

INFRASTRUCTURE

HOUSE OF REPRESENTATIVES

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

SEPTEMBER 28, 2005

Printed for the use of the

Committee on Transportation and Infrastructure

(
COMMITTEE ON TRANSPORTATION AND INFRASTRUCTURE

DON YOUNG, Alaska, Chairman

THOMAS E. PETRI, Wisconsin, Vice-Chair

SHERWOOD L. BOEHLERT, New York

HOWARD COBLE, North Carolina

JOHN J. DUNCAN, JR., Tennessee

WAYNE T. GILCHREST, Maryland

JOHN L. MICA, Florida

PETER HOEKSTRA, Michigan

VERNON J. EHLERS, Michigan

SPENCER BACHUS, Alabama

STEVEN C. LATOURETTE, Ohio

SUE W. KELLY, New York

RICHARD H. BAKER, Louisiana

ROBERT W. NEY, Ohio

FRANK A. LOBIONDO, New Jersey

JERRY MORAN, Kansas

GARY G. MILLER, California

ROBIN HAYES, North Carolina

ROB SIMMONS, Connecticut

HENRY E. BROWN, JR., South Carolina

TIMOTHY V. JOHNSON, Illinois

TODD RUSSELL PLATTS, Pennsylvania

SAM GRAVES, Missouri

MARK R. KENNEDY, Minnesota

BILL SHUSTER, Pennsylvania

JOHN BOOZMAN, Arkansas

JIM GERLACH, Pennsylvania

MARIO DIAZ-BALART, Florida

JON C. PORTER, Nevada

TOM OSBORNE, Nebraska

KENNY MARCHANT, Texas

MICHAEL E. SODREL, Indiana

CHARLES W. DENT, Pennsylvania

TED POE, Texas

DAVID G. REICHERT, Washington

CONNIE MACK, Florida

JOHN R. ‘RANDY’ KUHL, JR., New York

LUIS G. FORTUN ̃ O, Puerto Rico

LYNN A. WESTMORELAND, Georgia

CHARLES W. BOUSTANY, JR., Louisiana

JEAN SCHMIDT, Ohio

JAMES L. OBERSTAR, Minnesota

NICK J. RAHALL, II, West Virginia

PETER A. DEFAZIO, Oregon

JERRY F. COSTELLO, Illinois

ELEANOR HOLMES NORTON, District of

Columbia

JERROLD NADLER, New York

CORRINE BROWN, Florida

BOB FILNER, California

EDDIE BERNICE JOHNSON, Texas

GENE TAYLOR, Mississippi

JUANITA MILLENDER-MCDONALD,

California

ELIJAH E. CUMMINGS, Maryland

EARL BLUMENAUER, Oregon

ELLEN O. TAUSCHER, California

BILL PASCRELL, JR., New Jersey

LEONARD L. BOSWELL, Iowa

TIM HOLDEN, Pennsylvania

BRIAN BAIRD, Washington

SHELLEY BERKLEY, Nevada

JIM MATHESON, Utah

MICHAEL M. HONDA, California

RICK LARSEN, Washington

MICHAEL E. CAPUANO, Massachusetts

ANTHONY D. WEINER, New York

JULIA CARSON, Indiana

TIMOTHY H. BISHOP, New York

MICHAEL H. MICHAUD, Maine

LINCOLN DAVIS, Tennessee

BEN CHANDLER, Kentucky

BRIAN HIGGINS, New York

RUSS CARNAHAN, Missouri

ALLYSON Y. SCHWARTZ, Pennsylvania

JOHN T. SALAZAR, Colorado

JOHN BARROW, Georgia

(II)
SUBCOMMITTEE ON AVIATION

JOHN L. MICA, Florida, Chairman

THOMAS E. PETRI, Wisconsin

HOWARD COBLE, North Carolina

JOHN J. DUNCAN, JR., Tennessee

VERNON J. EHLERS, Michigan

SPENCER BACHUS, Alabama

SUE W. KELLY, New York

RICHARD H. BAKER, Louisiana

ROBERT W. NEY, Ohio

FRANK A. LOBIONDO, New Jersey

JERRY MORAN, Kansas

ROBIN HAYES, North Carolina

HENRY E. BROWN, JR., South Carolina

TIMOTHY V. JOHNSON, Illinois

SAM GRAVES, Missouri

MARK R. KENNEDY, Minnesota

JOHN BOOZMAN, Arkansas

JIM GERLACH, Pennsylvania

MARIO DIAZ-BALART, Florida

JON C. PORTER, Nevada

KENNY MARCHANT, Texas

CHARLES W. DENT, Pennsylvania

TED POE, Texas

JOHN R. ‘RANDY’ KUHL, JR., New York,

Vice-Chair

LYNN A. WESTMORELAND, Georgia

DON YOUNG, Alaska

(Ex Officio)

JERRY F. COSTELLO, Illinois

LEONARD L. BOSWELL, Iowa

PETER A. DEFAZIO, Oregon

ELEANOR HOLMES NORTON, District of

Columbia

CORRINE BROWN, Florida

EDDIE BERNICE JOHNSON, Texas

JUANITA MILLENDER-MCDONALD,

California

ELLEN O. TAUSCHER, California

BILL PASCRELL, JR., New Jersey

TIM HOLDEN, Pennsylvania

SHELLEY BERKLEY, Nevada

JIM MATHESON, Utah

MICHAEL M. HONDA, California

RICK LARSEN, Washington

MICHAEL E. CAPUANO, Massachusetts

ANTHONY D. WEINER, New York

BEN CHANDLER, Kentucky

RUSS CARNAHAN, Missouri

JOHN T. SALAZAR, Colorado

NICK J. RAHALL II, West Virginia

BOB FILNER, California

JAMES L. OBERSTAR, Minnesota

(Ex Officio)

(III)

(V)

CONTENTS

TESTIMONY

Page

Baggaley, Philip, Managing Director, Corporate and Government Ratings,

Standard and Poor’s Ratings Service ................................................................. 11

Kiefer, Mark, Associate Principal, CRA International, Inc. ................................. 11

Matesanz, Maria, Senior Vice President and Team Leader, Infrastructure

Finance Team, Public Finance Group, Moody’s Investors Service ................... 11

Morrison, Steve, Professor and Chair, Department of Economics, Northeastern University ................................................................................................ 11

Sokel, Stuart R., Director, Deutsche Bank Commodities Group ......................... 11

PREPARED STATEMENTS SUBMITTED BY MEMBERS OF CONGRESS

Carnahan, Hon. Russ, of Missouri ......................................................................... 48

Costello, Hon. Jerry F., of Illinois .......................................................................... 49

Oberstar, Hon. James L., of Minnesota ................................................................. 70

Porter, Hon. Jon, of Nevada ................................................................................... 72

PREPARED STATEMENTS SUBMITTED BY WITNESSES

Baggaley, Philip ....................................................................................................... 37

Kiefer, Mark ............................................................................................................. 51

Matesanz, Maria ...................................................................................................... 58

Morrison, Steve ........................................................................................................ 63

Sokel, Stuart R. ........................................................................................................ 00

ADDITION TO THE RECORD

Air Carrier Association of America, Edward P. Faberman, Executive Director,

statement .............................................................................................................. 75

(1)

CURRENT SITUATION AND FUTURE OUTLOOK

OF U.S. COMMERCIAL AIRLINE INDUSTRY

Wednesday, September 28, 2005,

U.S. HOUSE OF REPRESENTATIVES, COMMITTEE ON

TRANSPORTATION AND INFRASTRUCTURE, SUBCOMMITTEE ON AVIATION, WASHINGTON, D.C.

The committee met, pursuant to notice, at 2:00 p.m., in room

2167, Rayburn House Office Building, Hon. John L. Mica [chairman of the subcommittee], presiding.

Mr. MICA. I would like to call this hearing of the House Aviation

Subcommittee to order.

Welcome everyone today.

The topic of today’s hearing centers on an important subject: the

current situation and future outlook of the United States commercial airline industry. We only have one panel today so I am going

to let the panelists go a little bit longer and talk about eight minutes. We have assembled hopefully some of our Country’s best

minds on the subject and we will hear what the professionals have

to say.

The order of business will be opening statements by members. I

will start and then we will hear from the panelists.

I do have a request. We have Ms. Schmidt, a member who has

requested to participate in our hearings. The normal procedure is

I will ask for unanimous consent for you to participate and in doing

so, also you will be the last to be heard or last to offer questions.

So, welcome. I ask unanimous consent to allow Ms. Schmidt to participate in today’s hearing.

Mr. COSTELLO. Without objection.

Mr. MICA. So ordered. Thank you and welcome.

We will start with my opening statement. Today’s hearing will

focus on the current situation and future outlook of the United

States commercial airline industry. Looming changes in our Federal bankruptcy law and fuel prices helped send Delta and Northwest into bankruptcy earlier this month. Unfortunately, this is just

the tip of an iceberg of challenges that America’s airline industry

has experienced over the past four years. The airline industry in the United States lost some $32 billion during this time period and it may face an additional $9-$10 billion

loss which is projected for this year, 2005. An economic slowdown,

declining business travel, increased competition from low cost carriers, the 9/11 terrorist attacks, the SARS epidemic and rising fuel

costs have all contributed to the industry’s unprecedented losses.

After surviving all of these challenges, despite these great obsta-
2

cles, in the last quarter, American, Continental, United and several

discount carriers reported small operating profits.

Until yesterday, when US Airways emerged from bankruptcy to

merge with America West, almost half the capacity of the airline

industry was flying in bankruptcy. Most legacy carriers have made

cuts in labor, operational and also their administrative costs. Unfortunately, their only other option to bring about further reforms

has been bankruptcy.

While the airline industry is no stranger to bankruptcy, having

so many major carriers in bankruptcy certainly does get everyone’s

attention and it has. Historically, airlines have failed at a much

higher rate than most other types of businesses. The airline industry has the worst financial performance of any of our major business sectors. While the industry has enjoyed some profitable years,

airline operators as a whole have lost money since deregulation in

1978.

This instability has been attributed to the highly cyclical demand

for air travel as well as the structure of the industry, which has

very high fixed costs and few barriers to entry. Some argue that

the industry’s current problem is over-capacity and the bankruptcies, to the extent that they reduce capacity, will help solve the

problem. While such capacity reductions may offer temporary relief, history has shown that the growth of airline industry capacity

has continued unaffected even by major liquidations.

According to the Government Accountability Office, only recessions, which curtail the demand for air travel, and the September

11 terrorist attacks appear to have caused the airline industry to

reduce its capacity. This indicates that other airlines quickly replenish capacity to meet demand. Low cost carriers, in particular,

are continuing to take delivery of new aircraft and expand their capacity. For example, Southwest Airlines continues to grow at an 8

to 10 percent annual rate and Jet Blue at almost 30 percent annually. In addition, there are 17 new entrant airlines currently awaiting certification by the Department of Transportation.

One bright spot for legacy carriers is the continued profitability

of international routes where there is less competition from low

cost carriers. In adjusting to their new economic realities, legacy

carriers have made flying abroad a priority and sometimes they

shift aircraft from domestic to international flights and start new

service to foreign destinations as we have seen. For example, Delta’s plan for recovery included reducing mainline capacity by 15 to

20 percent and increasing their international flying by 25 percent.

Under President Bush, negotiators from the Department State

and Transportation have reached agreements with countries such

as India, Vietnam and Mexico as well as others to open international routes to U.S. carriers. These efforts are important and

hopefully will be of assistance to our legacy carriers.

The airlines’ financial woes may also impact our airports. Sometimes their financial problems do go beyond just the legacy carriers. Airports that serve as secondary hubs for financially weak

airlines are particularly at risk because reductions in connecting

passenger traffic can end up leaving a void too large for other carriers to fill. For example, flight schedules have been reduced by US

Airways at its Pittsburgh hub and more recently by Delta at its
3

Cincinnati/Northern Kentucky hub, leaving these airports with decreased revenues.

An airline’s withdrawal from a hub can also leave an airport

over-extended relative to its remaining passenger and revenue

base. They take on pretty significant obligations and we see the results for these airports. For example, when US Airways withdrew

from Pittsburgh, that airport was left with a financial responsibility for the new terminal building that it had built specifically for

US Airways operations. In addition, Fitch Ratings recently revised

its outlooks for the Detroit, Minneapolis and Memphis Airport bond

ratings from stable to negative based on their concerns that the

risk to financing at those airports may increase during Northwest’s

bankruptcy.

I think this also poses an issue for this Subcommittee and our

efforts to improve infrastructure at various airports across the

United States and we are putting hundreds of millions and some

billions of dollars in improving the facilities and airports themselves. This does raise some serious issues that our Subcommittee

needs to address.

For our hearing today, we have assembled a panel of airline industry, financial experts and academic professionals. I look forward

to hearing the views of our witnesses. We don’t have any associations here. I do welcome any associations that want to submit for

the record. We will leave the record open for a period of two weeks

so they may submit commentary on this important hearing and

their recommendations.

With those lengthy but necessary comments and caveats, I would

now recognize the outstanding Ranking Member of this subcommittee, the gentleman from Illinois, Mr. Costello.

Mr. COSTELLO. Mr. Chairman, thank you and thank you for calling this hearing today. I also welcome the witnesses that are here.

I will submit my statement for the record and summarize it.

As you indicated, since the terrorist attacks of 2001, we have seen the airline industry lose about $32 billion, staggering fuel

prices, thousands of people have lost their pensions and health care

and in the last two weeks, Northwest and Delta both have filed

bankruptcy. I have no doubt that thousands more will lose their

pensions and health care in this coming round of the bankruptcies

that were just filed. With close to 50 percent of our domestic aviation capacity in bankruptcy up until yesterday, we need a frank assessment of the short and long term condition of the industry.

It is difficult to gauge how much the industry’s current conditions can be attributed to September 11. We all know that legacy

carriers were in trouble before September 11. The legacy carriers,

in my judgment, failed to adjust their business plans to economic

trends that began long before September 11, including business

models that depended on extracting a premium fare from business

travelers.

In fact, the premium fare for business travelers amounted to a

significant amount of revenue for the legacy carriers. When the

economy started to tighten in 2000, the business traveler shifted

and went from the legacy carriers to the low cost airlines. Indeed,

low cost carriers are a significant force in the aviation industry

today with a combined domestic Origin and Destination (O&D)
4

market share of about 30 percent up from 23 percent just a few

years ago.

In addition, the aviation industry and the Nation as a whole is

faced with record high fuel cost which has stymied growth. According to the ATA, the Air Transport Association, the industry’s jet

fuel expenses could increase by $9.2 billion in 2005 alone. The ATA

also projects industry-wide net losses this year of approximately

$9-$10 billion.

Some have suggested ways to save the airline industry. ATA has

called for a repeal or the suspension of certain taxes and fees, a

move, in my opinion, that would wreak havoc on our Aviation

Trust Fund and does not take into account the fact that other

modes of transportation and consumers are also suffering from

high fuel prices. In fact, the amount paid in fuel taxes for 2005 is

expected to be $600 million, well short of the $10 billion projected

net industry losses. We should not make such policy decisions in

a vacuum.

Some current and former airline CEOs and others have suggested other ways to save the industry. Robert Crandall, the former

Chairman of American Airlines, wrote an op ed recently in the

Wall Street Journal suggesting that the bankruptcy laws need to

be changed. He suggested, ‘‘You say, look, if you fail, you liquidate.’’

In addition, Mr. Crandall and others have suggested that we

have too much capacity in the system. Crandall states, ‘‘The capacity never comes out. It takes all the guys that haven’t gone bankrupt and drives them into bankruptcy.’’ He and others have suggested that in addition to changing the bankruptcy laws, we should

remove perceived barriers to consolidation. In fact, ATA agrees that

consolidation and capacity reductions are needed. Yet, it is still not

clear to me that any one of these proposals or all of them together

will provide the much needed fix for this ailing industry.

I hope that our witnesses today will address those issues. In addition, I hope that the witnesses will talk to us about what this

subcommittee or what the Congress should be doing in the future

for the industry. When we get into questions, I will be interested

in knowing not only how you feel about the proposal from ATA

about the temporary suspension of the fuel tax, about the capacity

issue and also interested in knowing if the Congress did nothing

substantial for the industry, what would happen in the long and

short term.

Last, in addressing all of these issues, the suspension of the current fees and taxes, current bankruptcy laws and capacity issue, I

hope to hear what solutions you provide and will suggest to this

subcommittee.

Mr. Chairman, again, I appreciate you calling this hearing. I welcome the witnesses and look forward to hearing from them.

Mr. MICA. I thank the gentleman.

Mr. Coble?

Mr. COBLE. Thank you, Mr. Chairman. I will not take the five

minutes.

I commend you and the gentleman from Illinois for having scheduled this hearing and express appreciation to the panelists for their

attendance.
5

The future outlook of the United States commercial airline industry is an area of our commerce that needs thorough examination.

I like to avoid use of the word ‘‘crisis’’ because it is so obviously

laced with pessimism. There are many people and colleagues who

believe that the U.S. commercial airline industry is standing in the

shadow of a critical situation.

Someone said to me the other day airports are what bus stations

were four decades ago, 45 years ago. By that, I think he meant the

obvious overcrowding, wall to wall people. Oftentimes when you go

to an airport today, and I am not pointing accusatory fingers at

anyone, but a cancellation or a delay in flight almost becomes the

rule rather than the exception.

I appreciate your scheduling this, as I said, because we need to

examine this before it does become a crisis.

I yield, Mr. Chairman.

Mr. MICA. I thank the gentleman.

Ms. Norton?

Ms. NORTON. Thank you, Mr. Chairman, for trying to stay ahead

of the curve on the airlines and it is very difficult to do but I appreciate the hearings, and this is not the first, on the state of our commercial airline industry. It is kind of like a physical exam, only the

airline industry has had to take these physical exams often.

When two major airlines, not the ones most traditionally troubled, now find themselves in bankruptcy, it is very hard to know

where to go from here or what to think of the industry as a whole.

This much we know. This industry, even more than every other industry in the Country as a whole, did not need two hurricanes,

Katrina and Rita, and especially not Rita which has put very special pressure on all of our resources, gas and fuel resources.

I am concerned that the fuel crisis which does not seem to abate

is putting great pressure even on the lower cost airlines. You remember at our last hearing there was particular interest in whether all of them would become low cost and maybe somehow the industry would be saved that way. I heard the President say people

should not take trips they don’t need to take. Of course the airline

industry wants you to take as many trips as you can.

It is one indication of how the airline industry, every economic

change appears to negatively affect the airline industry. Conservation, for example, does not appear to be any kind of solution there,

although there is much to be said for why the Country ought to

have an explicit conservation policy which might then free up some

energy for industries like our airline industry which certainly can’t

do that.

I just think we need to talk to folks out there and notice that

these are not Government witnesses, so that we can get the best

information and the best thinking we can at this time.

Again, I thank you, Mr. Chairman, and yield back.

Mr. MICA. I thank you.

Mr. Ehlers?

Mr. EHLERS. Thank you, Mr. Chairman, and thank you for having this hearing.

I would just like to comment. Everyone knows the airlines are

in trouble and are having serious problems. It is perhaps no an appropriate business model as it has been traditionally practiced, but
6

I encourage us also to look on the positive side and what a tremendously positive impact the airline industry has had upon this Nation over the past half century.

I recall my first flight in a jet airplane, a 707, in the late 1950s,

early 1960s, and that was an incredible experience. Little did I realize that the first of over a million miles of travel I would perform

on jet airplanes. It has transformed American life, it has brought

families closer together with more frequent visits, it has changed

the very nature of the Congress.

When I first took office, one of my predecessors, former President

Ford, commented to me that when he was elected in 1948, he

moved to Washington with his family and they went home twice

a year, the August recess and the Christmas recess. Today, most

members of Congress go back to their districts every week and

have maintained much closer ties with the public and I think have

been much more responsive to the public as a result of that.

Air travel has been a very positive thing for the integration of

this Nation, of bringing people together, developing better understanding and we have to make sure whatever we do as we discuss

these issues we recognize what a strong, positive effect that has

been and that we work together to maintain a strong airline industry which can continue to keep the bonds of our Nation firm, but

not only that, but give us opportunity to visit other lands frequently and become better acquainted with other countries and

therefore, make us a better country in dealing with the problems

of the world.

I yield back the balance of my time.

Mr. MICA. I thank the gentleman.

Mr. DeFazio?

Mr. DEFAZIO. Thank you, Mr. Chairman. Thank you for the timely hearing on this issue.

My goal in debating this issue over the years has been to see

that we continue to have a system of universal air transport which

serves not only major hubs or profit centers in the United States’

large urban areas, but also medium and smaller sized cities. I am

concerned about whether continuing total deregulation, a hands-off

attitude with perhaps some liquidations in the industry of so-called

legacy carriers, is going to provide that sort of service to the traveling public, not only to leisure travelers who seem to be the target

model of many airlines, but to the business travelers.

We are moving toward a very inefficient system where more and

more corporate travel is being done on fractional ownership. I was

riding with a fellow from a not particularly large company out of

Eugene last week, crammed into a 50 seater from Phoenix to Eugene. He was waxing about how as soon as they could justify it on

the books, which he thought would be real soon, they were buying

a private jet.

So it is that desire to drive out all the people who used to pay

or were willing to pay a premium for access to that kind of a system and just run a low budget system which may or may not have

international links of any good significance for leisure travelers

who don’t quite pay for their cost of transport. That doesn’t seem

like a sustainable model.
7

There are other issues raised or touched on by the testimony. It

seems that the so-called rents attributable to the refiners have tripled in a year. That is interesting. People are wondering why is jet

fuel so expensive. Well, because our refinery capacity has been

squeezed down to the point where it is just about adequate to demand and the slightest burp allows an Exxon-like jacking up of the

prices saying oh, my gosh, we just can’t meet the demand, we will

have to jack up prices. The head of the largest refinery in America,

Valero, said the system was working real well for them. Their stock

is up 263 percent a year.

We want to blame the environmentalists and the regulatory system. It wasn’t the environmentalists or the regulatory system. It

was the lack of a regulatory system that allowed the mergers, the

closures and the downgrading in refining capacity and nothing has

been built. Even when George Bush offered to make military bases

available with no environmental restrictions, the industry said no,

we are not really interested. We are doing well where we are. So

we have to look at those sorts of things.

I am concerned about the idea that somehow we should let the

market squeeze and squeeze and squeeze and squeeze until we get

all the costs out of the system. I think the recent Jet Blue incident

points to the problems there when planes are maintained in El Salvador by people who may or may not be qualified mechanics, who

may or may not be using approved parts, who may or may not be

enlisted in terrorist networks because we can save money by maintaining planes in El Salvador. Meanwhile, mechanics here are put

out of work who are doing a good job, who were regulated, who

were overseen, that is good for the system. That is squeezing out

the inefficiencies.

That is pretty essential, your plane can land and you will live,

your plane can’t land and you won’t live. Most Americans are willing to pay a slight bit more to know their pilot and the mechanic

are trained and qualified and the plane doesn’t have unapproved

parts on it.

I am concerned about how we are squeezing and pushing the system. I am not sure that cutthroat competition will give us the service the American people need, particularly many small and medium

sized cities, and it is not going to give us the safety that we need,

particularly with an Administration that is so derogatory of government and regulation that led us to the point where we no longer

even have a functional Federal Emergency Management Agency let

alone an FAA that has enough people to oversee the maintenance

work being farmed out more and more.

I think there are a lot of questions raised by this model and I

hope the panel can respond to some of these points and tell us why

it is so great that most carriers are flying full and still losing

money.

Thank you, Mr. Chairman.

Mr. MICA. I thank the gentleman.

Mr. Ney?

Mr. NEY. Thank you, Mr. Chairman and the Ranking Member.

I will be brief.

I want to thank you for the hearing. I think it is important. The

airline industry is important. We have seen that through Katrina.
8

I have to credit the brave pilots of Jet Blue last week and the plane

they safely landed with 140 people on there.

Also mentioned before were the bankruptcies and an issue I

would like to know about is if some of the bankruptcies occur, what

happens with the pensions versus those who didn’t go into bankruptcy. Is there a level playing field? Does that have future repercussions? I think that is important.

Also the airlines are being asked to have cost saving measures

or to increase customer service which I know they want to do, I

still think that has to be analyzed. There are delays, baggage lost.

On a personal note, and I am not going to say the airlines but I

will take it up privately, but our office books my flights through

CATO, the service we have, and then I had to change it so I called

myself and had a lengthy conversation, about 20-25 minutes.

I arrived at the airport where they asked me to produce my employee ID because I was booked employee rate. Thank goodness I

didn’t accidentally travel on employee rate, and that would have

given people things to look at of, how did you get the employee rate

traveling to Washington. I didn’t have an employee badge, obviously, and then I asked, where did I call. I can’t remember whether

it was India or Ecuador but I called somewhere overseas. The past

couple of times I have called there.

If you talk to the employees, they will tell you that this may be

cost saving to outsource to India or Ecuador or wherever it was

outsourced to but at the end of the day, they said there are hundreds of mistakes they see coming in as a result of this

outsourcing.

I would like to know has anybody ever looked, in the quest to

save money, does outsourcing overseas come back to haunt the very

airlines that are trying to save money? I don’t know if small issues

like that are looked at or not but I think it should be because saving a dollar but costing the airlines a lot may not be good for them.

Again, would the bankruptcies result in reduction in services, cities served and the fate of the thousands of airline employees? I

think it is a topic of utmost importance to the citizens of the

United States.

Again, I want to thank the Chair and the Ranking Member for

the hearing.

Mr. MICA. I thank the gentleman.

Ms. Millender-McDonald?

Ms. MILLENDER-MCDONALD. Thank you, Mr. Chairman and the

Ranking Member, for holding this very important hearing.

I would like to say to the committee, Mr. Ehlers, a physicist,

after his positive stand on this hearing today, it was very enlightening, however, the issues facing the U.S. airline industry are indicative of the challenges that face all of us. Many of the issues

that we will be discussing today, hopefully, will be issues confronting our national economy in some capacity and that would be pension reform, bankruptcy reform, rising fuel costs and a changing

and evolving marketplace.

So I would like to commend our leaders, both the Chairman and

the Ranking Member, today for putting in front of us such a distinguished and focused panel. The panelists before us now are not industry representatives, but I am told from leading financial institu-
9

tions that offer an outside perspective with an investor’s eye, and

that is good.

As we prepare to reauthorize the aviation bill, this hearing is an

excellent first step and I commend the Chairman and the Ranking

Member and look forward to hearing from these experts on what

the next step for the airline industry could be. Of course I would

like to know what the impact of the most recent wave of bankruptcies will have on the airline industry as a whole, to what point

it will bring us and there are arguments made that major network

carriers are unprofitable now because their business models are no

longer functional.

These are some of the issues that I would like to hear from you

regarding our airline industry. As the Chairman and the Ranking

Member have stated, the industry has lost over $32 billion and it

is projected they will lose an additional $9 billion to $10 billion.

This is astounding. We do understand our airline industry is flying

in bankruptcy, so it is not a healthy industry.

I look forward to hearing from all of you today, outside of the

bronchitis that I have. Thank you, Mr. Chairman and Ranking

Member.

Mr. MICA. Thank you.

Mr. Kennedy?

Mr. KENNEDY. Mr. Chairman, Ranking Member, I want to thank

you for holding this hearing today and I want to thank all the witnesses for attending.

We are currently experiencing a time of financial crisis with the

commercial airline industry. As a representative from Minnesota’s

Sixth District, this concerns me. As you know, Northwest Airlines

based in my home State of Minnesota declared bankruptcy two

weeks ago. The airline industry is an enormous economic engine in

Minnesota. Northwest Airlines represents approximately 80 percent of the flights to of the Minneapolis-St. Paul Airport, they employ thousands of Minnesotans and tens of millions of passengers

fly into and out of Minnesota each year.

The pensions of tens of thousands of Minnesotans are foremost

on my mind. Over the past four years, U.S. commercial airlines

have lost over $32 billion collectively and it is estimated that the

industry will experience another $10 billion in loss in 2005.

We all know that skyrocketing fuel prices have become a burden

on everybody, individuals, families and businesses. Northwest Airlines is no exception. In 2003, Northwest spent $1.6 billion on fuel.

It is estimated that the airline will spend $3.3 billion on fuel in

2005. When fuel costs are combined with the climbing cost of pension plans, the results are a perfect storm. Over the next three

years, Northwest must contribute $3.3 billion to its pensions plans

in order to meet their obligations. The airline has already missed

a $65 million payment to the fund.

Northwest is only the latest of a string of airlines which have

sought bankruptcy protection for these same reasons. United Airlines and USAir’s decisions to terminate their pension plans gave

those airlines an enormous competitive advantage as they plot to

emerge from bankruptcy protection. United’s shortfall of $9.8 billion and USAir’s shifting of further billions in liabilities not only

puts the Pension Benefit Guarantee Corporation at risk, but cuts
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the guaranteed benefits for thousands of employees and retirees.

Statistics like this explain why until yesterday almost half the capacity of U.S. airlines is flying under bankruptcy protection.

Mr. Chairman, we must continue to work with the airline industry, its workers and retirees to find solutions to this crisis. I look

forward to the testimony of the witnesses today and I am hopeful

that we can determine how to go forward to protect the ticket buying public, workers, retirees and the airline industry as a whole.

I yield back the balance of my time.

Mr. MICA. Thank you.

Any other members of the Subcommittee seek recognition? If no

other members of the Subcommittee seek recognition, we will recognize Ms. Schmidt from Ohio.

Ms. SCHMIDT. Thank you, Mr. Chairman, for allowing me to participate in this important review and outlook of our Nation’s commercial airline industry.

I know I am not the only member of Congress with constituents

who have been directly affected by the serious difficulties facing

many of our commercial airlines. Delta Airlines, which filed for

Chapter 11 bankruptcy on September 14, has its second largest

hub in my local area at the Cincinnati-Northern Kentucky International Airport.

According to a 2005 study by the University of Cincinnati, the

airport contributes $4.52 billion annually to the Ohio-Kentucky-Indiana tri-state economy and supports more than 55,000 jobs

through the region. Delta accounts for about 83 percent of the passengers at the airport annually.

When I was sworn in on September 6, I was notified by Delta

of its intention to accelerate its overall transformation plan which

includes realignment of Delta and its subsidiary, ComAir’s services

at the Cincinnati-Northern Kentucky International Airport. Locally, this will result in the loss of nearly 1,100 jobs in my area.

A week later, as I mentioned, Delta and its subsidiaries filed for

Chapter 11 bankruptcy.

I am a strong believer in competition and free enterprise. I am

also concerned at what appears to be difficult economic conditions

including pension costs and the rising cost of fuel that confront virtually every airline in our Nation. A vibrant, safe and reliable airline industry is vitally important to our Country.

I look forward to learning more about the outlook of our airlines

at today’s hearing.

On a personal note, as I flew up here yesterday morning, one of

the flight attendants came to me and thanked me for serving and

said that she loved working with Delta, was willing to take another

pay cut in order to keep her job and was very, very worried about

her pension, and asked for my consideration on that. I am just

bringing that to this committee’s attention.

Thank you once again, Mr. Chairman, for the opportunity to participate and for holding this most important hearing.

Mr. MICA. I thank the gentlelady.

If there are no further opening statements, we will recognize our

panel of witnesses today. As I said, we have assembled some of

hopefully the Country’s leading experts on this topic. We have Mr.

Mark Kiefer, Associate Principal, CRA International, Inc.; Mr. Phil-
11

ip Baggaley, Managing Director, Corporate and Government Ratings, Standard and Poor’s Ratings Service; Mr. Steve Morrison,

Professor and Chair, Department of Economics, Northeastern University; Mr. Stuart R. Sokel, Director, Deutsche Bank Commodities

Group and Ms. Maria Matesanz, Senior Vice President and Team

Leader, Infrastructure Finance Team, Public Finance Group,

Moody’s Investors Service. Welcome to all of you.

As I said, normally we go five minutes. We won’t run the clock

in the normal fashion. We will let you go seven or eight minutes.

We want to leave time for questions. We will start with Mr. Mark

Kiefer of CRA International, Inc. Welcome and you are recognized.

TESTIMONY OF MARK KIEFER, ASSOCIATE PRINCIPAL, CRA

INTERNATIONAL, INC.; PHILIP BAGGALEY, MANAGING DIRECTOR, CORPORATE AND GOVERNMENT RATINGS, STANDARD AND POOR’S RATINGS SERVICE; STEVE MORRISON,

PROFESSOR AND CHAIR, DEPARTMENT OF ECONOMICS,

NORTHEASTERN UNIVERSITY; STUART R. SOKEL, DIRECTOR,

DEUTSCHE BANK COMMODITIES GROUP; AND MARIA

MATESANZ, SENIOR VICE PRESIDENT AND TEAM LEADER,

INFRASTRUCTURE FINANCE TEAM, PUBLIC FINANCE

GROUP, MOODY’S INVESTORS SERVICE

Mr. KIEFER. Thank you, for the opportunity to appear before you

today to hear my comments on this very important subject.

I have a Power Point presentation for you although I would ask

that my prepared statement be made a part of the record.

Mr. MICA. Without objection, the entire statement will be made

a part of the record.

Mr. KIEFER. I will speak directly to the issues that brought us

all here today, namely the current situation facing the U.S. commercial airline industry, the impact of the recent bankruptcies and

high fuel costs, and also the outlook for the future of this industry.

I do believe it is fair to characterize the current situation in this

industry as the greatest crisis it has faced in its nearly 100 year

history. We have heard from several members of the Subcommittee

the number, $32 billion in losses since 2000 and I agree with the

assessment, that loss is expected to reach $40 billion by the end

of this year.

At the same time, the millions of shareholders among the American public that own these publicly traded companies have experienced over $24 billion in losses in the market value because of the

steep declines in the prices of their shares. We have also heard

that five of the ten largest airlines in the industry have entered

Chapter 11 to this point since the year 2000.

At the same time, well over 100,000 jobs have been lost in this

industry since that time and just recently, in concert with their announced bankruptcies, Delta and Northwest have announced the

likelihood of additional layoffs. Pay and benefits have been cut very

substantially. You may recall before their bankruptcy, Delta pilots

negotiated pay cuts of over one-third, and significant cuts in benefits. The failure of the pensions at United and USAirways have resulted in the largest pension default in U.S. history. Those airlines

that continue to have pension plans now have unfunded liabilities

of over $14 billion.
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The effect of this crisis is felt not just in the airline industry

itself, but in other sectors of the economy. Those institutions engaged in aircraft finance are having to accept less favorable terms

just to have any business from the airline industry, aircraft manufacturers and parts suppliers are facing canceled or foregone orders

or delayed orders for their equipment, and as mentioned, the current environment has caused a potential funding shortfall in supporting the FAA and its infrastructure because that system is funded through taxes and fees paid by the carriers, a large portion of

which are based on air fares.

Not all of the news is bad. I would share the optimism of Mr.

Coble in this regard. The low cost carriers are very profitable and

growing. Southwest has had 57 consecutive quarters of profit, Jet

Blue has had 18. They have weathered this storm remarkably. In

fact, the resulting low fare environment has produced tremendous

benefits to consumers because they are paying lower prices as a result.

I would like to talk a bit about how we got here and add to the

comments that have gone before. I think there are three basic factors that have contributed to the current situation. Business travel

has undergone a fundamental reorientation since 2000. At that

time, a weakening economy had already begun to dampen travel

and business travelers were becoming increasingly intolerant of

very expensive tickets.

After September 11, 2001, there was a disproportionate drop in

business travel as many corporate travel departments restricted

travel altogether. As a result, there is much more cost consciousness among the traveling public but among business travelers as

well.

We have heard there have been an unprecedented combination

of challenges that have buffeted the industry since the year 2000,

the economic slowdown, the events of September 11, the outbreak

of SARS, the war in Iraq and the dramatic increase in fuel prices

now at a historic high at least in nominal terms.

At the same time, advances in technology have reshaped the demand for travel. Improvements in teleconferencing and related facilities have made it less necessary for business people to travel.

At the same time, the growth in online ticket sales has created

much greater, really unprecedented price transparency so that

business travelers are more easily able to seek and find lower cost

alternatives to the traditional legacy carrier business model of

charging much higher fares. At present, low fares are not the exception but really the rule.

The other important contributing factor in that regard is that

low cost carriers have become an integral and significant part of

the industry. Their market share has almost tripled in the last ten

years and is expected to constitute about one-fourth of the domestic

industry by the end of this year.

The largest domestic airline in the United States is Southwest

Airlines at this point. Jet Blue and Air Tran are now classified as

major carriers by the Department of Transportation, earning more

than $1 billion in annual revenue. Most of the cities served by legacy carriers are served by at least one low cost carrier. At the same
13

time, legacy fare carriers face low cost competition in most of their

city fare markets.

As a result of this significant market penetration, low cost carriers are now able to dictate price in many markets. It is important

to point out the low cost carrier business model is not really predicated so much on low cost, but on low fares. These carriers were

designed from the beginning to charge low prices and their low cost

structure is a result of that imperative.

At the low cost carrier prices, legacy carriers simply cannot make

money with their higher cost structure. The chart you see before

you reflects a measure of the operating profitability of Southwest

and Jet Blue compared to the major legacy carriers. You can see

in the last calendar year, there was a remarkable difference in that

regard.

I would submit to you that deregulation of the industry in 1978

has finally caught up as it were with the legacy carriers. The legacy carrier cost structure is even today to a significant extent, a

remnant of the regulated era where routes and fares were regulated by the Civil Aeronautics Board and in effect, cost increases

could be passed on to customers through higher fares. This made

possible higher wages and lucrative benefits such as pension plans.

In effect, there was to some extent a disincentive to reduce costs

because the profits were in effect a function of costs.

Until recently, legacy carriers faced only limited price and route

competition on a national scale. The legacy carriers competed mostly with other legacy carriers and hub dominance and limited competition for nonstop service are a feature of the hub and spoke networks that the legacy carriers employ. In the current market environment, the high labor costs which were possible under the regulated environment have become unsustainable such that the unfunded pension liabilities now exceed $14 billion.

You can see from this chart just how much they have grown in

the last four years. That is a reflection in part of the poor investment performance of these plans. At the same time, the rising cost

of health care, which we have talked and heard so much about, has

produced large unfunded liabilities in the post-retirement insurance benefits offered by many of the legacy carriers.

I would submit that conversely, low cost carriers are ostensibly

post-deregulation carriers. They have been designed from the

ground up to compete on price and their cost structure is fundamentally different, fundamentally lower and their operating

model likewise is designed for low cost.

I would quickly add that I think with respect to the impact of

the recent bankruptcies, I think we will see further wage reductions at Delta and Northwest, elimination of the pension plans are

likely. Going forward, I think the other legacy carriers that have

not yet gone into bankruptcy will have no choice but to eliminate

their pension plans as well should Delta and Northwest do so.

I think the low cost carriers are indeed vulnerable because of

higher fuel prices but finally, I would say new aircraft on the horizon promise greater increases in fuel efficiency and significant

growth in air travel is forecast which I think will return this industry to financial health in the long term. I think the prospects are

very good in the long term.
14

Thank you very much for the opportunity to appear before you

today.

Mr. MICA. Thank you.

We will wait until we have heard from all the panelists to start

questions.

Mr. Baggaley with Standard and Poor’s Ratings Services, welcome, and you are recognized.

Mr. BAGGALEY. Thank you.

Good afternoon. Thank you for the opportunity to testify today.

I am the Managing Director with Standard and Poor’s Ratings

Services and Senior Credit Analyst for the airline industry. Please

see my written testimony which I ask be included in the record.

Mr. MICA. Without objection, so ordered.

Mr. BAGGALEY. This afternoon I hope to provide some perspective

on the airline industry’s problems by addressing three related topics: first, what are the principal causes of the U.S. airlines’ current

financial problems; second, how are airlines responding to that situation; and third, what broader changes might improve the industry’s prospects.

First, why are most airlines reporting losses and bleeding cash

in a strong economic environment? Numerous factors have contributed to the problem and Mr. Kiefer mentioned some of them. I

would say that three stand out in the current environment: very

high jet fuel prices, intense price competition in the domestic market; and heavy debt and pension burdens.

Fuel prices are the most serious concern at the moment. Oil

prices have increased sharply over the past year and the future

outlook is for an extended period of high prices. Added to that is

limited refining capacity which has widened the normal price difference between oil and jet fuel. Exhibit 1 of my written testimony

shows the movement of oil and jet fuel prices this year with the

levels of January 1st set to equal 100. You can see the heavier line,

jet fuel prices, jump above the lighter crude oil line over the past

month due to damage to refineries in the wake of Hurricane

Katrina.

The Air Transport Association estimated recently that the U.S.

airlines will spend $30.6 billion on fuel in 2005 compared to $21.4

billion in 2004 and double 2003’s $15.2 billion. These and other

years are shown in my Exhibit 2.

Even low cost airlines are under pressure. Southwest Airlines

would be operating around break even without its fuel hedges and

Jet Blue recently warned that it could report losses. Standard and

Poor’s last week placed our ratings on Jet Blue on credit watch for

a possible down grade.

Most airlines don’t have the credit profile that would allow them

to hedge fuel prices without putting up cash collateral, thereby depleting their reserves of cash. In any case, hedges cannot undo current price levels, only protect against further increases. Airlines

are trying to raise fares in response. However, unlike railroads,

trucking companies and shipping lines, airlines don’t have corporate contracts that allow for automatic fuel surcharges. Rather,

they must try to raise fares, a move that requires all the major

players to go along or the attempted fare increase will fail.
15

The second major cause of the airlines’ financial problems is intense price competition, particularly in the domestic market. Exhibit 3 in my remarks shows domestic yield and revenue per available seat mile. Both measures turned sharply downwards starting

in 2001 and have improved little despite several years of economic

recovery. The rapid spread of low cost airlines and excess seat capacity have prolonged the pricing weakness.

Over the past year, airlines have managed to raise their fares

somewhat in response to high fuel costs. However, if high oil prices

cause the U.S. economy to slow, that momentum towards higher

fares will likely stall.

The third big financial problem for the airlines currently is debt

and pension deficits. Airlines tend to operate at higher leverage

than manufacturing companies even in the best of times. Starting

in 2001, the legacy carriers had to borrow heavily to fund losses

and maintain adequate cash reserves even with Federal aid. On

top of that, pension plans that were fully funded in the stock market boom of the late 1990s fell into deficits when share prices and

interest rates fell. Exhibit 4 in my remarks shows the effect for

Delta Airlines.

What have airlines been doing in response to all these problems?

First, airline employees have been asked to take substantial pay

cuts, trim their benefits and in some cases, lose their jobs. Exhibit

5 in my remarks shows broad expense categories for AMR, parent

of American Airlines, in 2002 and in the second quarter of 2005.

Over that period labor costs declined from 41 percent of total expenses to 32 percent. Exhibit 6 shows the dollar value of the labor

concessions and of significant other cost initiatives and the large

negative effect of higher fuel costs that offset much of that

progress.

The final question that I posed at the outset of my remarks is

perhaps the most important one. Are there broader trends or

changes that could provide an answer to the industry’s financial

problems? I will consider three such possibilities: bankruptcies,

mergers and reductions in capacity. Obviously, bankruptcy signals

financial failure but it also gives an airline tools to correct that situation. Exhibit 7 shows selected financial data for United Airlines

in 2002 when they entered bankruptcy and from the forecast in

their reorganization plan.

Three items are shown. First, there is some reduction in debt,

mostly through canceling unsecured obligations. The scope for cutting secured debt and leases is rather less unless United wants to

turn back planes to their creditors, some of which they have done.

Second, the pension deficit was eliminated by terminating the defined benefit plans. Lastly, United’s forecast shows much lower

labor costs by 2006. Bankruptcy makes it easier for an airline to

secure labor concessions because ultimately the Bankruptcy Court

can impose them.

Delta and Northwest will face similar opportunities and constraints as they proceed through Chapter 11. Bankruptcy can help

an airline improve its financial prospects, but the struggles and

continued losses of United and the fact that USAirways paid a second visit to the Bankruptcy Court shows this is no panacea.
16

Mergers are a second change often suggested as a cure for airline

problems. Such combinations do allow the merged airline to capture more passengers but diversion of traffic is by its nature a zero

sum game. What the merged airlines gain, others lose. Furthermore, these mergers have tended to drive up labor costs because

union cooperation is needed for smooth integration.

For example, United’s proposed acquisition of USAirways in 2000

led management to negotiate an expensive pilot contract that later

helped push the airline into bankruptcy. For these and other reasons, the track record of airline mergers has been discouraging.

Fortunately, mergers in the current environment may fare better, particularly if the acquired company is in bankruptcy. Consider

America West acquisition of USAirways just completed yesterday.

USAirways had already lowered its operating costs to levels approaching those of America West. As a bankrupt company,

USAirways had the flexibility to rid itself of aircraft and facilities

not needed in the combined airline, and America West managed to

attract significant outside investment and loans to bolster its cash

reserves.

The merged company will still face difficulties in integrating its

two labor forces over the next several years. Also, outside forces

such as high fuel costs could certainly cause a renewed financial

crisis. Even so, acquiring a bankrupt but potentially viable airline

appears to avoid some of the pitfalls that have plagued previous

mergers.

From the perspective of the airline industry as a whole, the main

benefit of airline bankruptcies and mergers is that they can reduce

overall capacity. This should is often suggested improve the balance of supply and demand and allow for increased fares to cover

added fuel expense. One of the most frequent criticisms of the

bankruptcy process is it has allowed struggling airlines to survive

to the detriment of their solvent competitors.

There is no doubt that liquidation of a major airline in bankruptcy would allow the survivors to raise prices somewhat, however, whether that revenue gain is sustainable would depend on

where the parked aircraft end up and whether the surviving legacy

airlines have competitive cost structures. If the liquidated airline’s

planes simply change hands or if low cost airlines still have a huge

cost advantage, then the revenue benefits would likely erode over

time. In other words, consolidation, whether through bankruptcy,

liquidations or mergers, will help the industry only if accompanied

by withdrawal of planes from the U.S. market and by competitive

cost structures at the survivors.

To conclude, let me summarize my answers to the questions

posed at the beginning of my testimony. First, the dire financial

condition of most U.S. airlines is due principally to high fuel costs,

intense price competition in the domestic market and heavy debt

and pension burdens.

Second, legacy airlines have undertaken significant steps to trim

their losses but these have so far been insufficient to restore profitability, largely because of the fuel prices. Lastly, bankruptcy, restructuring and mergers have the potential to improve the industry’s financial health, but only if accompanied by reduced capacity

and most important, by lower operating costs.
17

Thank you for your attention.

Mr. MICA. Thank you for your testimony.

We will now hear from Dr. Steve Morrison, Professor and Chair,

Department of Economics, Northeastern University.

Mr. MORRISON. Thank you. It is my pleasure to be here today.

I should note that the statement I submitted was co-authored

with my longtime collaborator, Cliff Winston. When I say ‘‘we’’ in

the testimony, I am referring to he and I.

Mr. MICA. Thank you, and we will include the entire statement

in the record without objection.

Mr. MORRISON. The airline industry has always been a cyclical

one because the demand for air travel is sensitive to the level of

economic activity and carriers must invest in capacity well before

they know the level of economic activity and demand. In the current down turn from 2001 to 2004, the U.S. airline industry lost

$13 for each of the nearly 3 billion passengers it flew resulting in

the $32 billion number we have heard several times here today but

the causes of the current financial state of the airline industry are

more complicated than mere cyclicity.

What the industry is experiencing is unprecedented and is due

to a confluence of factors which have exacerbated the longstanding

and underlying challenge that carriers have of aligning capacity

with demand over the business cycle. To understand the current

situation better, we need to look at what has happened during the

last several years to some of the key components that determine

an airline’s profitability, the number of travelers, the fares those

travelers pay, the price of fuel, wages and salaries of employees

being of particular interest.

As far as the number of passengers goes, the good news is the

traffic in 2004 exceeded its previous peak in 2000 before the down

turn began. I should note that month to month traffic turned down

in February 2001 before the recession began in March 2001. The

recession ended in November 2001 so this situation goes well beyond cyclicity as I said.

Although the industry is cyclical, year over year traffic declines

are relatively rare and the latest down turn is unprecedented in

that it took four years for traffic to rebound, but traffic did rebound. The question there is why. One is the GDP is growing,

about 3 percent a year since the end of the recession.

Another reason is more travelers are feeling that flying is safe

enough for them to travel by air, but perhaps most important, is

that airlines responded to the drop in traffic by significantly reducing fares. That is good news for travelers and bad news for airlines.

Fares have fallen by 25 percent from 2000 to 2004 after adjusting

for inflation. This substantial decline in fares has only occurred one

other time in the U.S., namely right after World War II when capacity restrictions were eased.

Because of the dramatic decline in fares, the rebound in traffic

masks underlying changes in passengers demand for air travel.

Our back of the envelope calculations suggest that air fares in 2004

generated 17 percent less traffic than those same low fares would

have generated in 2000. Demand has changed. This raises the

question of what has caused this change in passengers underlying

willingness to pay for air travel.
18

Plausible reasons are that the airlines product has changed. Increased security leads to earlier arrival at airports and longer trip

times. To quantify this with another back of envelope calculation,

if passengers now arrive at the origin airport one half hour earlier

than previously, then under plausible assumptions, travel would

decline by 7 percent.

Fuller planes, now over 75 percent full on average, the highest

since right after World War II, make travel more unpleasant. An

alternatives to air travel, teleconferencing and rail travel at least

in the northeast corridor, have become more attractive options. In

addition to these considerations, the traveling public, especially the

formerly lucrative business travelers are less willing to pay fares

many times higher than their fellow leisure travelers.

Fuel, we have heard a lot about fuel. In addition to unanticipated

reductions in travel demand, the industry is vulnerable to unanticipated increases in costs. Jet fuel makes up 10 to 30 percent of airlines costs and its price can fluctuate widely which can have a significant effect on airline profits.

Relative to the price of jet fuel that prevailed in 2000, the last

so-called good financial year for the airline industry and one in

which the price of fuel was relatively high by previous historical

standards, in 2003 and 2004, the industry lost an estimated $8 billion due to the higher price of jet fuel. Given the higher prices in

2005, especially the post Hurricane Katrina price spike, the industry is estimated to lose even more.

Before discussing labor costs, it is important to note the change

in the competitive environment of the industry. Since deregulation

low cost carriers have expanded more or less steadily to the point

where in 2004 low cost carriers competed on routes between metropolitan areas that accounted for over 50 percent of the Nation’s domestic air travel. This increased competitive presence by low cost

carriers has put increased pressure on legacy airlines to reduce

their fares and costs.

I should add here that the surprise here is that it has taken so

long for low cost carriers to have this role. Advocates of deregulation looked at the performance of Southwest Airlines in Texas and

PSA in California and saw that as the model that would prevail in

the Country and it may well be the case but it has taken 27 years

for that to happen.

Labor represents the biggest single category of airline costs,

about 28 percent. Legacy airlines were, by definition, those that existed during the period when airlines were regulated. In the regulated environment, there was what economists call rent sharing as

unionized workers and others sought and received a share of the

profits that the regulated firms earned. Low cost carriers adopted

a different style of labor relations that resulted in lower pay and/

or higher worker productivity than legacy carriers were able to

achieve with their work force.

Legacy carriers have been cutting costs where they can and since

labor is the largest category of airline costs, it has been the target

of cost cutting and enhanced productivity through negotiation as

well as in bankruptcy as the legacy carriers seek to reduce costs

to compete with low cost carriers.
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As a result of these demand and cost shocks, the U.S. airline industry finds itself with more capacity, high cost capacity in particular than can be profitably supported at the fares passengers are

willing to pay. This problem will be rectified if when demand increases, costs are reduced or high cost capacity leaves the industry.

Competition among carriers will reduce such capacity and may well

lead to at least one if not more carriers to contract, undergo liquidation or be absorbed by another carrier.

Successful carriers, those that are cost efficient and responsive to

passenger preferences, will be poised to pick up any slack. Indeed,

travelers will gain if legacy carriers make the required changes to

be effective competitors in the new environment or are replaced by

lower cost carriers.

We looked at competition between carriers through the year 2000

that low cost carriers tended to enhance traveler welfare much

more than legacy carriers. That sounds obvious but there are factors other than fares that affect traveler welfare like frequency of

service. This is an important finding because it indicates airline

markets are working in the sense that those carriers that enhance

traveler welfare are rewarded with higher profits.

Some have argued that our bankruptcy laws need reforming because carriers operating under Chapter 11 are able to artificially

reduce their costs and thus drag down healthier carriers. In previous work, we found the effect of bankrupt carriers competing

against healthy carriers was mixed. For some bankruptcies competing against bankrupt carriers were helped, competing against a

weakened competitor and others, healthy carriers were hurt by

such competition. On net, the effects did not merit reevaluation of

current policy.

The current situation with nearly 50 percent of carriers in bankruptcy could well be different but analysis that we have done so far

suggests that is not an area in which to look for a solution.

Thank you.

Mr. MICA. Thank you for your testimony.

Now we will hear from Mr. Sokel, Director of Deutsche Bank

Commodities Group. Welcome and you are recognized.

Mr. SOKEL. Good afternoon.

My name is Stuart Sokel. I am a Director at Deutsche Bank in

New York City. Having spent the last 14 years in the oil trading

industry, my testimony today will attempt to provide insight into

the logistical and economic forces currently in place today.

Without a doubt, high energy prices are having a major impact

on the Nation’s economy and it is imperative to understand the

core issues which are significantly affecting the United States’ commercial airline industry. I invite questions and comments at any

point should further clarity be required.

In brief, the oil market today reflects a composite view of global

macro economic strength, environmental concerns and demographic

changes, all of which have contributed to dramatically higher energy prices over the past year. Most Americans are keenly aware

of how limited refinery capacity in the United States, a point that

has been pronounced due to the damage wrought by the hurricanes

in the Gulf Coast region has meant higher refined product prices.
20

This point only gives a partial explanation and I believe it needs

greater scrutiny.

To start, let us remember what has taken place in the world

since 1998. At precisely the same time that a number of emerging

market countries, for example, India and Thailand, were rapidly

expanding domestic refinery capacity, a financial crisis in Asia coupled with over capacity from OPEC pushed oil prices to levels that

seem like a mere memory today. Ten dollar oil was just another

session away and many respected journalists and pundits alike predicted the end of reliance on oil, Middle Eastern or otherwise.

Thus, there was no perceived financial pressure for airlines to

change their operating procedures.

In retrospect though, this period was a mere blip on the trend

line of growth that has taken place in the world today. Today, the

major United States airlines are competing for the same marginal

barrel of jet fuel that Singapore Airlines, Quantas and British Airways need for their own fleets.

Seven years ago, domestic passenger demand in India and China

alone was a mere pittance compared to today. In addition, the environmental regulations of lower sulfur gasoline and diesel fuel in

Europe and the United States have only served to take the jet fuel

market into further deficit given the continuing difficulty of refiners to adopt to changes in product specification. In short, the situation would appear to be dire and it becomes critical to develop a

strategy that serves the industry in the coming years while addressing the immediate need to remain solvent.

To start, we have to acknowledge that the lack of investment in

refiner and terminal capacity over the past 30 years will not likely

suffice for the next 30 years. To be critical of the oil industry, however, neglects a very important point. I would like to address one

of Congressman DeFazio’s points. The logistical hurdles of building

a new refinery coupled with the questionable return on investment

given history poor margins did not exactly provide the integrated

companies with any major incentives.

It is true that the stock of Valero, for example, has risen 260 percent though I forget the precise number. However, from 1985 to

2000, if you had been managing an equity portfolio, similar returns

would not have been made. So it is a recent phenomenon that the

oil and gas sector in terms of the equity market has rewarded the

sort of returns we have seen over the last one to two years.

This point may be small consolation for the aviation industry but

it does provide a bit of historical context to the current dilemma.

In order to remedy the supply bottlenecks, the coastal areas of the

United States will need investment in the downstream sector. By

that, I mean the refinery sector and will also need support from the

Congress in order to educate an electorate which seems very comfortable with the notion of affordable oil as long as the infrastructure is not in their specific backyard.

Storage facilities need to be in close proximity to high volume

airports and major markets. Such projects will need to be environmentally and economically sound but without a reasonable commitment from all interested parties, the burden of supplying jet fuel

will fall exclusively into the hands of market forces which will lead

to a continuation of higher prices in years ahead.
21

I should point out currently it is very likely that a carrier flying

into LAX airport is utilizing jet fuel supplied from a Korean refiner

given the nature of the physical arbitrage that we see in the oil industry today.

Management of energy risks is an area that many carriers have

neglected in recent years and unfortunately the blame may be

spread around in no short order. Most of the airlines which did

hedge for the current fiscal year have not hedged their exposure for

2006 and beyond.

In addition, a large percentage of the hedges were placed in

crude oil as opposed to their actual exposure which is jet fuel. In

trading jargon, this differential is commonly referred to as basis

risk. Given the potential for jet fuel to out pace the rise in crude

oil prices, in effect, that is precisely what has happened this year

and the market expectation is that this will continue.

Anecdotally today, the price of jet fuel has risen by seven cents

a gallon and by virtue of the Air Transport Association’s statistics,

each penny increase in the price of a gallon of jet fuel drives an

additional $190 million in annual fuel costs for the United States

airlines.

For airlines that did not hedge or for those which liquidated

hedges due to court ordered instruction, the outlook remains very

severe given the current forward price of approximately $2 per gallon for 2006. I understand that the forecast by United Airlines for

their 2006 jet fuel costs is roughly $1.50 per gallon.

It is fair to say that Wall Street can be critical of hedging activity which is unprofitable or deemed to be speculative as exemplified

by certain refiner activity. However, the incremental cost of fuel

and labor will continue to play the largest role in the future outcome of the industry. While labor costs cannot be hedged, oil prices

certainly can be managed in the same manner in which companies

monitor their foreign exchange, interest rate and credit exposure.

There is an adage in financial markets which states the only

thing that can cure high prices is high prices. The airline industry

however suffers from the burden of having to pay high prices without the flexibility of necessarily receiving higher fares. Historically,

carriers have been loathe to pass on higher fuel costs in the form

of any additional tariff for fear of being undercut by competition.

This has led to a vicious cycle within the industry, an important

matter left for an airline industry expert to discuss as opposed to

an oil trader.

From my perspective, however, the potential solutions aforementioned are sound and will allow the forces of supply and demand

to act to the advantage of consumer and industry alike.

Thank you very much.

Mr. MICA. Thank you.

Now we will hear from Maria Matesanz, Senior Vice President

and Team Leader, Public Finance Group of Moody’s Investor Service. Welcome, Ms. Matesanz. You are recognized.

Ms. MATESANZ. Good afternoon. I am Maria Matesanz and I

manage the team at Moody’s that rates debt issued by U.S. airports. Thank you for inviting me to speak today.

Moody’s Investors Service is the oldest bond rating agency in the

world. We have been rating bonds since 1909. Today we have more
22

than 1,000 analysts in 19 countries around the world. Our ratings

and analysis cover approximately 10,000 corporations and financial

institutions, more than 20,000 municipal debt issuers, over 12,000

structured finance transactions and 100 solvent issuers.

In Moody’s view, the main and proper role of credit ratings is to

help enhance transparency and efficiency in debt capital markets

by reducing information asymmetry between borrowers and lenders. We believe that this benefits the market by enhancing investor

confidence and allowing borrowers to have broader access to funds.

Moody’s does this by publishing forward-looking rating opinions

publicly, freely and broadly and by publishing credit research about

debt securities and their issuers. Our credit ratings are opinions

about the future probability of full and timely repayment of debt

obligations such as bonds, notes and commercial paper. Our opinions are communicated to the market through a symbol system

originated almost 100 years ago which rank orders relative credit

risk on a scale with nine broad categories ranging from AAA to C.

My comments today will focus on the impact of airline bankruptcies on U.S. airports. Moody’s has ratings on 166 debt issues

at 114 publicly owned U.S. airports. The median airport rating is

A2. This contrasts sharply with the median rating of B3 for airlines.

Airlines have had a very unprofitable number of years as a result

of extremely low air fares, high labor costs and increasing fuel

costs. The combination of low fares and the growth in capacity by

both the legacy airlines and the low cost carriers has resulted in

very strong passenger and revenue growth at airports and stable

outlook for airport sector issuers. In most markets, passenger volumes have now exceeded pre-9/11 peak levels and many airports

are experiencing flight delays due to capacity constraints.

In Moody’s opinion, credit quality in the airport sector has stabilized due to the maintenance of solid liquidity levels, growth in

non-airline concession revenues, management control over operating and capital budgets and the strength of the underlying origin

and destination service area economies. Moody’s analysis focuses

on these factors as key explanatory variables for the increasing gap

between the median airport and the median airline rating.

Air transportation remains an essential service in our economy

and Moody’s believes that because of the difficulty in building new

airports and the long lead time needed for environmental approvals, existing airports will generally be able to pass justifiable operating and capital costs on to airlines and passengers despite financial turmoil in the airline industry. Given the strategic importance

of hub facilities for legacy carriers and their large investment in

local facilities, certain hubs may even benefit from route restructuring by their dominant carrier.

For example, when Delta chose to de-emphasize its Dallas-Ft.

Worth hub last year, Atlanta Hartsfield Jackson saw significant increases in its connecting traffic. Likewise, when American scaled

back its hub at Lambert St. Louis, Chicago O’Hare saw an increase

in connecting traffic. We define a hub as having more than 30 percent connecting passengers.

With three of the six legacy airlines in the U.S. now operating

in bankruptcy, our focus is on identifying those airports that may
23

suffer financial stress as a result of cuts in service, reductions in

passengers and revenues as well as those airports that may suffer

a rejection of key airline leases. Airlines operating in bankruptcy

generally continue to pay airport rates and charges and in most

cases do not radically downsize their operations. These are two important offsetting factors that help buffer the impact of an airline

bankruptcy on the ability to generate revenue at an airport.

Our analysis will continue to weigh the credit impact of the

bankruptcy filing of an airline on the ratings of its hub airports.

We will also consider such credit fundamentals as the size and economic health of the origin and destination base, the financial

strength of the airport and the operating agreements for airlines at

each facility.

Hub airports served by airlines in bankruptcy often have agreements that allow the airport to charge the airlines fees to recover

all operating and debt expenses. The so-called residual agreements

often include a credit for all non-airline revenue such as parking

and rental car fees and food and beverage concessions as an offset

to airline charges. While some airlines may not wish to pay increased fees, Moody’s believes that the opportunity to serve many

of the larger local markets and the higher fares in some of these

markets would be an incentive for the remaining or new carriers

to increase service and continue to pay the agreed upon rates and

charges.

While the bankruptcy filings of Delta and Northwest are partly

the result of certain pressures common to all airlines such as high

fuel costs, rising labor costs, low yields in the aftermath of Hurricane Katrina, the circumstances surrounding each filing differ significantly and the resulting impact on airports may be different.

Both airlines will look to regain their long term business viability

by seeking to lower their costs in a variety of areas. Some of these,

for example, labor costs, are neutral to airports. Strategic decisions

about route structure and capacity reductions on the other hand

can have a significant operational and financial impact on airport

credit.

Airports may also be affected by the legal strategy the airlines

adopt regarding their airport leases. Airlines may choose to reject

comparatively expensive or older leases, especially at airports they

are also considering for service cuts. On the other hand, and as we

have seen time and again, airlines are likely to affirm other leases

at airports they deem strategically vital to their network.

In conclusion, we continue to focus on those airports that in our

view lack one or more of the credit strengths that support the divergence in credit quality of airports and airlines. In Moody’s opinion, the increased risk that the airline restructuring process implies will be borne by those airports with less favorable routes, a

high reliance on airline-derived revenues, a service area that is

below the median in terms of generating demand for air travel,

below average liquidity levels and limited ability to cut airport operating costs and/or scaled back capital programs.

Thank you again for the invitation to testify. I would be happy

to respond to any questions.

Mr. MICA. Thank you and thank all the panelists. It took a little

time to get through but we don’t have any other witnesses today
24

and we wanted to hear from each of you involved in looking at the

industry and give you an opportunity to make presentations.

I have a few questions. Unfortunately, there is a conference

going on so we have lost at least half of the membership but I want

to go ahead since you have been patient and continue with the

hearing.

My question for each of you, first of all, is do you expect additional bankruptcies in the short or the near term and the long

term? Mr. Kiefer?

Mr. Kiefer. I would have to say I am optimistic at the prospect

of American and Continental, the two major legacy carriers that

have thus far avoided bankruptcy. I am optimistic at the prospect

of them avoiding bankruptcy. Certainly in the near term, there is

not a likelihood of that. Their cast positions are such that it is not

likely in the near term.

I think in the long term, American was among the first of the

major legacy carriers to negotiate major concessions with their

union early on in this crisis. Continental has probably the reputation as the best labor relations among the legacy carriers and I

think the combination of those two things implies they are likely

to be able to negotiate further concessions in order to avoid bankruptcy.

However, as I mentioned, should Delta and Northwest elect to

terminate their pension plans or convert them to defined contribution plans, American and Continental will find themselves to be ostensibly the only major legacy carriers remaining that offer pension

benefits. I think those costs will prove unsustainable to those carriers in the long term. So their ability to negotiate those potential

reductions in benefits and costs will be a key factor in their avoiding bankruptcy in the long term.

Mr. MICA. You answered part of my next question. Let me give

Mr. Baggaley a chance.

Mr. BAGGALEY. In the near term, I think the most likely bankruptcy candidate is an airline you are familiar with in this area,

Independence Air. I don’t expect that American or Continental are

likely to file unless there are further shocks to the system such as

a further major increase in fuel prices or terrorism.

Over the longer term, I think I would agree with Mr. Kiefer that

the pressure of the benefits and pensions might cause them to file

for bankruptcy. I would expect what they would try to do is negotiate outside of bankruptcy to at least reduce those benefits. Their

pension deficits are not nearly as large as those of Delta and

Northwest, so they are not under quite as much pressure.

Mr. MICA. Dr. Morrison?

Mr. MORRISON. I should add that my study of the industry is not

at the firm level and my fellow panelists may be much better informed than I am, but I will say it wouldn’t surprise me to see another bankruptcy.

Mr. MICA. Mr. Sokel?

Mr. SOKEL. I think if the situation in terms of high jet fuel prices

continues in the next fiscal year, it is difficult to see how you

wouldn’t have additional bankruptcies unless the additional costs

of operation were passed on to the flyer because at this point, it

strikes me that most of the major carriers have very little sense of
25

what the outlook really is in the sense that if they had to hedge

at this precise moment. I don’t think any increases in refinery capacity are going to meet the short term needs of the industry.

Mr. MICA. Ms. Matesanz?

Ms. MATESANZ. I would defer answering that question to our airline analyst at Moody’s and I would be happy to report back his

views.

Mr. MICA. I have a question for you and you are sort of our airport expert. Did you say the airport bonds were at what rating?

Ms. MATESANZ. The median rating for airport bonds is A2.

Mr. MICA. And airlines were B2?

Ms. MATESANZ. B3.

Mr. MICA. Do you see any change in that rating for airports as

a result of the current bankruptcies or financial problems that we

have seen over the most recent period of time?

Ms. MATESANZ. The median rating is something that moves very,

very slowly.

Mr. MICA. So it would take a while to impact that?

Ms. MATESANZ. Exactly, and we don’t see any radical changes in

the profile of the sector. We have a stable outlook on the airport

sector as a whole.

Mr. MICA. What should Congress do and Mr. Kiefer, you said the

pension was the big enchilada.

Mr. KIEFER. I think with respect to the question what should

Congress do, with respect to the pension benefits I suppose one

piece of guidance I would offer is that I think it is likely if not certain in the long term that pensions will no longer be a feature of

the U.S. airline industry. The low cost carriers have never had

them and never will. I think any efforts at pension reform ought

to be aimed at preserving benefits for existing employees rather

than trying to maintain them for potential future employees because I think they are likely to go away in that regard.

Mr. MICA. Mr. Baggaley?

Mr. BAGGALEY. Standard and Poor’s has a policy of not recommending for or against any public policies. I would just make a

note as to the pensions.

Mr. MICA. You have also provided the charts on AMR that reflect

also industry. They cut labor.

Mr. BAGGALEY. That was $1.8 billion.

Mr. MICA. Right. They are getting hit in the shorts here with the

fuel and they have cut some of their overhead.

Mr. BAGGALEY. There were various other cost reductions on the

order of $2.2 billion, so one can see just how much of their progress

has been wiped out by the rise in fuel prices.

Mr. MICA. Again, pensions would still be sort of the big enchilada

in obligations and fuel?

Mr. BAGGALEY. Actually, the largest portion of American and

other airlines’ obligations are secured debt and leases. Pension deficits are significant but they are a minority of the total.

Mr. MICA. The only way you can restructure those would be

through bankruptcy or negotiation?

Mr. BAGGALEY. Yes.

Mr. MICA. Dr. Morrison?
26

Mr. MORRISON. I mentioned in my testimony that an extra half

hour early arrival at the airport is estimated at 7 percent.

Mr. MICA. Seven percent. That was interesting. I am going to use

that because I am trying to get them to do in-line systems and

some other things, faster screening.

Mr. MORRISON. That is my suggestion precisely. It seems to me

that in the scheme of suggestions, it is relatively uncontroversial.

Mr. SOKEL. I am not entirely sure what can be done in the short

term and the longer term. The Congress should look into the initiative offered by the Kuwaitis with regards to their offer to build a

refinery within the United States because it would seem it is a bit

of robbing Peter to pay Paul at the moment.

Mr. MICA. Interesting. Ms. Matesanz?

Ms. MATESANZ. Again, I would limit my remarks to the impact

on airport credit and would be happy to provide an answer.

Mr. MICA. So you don’t see a big problem and you don’t see that

Congress has to step in at this point?

Ms. MATESANZ. Again, with respect to the airlines, I would defer

answering that question.

Mr. MICA. Right, but I meant airports.

Ms. MATESANZ. As far as airport credit, again, our outlook is stable for the sector. While airline bankruptcies are something that

we look at closely, particularly for hub airports, we look at a whole

host of other factors that airports have under their control such as

the ability to offset airline revenues with other sources of revenue,

the ability to cut their operating and capital budgets, their ability

to attract other carriers to those markets through efficiencies in

their own operations as offsets to the credit impact of an airline

bankruptcy on their own operations.

Mr. MICA. I thank all of you for your comments. We don’t have

jurisdiction over fuel prices, we don’t have jurisdiction over the four

cent jet fuel tax and we don’t have jurisdiction over pensions, but

I think it is important that we review the impact of all of these on

the airline industry and if necessary, take steps where we can assist, but don’t underwrite a failing business operation or model. I

have been sort of the tough guy on the block on this because I

think that subsidies would only temporarily delay the inevitable as

far as the airline business is concerned.

Last, I thought we were doing a pretty good job in increasing

fares and the airlines have increased fares from February to some

time this summer about eight times. That has helped some of them

see at least a minimal operating positive. I think one of you said

all failed to institute price increases as a competitive area they

won’t touch. They have done that. Does anyone want to comment?

I just don’t see any other way for them to survive if they don’t increase their fares.

Mr. KIEFER. I think one thing that is important to point out is

if we observe any recent fare increases that in addition to being

very cyclical, this business is also quite seasonal. Fares typically,

both for domestic travel and international travel, will increase in

the summer because that is a higher demand season. That may be

something we are observing there.

I would offer one other further comment to the prior question. I

think it is important when Congress looks into this issue and when
27

you are thinking of what you may do about it, to think of this issue

in the broader industry context which is to say that some of the

same factors that are causing the large financial losses in the industry, the low cost competition and so forth, are also affecting the

ability of the system to fund its future infrastructure needs.

I think issues like the proposed fuel tax holiday or proposals that

may soon be on the table to restructure the Federal Aviation Administration and so forth need to take into account not only the

current but the long term financial health of this industry. Those

proposals that might threaten that should be considered in that

light.

Mr. MICA. Thank you. I agree with that.

Mr. Baggaley? Anyone else?

Mr. BAGGALEY. Historically, it has been very difficult to pass

through fare increases in the domestic market but this year the

pattern has changed somewhat. As you said starting in February,

there have been a series of increases. I think the level of fuel prices

reached the pain threshold even for the low cost carriers and they

went along with these fare increases.

The bankruptcies of Delta and Northwest will probably result in

some further withdrawal of capacity and probably out of the Country because there are other areas where there is strong demand

and that should help that a bit further.

Mr. MORRISON. It is safe to say that fares over the longer term

have to rise but it is hard for them to rise in the current environment with the capacity that is there. Unilateral action by one carrier won’t do it and we generally frown on collusive behavior which

might be in their collective interest but not in the interest of passengers.

Mr. MICA. Mr. Sokel?

Mr. SOKEL. I suspect the problem is that the rate of fare increase

doesn’t match the rate of the jet fuel price increase ultimately.

Mr. MICA. Mr. Costello?

Mr. COSTELLO. Mr. Baggaley, you addressed the issue of capacity

in your statement. In fact, you refer on I think the last page of

your testimony to that where you say ‘‘Consolidations, either

through bankruptcy or liquidation or mergers will help the industry but only if it is accompanied by the withdrawal of planes from

the U.S. market and by competitive cost structures.’’ What do you

mean by that? In other words, regardless if you have mergers, if

you have bankruptcies, whatever takes place, we have too much capacity? Is that what you are saying?

Mr. BAGGALEY. Capacity is a partial problem. If you look at the

percentage of seats filled, it is actually quite high and to the extent

that some planes of a high cost carrier are simply moved out, low

cost carriers will expand to fill the void.

The thing that gives some hope for the current situation is that

with strong demand overseas, some of these planes will be redeployed there and the legacy carriers are lowering their costs to be

closer to the low cost carriers. Over capacity is a problem but it is

not the sole problem and some of the changes that have been suggested as potentially helping the industry work only if it is accompanied by cost reductions.
28

Mr. COSTELLO. You also say that broader trends and changes

could heal the industry. Elaborate on that.

Mr. BAGGALEY. They could help somewhat but I think the industry is going to be financially stretched for the foreseeable future.

The best case scenario is that the legacy carriers lower their costs,

are modestly profitable in the best of times but still highly leveraged and at risk in a down turn. The best case is not terribly

bright but it is certainly better than the worst case.

Mr. COSTELLO. The hub and spoke system, is it still an effective

model for the legacy carriers?

Mr. BAGGALEY. The hub and spoke system can generate more

revenue and there are some very successful carriers overseas who

use it. Also some of the low cost carriers use it, so it is not pure

dichotomy between a Southwest model and an American Airlines

or United model. The problem is that the extra revenues generated

by the system have been shrunk by the low cost competition and

that still leaves them with the higher costs. So they have been trying to shift more of their flying overseas, shift more to local markets and lower the costs at which they operate the hub and spoke

system.

All the low cost carriers, they don’t have international operations, they don’t have regional feeders so if we are to serve the

Country, there is a place for a hub and spoke system but it has to

operate at lower costs.

Mr. COSTELLO. Mr. Kiefer, I mentioned in my opening comments

about the argument that the legacy carriers are operating under a

business plan that may no longer be effective, in particular the

business traveler, the premium ticket price made up in the past a

major portion of the revenue going to the legacy carriers. I am wondering if you agree with that and if so, what changes will have to

take place in the legacy carriers business plan in order for them

to get back into the market?

Mr. KIEFER. I think I would agree with it at least in part which

is to say that the composition of the traveling public that now exists is fundamentally different than it was four or five years ago.

There is much more price consciousness and so it is true if the

business model is predicated on the ability to charge much higher

fares on business travelers, it is proving problematic. I think there

are business travelers willing to pay those higher fares out there;

the problem is there are simply not enough of them to sustain the

legacy carrier’s profitability.

At the same time, however, legacy carriers do offer certain premium services such as first class, airport clubs and so forth which

are attractive to business travelers and provide benefits that are

desirable to the extent I don’t see them going away in the long

term. They also offer international services which as we discussed

because of their continued regulation largely do have much higher

profitability than domestic services and so forth. I don’t think the

business model is completely broken but I think it is much more

difficult to apply in the current environment.

With respect to the operating model to address some of the comments of Mr. DeFazio earlier, I think the hub and spoke system

likewise provides some very significant benefits to the traveling

public. It allows the connection of far more origins and destinations
29

than would be possible with strict point to point service, it allows

the connection to international gateways which is vital to the air

transport system and finally, perhaps most importantly, it provides

connection for small communities to the air transport network that

simply might not be possible otherwise. So I think it has a lot of

benefits that will probably keep it around for some time.

Mr. COSTELLO. You also mention in your testimony that the low

cost carriers are quite vulnerable to some of the challenges that

face the legacy carriers, obviously high fuel costs being one. What

other challenges do you see for the low cost carriers and what does

the future look like for the low cost carriers?

Mr. KIEFER. I think certainly fuel is the most significant of those

challenges. Southwest hedges a significant 85 percent this year at

I think $26 or $28 a barrel. Those hedges will subside in the next

few years. They are only hedged I think about 28 percent on average. I could be corrected on that but for the other low cost carriers.

I think the other big issue is labor costs. Ironically, just as we

have talked about the very significant cuts in wages and benefits

that the legacy carriers have instituted, if anything, low cost carrier wages are likely to increase. I don’t ever see them instituting

pension plans or post-retirement, health insurance but it is likely

that pay for those carriers, particularly as they grow and continue

to be profitable, will increase. Labor being upwards of a third of the

total operating costs of the carriers, that will begin to bear on their

future profitability.

Mr. COSTELLO. Mr. Sokel, it is my understanding that a large

percentage of the airlines hedges were in crude oil as opposed to

their actual exposure which is jet fuel. Why was that?

Mr. SOKEL. I think there are a few reasons. The first is that

there was the perception at the CFO level within many of the carriers that WTI, which is the benchmark in the United States, is the

liquid most actively traded index and therefore because it is liquid

and because it is screen based, New York Mercantile Exchange

based, there was a belief that this would seem to be a benchmark

that was more suitable versus something that was strictly traded

over the counter.

The problem in that perspective is that it doesn’t recognize accurately the fact that in times of extreme demand or supply restriction or both, such as we have now, you can have this increasing

basis risk and companies that are only hedged in crude oil lose out

on this increase in price in the actual product. I think another reason is that once one airline hedges in WTI and another reports that

they are hedging in WTI, it almost becomes the standard for the

industry.

Without going into specifics, I would debate that the jet fuel

index as traded in the over the counter market is very liquid. It

takes a little bit more of an understanding of how it is traded and

what the basis is but clearly the difference between hedging in jet

fuel or heating oil or crude oil probably makes the difference on the

bottom line of tens of millions of dollars.

Mr. COSTELLO. Final question for the panel. Just a brief response, if you will.

The Chairman asked the question about what Congress should

be doing. I would ask, as I made mention in my opening statement
30

that Mr. Crandall and others have asked, regarding the issue of

bankruptcy, what he thinks should be done as far as the bankruptcy laws are concerned, capacity issues and so on. My question

is, what if Congress does nothing? What if we take no action whatsoever with the issue of bankruptcy, with capacity, with fees and

taxes, what happens to the industry? Mr. Kiefer?

Mr. KIEFER. I think as I stated earlier, there are additional job

losses that are likely, there is the real prospect of additional loss

of pension benefits for significant numbers of employees and I

should point out in the case of pilots, this is a very substantial reduction in benefits from perhaps as much as over $100,000 a year

in benefits being reduced to less than $30,000 a year in benefits.

Having said that, I think inevitably if Congress does nothing, I

do believe this industry will right itself in the long term and perhaps additional consolidation whether it be liquidation or even just

the renegotiation of benefits will ultimately provide for the long

term financial health of the industry.

Mr. COSTELLO. Mr. Baggaley?

Mr. BAGGALEY. If fuel prices gradually decline, that can be partly

covered by fares, I think the legacy carriers will struggle through.

They will shrink, some of them will merge and as I indicated earlier, they will be financially weak, but still flying. If there are further price shocks or other outside shocks, I could certainly see some

major carriers shutting down in bankruptcy.

Mr. COSTELLO. Dr. Morrison?

Mr. MORRISON. What if Congress does nothing? I am an economist so the perspective that I take is one of is there a market failure that needs correcting? I am unaware of a market failure in the

sense that economists mean it, that needs correcting. I would agree

with my colleagues as to what would happen in the absence of action.

Mr. COSTELLO. Mr. Sokel?

Mr. SOKEL. If Congress does nothing, then the average American

can expect to pay a lot more for their privilege to fly. In absence

of that, you will have increased bankruptcies.

Mr. COSTELLO. Ms. Matesanz?

Ms. MATESANZ. Speaking from the standpoint of the airport sector, the capacity issues that are strained by the hub and spoke

model are something that need to be focused on as far as facilitating airport expansion at those airports that are capacity constrained already. That is an area that potentially need some more

study and some more scrutiny as far as how to expedite the building and development of additional capacity to support the efficiency

and fuel economy by extension of the airport tenants that serve the

airports.

Mr. COSTELLO. Mr. Chairman, I have another question or two

but my time is up and there are other members here. Hopefully,

we can come back.

Mr. MICA. Mr. DeFazio?

Mr. DEFAZIO. Thank you.

Mr. Kiefer, you seemed to indicate a little sensitivity to the concern I raised about connectivity of the system. It obviously can

profit the system if it works properly in dealing with small or midsized cities.
31

What I would like to understand both from you and others is

what do you think is a policy role? I am not sure that markets are

enough to continue to serve those areas especially since, if we want

to talk like economists, we don’t take into account external

diseconomies, the external diseconomy being the people who live in

the second largest city in Oregon have to drive 120 miles to the airport in Portland because all of the little planes that now fly out of

our market are overbooked. They are 100 percent full.

So it is kind of a problem. You can’t get there at night any more,

but other than that, it is working pretty good. That is happening

to people outside of virtually every major urban hub in America

and most of us do not represent major urban hubs.

If you look at the GAO studies, that is where the big drops in

air fares have come but in a lot of your smaller, mid-sized cities,

air fares have not been as generously discounted into those markets and the service is crummier.

The question is as a policy maker, what is the vision for the system? Are we ultimately going to abandon everything but say

SEATAC and San Francisco and LA on the West Coast and I don’t

know what it will be in the middle and a few on the East Coast

because that is where the market takes us? So, you have to drive

400 miles, that is your problem if you want to fly? We are losing

something here.

Does anyone have any ideas on what we should do as policy makers as opposed to pointing fingers in terms of dealing with us?

Mr. KIEFER. I think as policy makers, the Congress has already

addressed the issue of service to small communities through the

Essential Air Service Program.

Mr. DEFAZIO. It is a pretty lame program and I keep asking people for a better model.

Mr. KIEFER. I just offer that as context but I think you raise an

important point that while at the same time the hub model allows

more frequent service or connects to more destinations, the small

community, often it does so through perhaps one airline. That is

why I think you observe the much higher prices that you do in your

community or elsewhere from these smaller communities to the

large hubs and so forth.

I am not sure I can offer a direct policy prescription for that

issue but I agree with you that it is not to say that there are not

other issues with respect to the hub and spoke system and its ability to serve small communities because it does indeed do it perhaps

more frequently but more expensively as well.

I don’t see in the long term however, a reduction in the number

of airports that serve passenger traffic or serve it at any significant

volume because air travel is forecast to grow over time and if anything, the trend has been particularly through the advent of regional jets and so forth to add more point to point service to medium-sized airports rather than service at very large hubs.

So I think the future is not necessarily bleak for the smaller or

medium-sized cities with respect to their air service, but I agree

that it may not be ideal at present and it may look a little different

in the future. As for how to reinvent that from a policy perspective,

I am not sure I have a prescription for you at this point.

Mr. DEFAZIO. Thanks. Anybody else have a comment or idea?
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Mr. BAGGALEY. There is an interesting experiment which will be

rolling out shortly and that is Jet Blue, a low cost airline, will be

deploying large 90-100 seat regional jets and they expect to expand

those throughout much of the eastern half of the Country. If that

works and there are some new larger regional jets that are very

efficient and the pilot unions at the major airlines, the contracts

have been changed to allow that in many cases, you could see a

greater seat capacity available to some of these communities and

therefore, lower fares. They wouldn’t be 100 percent booked anymore.

Mr. DEFAZIO. Mr. Morrison?

Mr. MORRISON. The issue of service to small communities is

something I looked at ten years or so ago and the issues may well

have changed or the situation may have changed, but what I found

then was the level of service and the fares charged which are certainly higher than others, were based on the less demand and higher costs attended with lower capacity aircraft, that they are more

expensive to fly, there are fewer passengers flying so frequency is

less, service is definitely less but there are fewer passengers.

As far as some regulatory type solution or a non-market solution,

I know some local communities make contracts with airlines guaranteeing some minimum.

Mr. DEFAZIO. My largest city pioneered that, so it is a marketbased way of attracting people.

If we could, someone referred to going to Europe, people are

going overseas. The question is how are fares set overseas. My understanding is in Europe everybody is charging a fuel surcharge

and somehow that happens.

I guess it is not a market-based system or it is a market-based

system that somehow tolerates getting a premium for higher fuel

costs and so American airlines have to go over there to operate so

they can make money when the planes are full as opposed to losing

money when their planes are full here. Can you help me out with

that? What is the difference?

Mr. BAGGALEY. The legacy carriers have expanded their flying to

foreign destinations, they are not flying within those destinations

but transatlantic flights, transpacific and so forth. There are as yet

no true low cost carriers serving many of those markets, so the

fares, at least in the summer, are higher, the planes are full there

are fewer participants on each route, so they are more attractive.

However, that has its limits. In the past, the transatlantic market airlines have dumped in too much capacity and the fares have

fallen. At the moment that is the relatively good area.

Mr. DEFAZIO. On the issue of fuel, Mr. Sokel, I have been looking

at some analysis of what has happened to refining. It is pretty interesting. You talked about the historically low rates of return and

I grant you from 1999 to 2004, refineries were making 22.8 cents

for every gallon refined.

By the end of 2004, they were making 40.8 cents, almost twice

as much, and this year they are making $1.10 or somewhere between $1.00 and $1.10. That is up five times. Were you talking

about the 22.8 cents for historically low rates of return, the 40.8

cents or were you talking about today’s $1 rate of return?
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Mr. SOKEL. I was talking about really prior even to the 22.8

cents because if we go back to the example of what took place in

the mid-1990s and even in the late 1980s, the downstream sector

has been in a period of significant consolidation probably for the

better part of the last 15 years and it is really only in this last

three or four years that companies such as Valero, Exxon-Mobil,

British Petroleum are showing significant returns in the refiner

sector.

Mr. DEFAZIO. Would you say at $1 a margin per gallon that

would be enough incentive economically to build a refinery?

Mr. SOKEL. That is a very interesting question but I guess if I

listen to Lee Raymond or Sir John Brown, it would seem the logistics of actually building a refinery in a place that is commercially

viable is still a question that needs to be answered. There are not

too many people sitting in this room who would like to have a refinery or a terminal capacity put near where they live.

I think it is a combination of things. How much environmental

legislation needs to be passed if it is particularly in California, in

New York, in Florida and in some of the major markets. I would

imagine in the State of Oregon, it would also be difficult to hurt

the pristine vantage point that people have by putting a refinery

there.

Mr. DEFAZIO. We are looking at several liquefied natural gas facilities in Oregon. We are connected to the gas lines. We aren’t connected to the gasoline lines except for one very small pipeline. That

is why they tell us we on average always pay more than Washington and California. So bringing it into Oregon wouldn’t do you a

lot of good because you can’t get it out again.

The point becomes as I understand the President’s proposal

which may or may not have been serious but he said that he would

work to waive all environmental laws or could potentially in an executive manner waive environmental laws to put a refinery on a

closed military base which could likely be in one of those areas.

It seemed there was a resounding silence from the industry and

when you see quotes like Valero’s chief operating officer, a quote

in the Post saying, basically it is working pretty well the way it is.

It kind of reminds me a bit more of California in the days of the

former Enron where our plants are down for maintenance, markets

up, so if we run right on the edge of refinery capacity, when they

shut down, we see a little blip. We went up 30 cents a gallon in

Oregon, even though we are not in the East Coast network, because of Katrina. That was interesting.

I guess I am questioning whether there is a market here and

whether we need to look at a little bit of disaggregation in this industry when you look at the concentration. I would be curious if

you think this is adequate that we have gone to the point now from

34.5 percent being the top five refineries in 1993 to 56.3 percent

and 83 percent in the top 10. I am beginning to wonder whether

we have real market characteristics here or whether we are seeing

a little bit of manipulation and excess rents or price gouging as

some of us call it?

Mr. SOKEL. I would almost argue that price gouging occurs more

when the price is low in terms of gasoline than when the price is

high because the level of sensitivity is that much higher when the
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prices are high. I think there are more than a number of national

oil companies that would love to be able to put a refinery in the

United States if for no other reason than to have an outlet for their

additional crude oil. Whether that would be Saudi Arabia or Kuwait or the Emirates, and I can name a host of others, I suppose

it has 30 years or thereabouts since the last refinery was built in

the United States, so most of the executives who have been with

these companies for a long time can’t even remember.

Mr. DEFAZIO. They don’t know how to build them any more.

Mr. SOKEL. They might have forgotten or if they do, the building

prospects are mostly in the emerging market countries. That is

kind of the perspective that I have. It is precisely in the countries

that are considered emerging markets now where most of the refinery capacity has increased over the last decade.

Mr. DEFAZIO. The interesting thing there is what are the profit

margins over there?

Mr. SOKEL. They are good but they are not as good because of

the simple fact that people don’t drive in the same way that they

do in the United States.

The one point I would like to make is that in terms of the waiver

of sulfur, that is an interesting proposal from the President because a number of the refineries in the Middle East, for example,

produce a higher sulfur of gas oil that currently does not come into

the United States in its natural form. Were sulfur requirements to

be removed, a lot of that product by normal market forces would

find its way into the United States.

Mr. DEFAZIO. I think there is a problem with the outfall of burning the higher sulfur fuels particularly with catalytic converters

and other things I don’t think we are going to recommend we step

back from.

Mr. SOKEL. The problem is, given the environmental legislation

that would be needed to do that, that is probably a non-starter.

Mr. DEFAZIO. Thank you.

Mr. MICA. Mr. Larsen?

Mr. LARSEN. Thank you.

A little more about hedges. We are doing our part in Washington

State out of the four refineries located from northern California to

Washington State to the border, four of them are in my district, so

we are doing our part on refineries.

Mr. Sokel, with regards to hedges, Mr. Costello asked a question

about why hedge on crude oil and not jet fuel and it seems to me

in terms of that regard, nothing government did stopped or prevented or forced people to hedge into the crude oil market versus

jet fuel, that the decisions made by airlines based upon whatever

advice they got, they made those decisions to go into crude oil and

not jet fuel.

Why make that choice versus Southwest Airlines, if I am not

mistaken, has a better hedge in jet fuel versus crude. What is the

decision-making process that takes place within an airline so we

can understand that because it is not something we are going to

be able to address, nor should we interfere in a market like that.

Mr. SOKEL. It is an interesting set of questions. I guess you could

start by saying that unto each individual airline goes their own rationale of how to hedge, when to hedge, whether to hedge at all.
35

There are a lot of concerns that go into the matter, not the least

of which is what happens if we put on a hedge that loses money

and Wall Street says, well, we didn’t invest in your company because we thought you were a good oil traders, we wanted a pure

view on the positive prospects of the industry.

Just to step away from the aviation industry for a moment, that is exactly what happened recently with Valero. Valero lost $300

million on their refinery hedges and more than a few analysts did

say to William Grehee, we didn’t invest in your company because

we thought you were good oil traders. We wanted a pure view on

the refinery sector. It didn’t matter that the stock price has gone

from $40 to $120 in the last year, people always found something

to moan and groan about.

If I can make a comparison with one of the European carriers

that Deutsche Bank does a great deal of business with, the way

they set it up is they try to mirror the hedging program actually

with their route structure. For example, if they know they are

going to be refueling 70 percent in the northwest European market,

that is where 70 percent of their hedges go. If it is 10 percent in

the Gulf Coast or related pricing to the Gulf Coast, then that is

where they would do it.

In terms of the American carriers, I think Southwest is probably

the best example of having instituted a hedge program at least that

in percentage terms goes out to 2009, I believe between 30 and 40

percent hedged between 2007 and 2009. Ultimately it comes down

to an individual or group of individuals saying, we really don’t

think there will be that much demand for jet fuel relative to crude

and we are trying to place our hedge in something that will at least

reflect the broader price of oil.

Again, the question of liquidity and transparency typically is one

reason because a typical CFO is not only hedging oil, they are

hedging interest rates, currency, so familiarity may go to the heart

of the matter of how hedges are placed and certainly when they are

placed.

Mr. LARSEN. In your view, for future planning for individual airlines, has the econometrics model that has existed for the price of

the barrel oil permanently shifted up, is the delta steeper now and

should they be thinking about that?

Mr. SOKEL. I think it is a very delicate point because arguably

most airlines are now on the more optimistic side of their view of

what jet fuel prices will be for the next two years. I am a little bit

conservative in my view but I believe you have to estimate the

price of jet fuel as to what the price would be if you had to hedge

100 percent of your fuel today.

Many in this room would argue that is not necessarily indicative because the analyst community did not expect to see $70 right now,

they were forecasting much lower price and it is now for next year

they are predicting $60 prices, so the contrarian in me says maybe

there will be lower prices just because everyone now has suddenly

gotten onboard that the prices of energy are high.

Having said all that, an absent a recession, global reduction of

growth, it is hard to see given the global situation in jet fuel and

with global airlines. I did mention the demand for the marginal

barrel of fuel. It is a fungible market, the barrel of jet from a Ko-
36

rean refiner to LAX airport, so on and so forth, has its way of when

one market is in deficit, the other market in surplus provides that

market but all that means an increasing demand period, it just

means higher prices for the extended period.

Mr. LARSEN. Mr. Baggaley had some comments about hedging

and Southwest. Do you want to comment on any of this?

Mr. BAGGALEY. Yes. It is certainly the case that many airline

managements are regretting that they didn’t try to put more

hedges in place but the biggest difference between Southwest Airlines and the legacy carriers is Southwest Airlines is rated A, a

solid investment grade credit. They can do business in setting up

hedges with others because counter parties will take their credit

risk.

For most of the legacy carriers, for all of the legacy carriers, they

would have to put up cash collateral and they are trying to conserve their unrestricted cash. That is their last line of defense

against bankruptcy. So their choices at this point have narrowed.

Mr. LARSEN. Thank you, Mr. Chairman.

Mr. MICA. I thank all of our panelists. I think you have answered

the question of what should Congress do and what if Congress does

nothing.

I guess that is sort of the question. It looks like we are headed

toward some type of assistance with pension reform which is also

spilling now into other aspects and segments of our economy. Regarding fuel, we must increase refining capacity and supply on an

expedited basis. Not much is going to happen there. I think we are

at sort of a standoff as to what Congress can do.

I am glad you all raised the four cents and the ticket tax, and

financing the infrastructure. We talked a bit about capacity of the

airlines interns of seats but we also face a capacity crunch with airlines as far as a place to land planes. We can only fit so many

planes in so much air space and we are back to the pre-September

11 capacity issues facing the industry.

I am concerned about the impact of leaving airports and others

holding the bag so to speak, particularly when it is necessary to

continue increasing capacity for more planes to land. If you can’t

have more revenue and you can’t do more business, there is not

much hope for the future. That is just a couple final comments.

I appreciate your participation. We may have some additional

questions. Some of our members were called away for a conference

but we do appreciate your insight and sharing your opinions, your

knowledge, your experience with us. Again, on behalf of the Subcommittee, we thank you for your participation today.

We will conclude the hearing. There being no further business

before the Aviation Subcommittee, this hearing is adjourned.

Thank you.

[Whereupon, at 4:15 p.m., the subcommittee was adjourned.]
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