By PETE FAHRENTHOLD, managing director, risk management, Continental Airlines
First of all, air travel is derived demand, and for the majority of the world's airlines, that demand is based chiefly on the desire for business travel. The airline industry is also very capital-intensive and characterized by high fixed costs. High utilization of assets and economies of scale to reduce unit costs are key elements to airline financial success.
In addition, the inventory an airline produces can't be stored and the amount of inventory it produces can't be easily reduced. Seats on a flight are perishable assets that "spoil" once the aircraft leaves the gate. Although an airline can remove aircraft from the flight schedule to reduce the capacity being provided, most of the cost associated with those aircraft continue.
Those fixed costs can be substantial. A typical twin-engine aircraft used for a domestic route is an investment in the vicinity of $50 million and a long-range aircraft for transoceanic service can cost $130 million. Removing an aircraft from service can significantly increase unit costs for operating the remaining aircraft and further undermine profit margins.
These inherent structural risks are being intensified by the current economic downturn. The reduction in the availability and the increased cost of capital has impacted the ability of airlines to finance needed aircraft replacement and refinance existing obligations. Demand for business travel has gone down due to layoffs in key industries such as financial services and to reductions in travel budgets. Nearly all of the U.S. airlines have responded by grounding aircraft to reduce capacity.
In the past, airlines outside the United States were expanding and provided a market for the aircraft removed from the U.S. system. However, the fact that the economic downturn is a worldwide event has greatly reduced the demand for used aircraft and the financing available to purchase them. Fixed costs continue to be incurred while these aircraft sit in desert storage.
Fuel availability and cost remain a significant risk in spite of the fact that current oil prices are down from their record levels 18 months ago. The reduction in the price of oil has reduced operating costs for the airline industry but it has also reduced the profitability of many of the corporations that purchase business air travel. As a result, airline passenger traffic is down. In addition, fuel prices are always subject to spikes resulting from a sudden decrease in availability, such as a terrorist attack or a change in the political outlook of a major oil-producing country.
Greenhouse gas legislation is becoming a reality for airlines operating in Europe, including the U.S. airlines that fly into Europe. The cap-and-trade program being implemented in the EU will begin to impact the airlines in the next two to three years and U.S. legislation is expected in the near future. The budget proposals currently being debated in Congress specifically include revenue from a cap-and-trade system beginning in the next three years and there is no reason to assume that airlines will be exempted from that requirement.
How has Continental Airlines responded to this environment? While we use a number of risk mitigation techniques, including traditional approaches like financial hedges for oil and lobbying efforts on issues such as cap-and-trade, our most critical risk mitigation technique is the use of an enterprise risk management approach to ensure that we are focused on the right risks.
Our ERM process ensures that emphasis is placed by the right people on those exposures that represent the greatest threat to the "business" that is Continental Airlines. Managing risk at this level requires the involvement of senior executives and a system to anticipate and analyze business risks. The fact that we have excellent fire protection in the hangars or that we hedge our foreign currency exposures is good but it does not respond to the business exposures. The captain of the Titanic had the most up-to-date fire protection systems available for ocean liners but he did not have enough binoculars.
April 15, 2009
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