SKY HIGH

06.22.15 9:21 AM ET

The Cartel That Makes Sure Airplane Tickets Never Get Cheaper

It’s been a windfall year for the industry, but you won’t be getting any better accommodations or more affordable fares. What gives?

Screw the passengers.

That appears all too often to be the governing philosophy of the airline business.

Take the case of a United Airlines flight from Chicago to London last weekend. A technical problem forced the plane to abort its trans-Atlantic route and divert to Goose Bay in Canada. The 176 passengers were marooned there for more than 20 hours, sleeping in unheated military barracks at near-freezing temperatures.

“There was nobody from United Airlines to be seen anywhere,” one passenger told NBC News. “No United representative ever reached out to anybody, no phone calls, no human beings, no nothing. Nobody had any idea what was going on.”

It so happened that this came at the end of a week in which the world’s airline chiefs, junketing in Miami, celebrated their most lucrative year ever. They are projecting profits totaling $29.3 billion in 2015—almost double what they made in 2014.

And you must have noticed if you’re flying anywhere in the U.S. this summer that seat prices are not falling. Indeed, if the owners of those seats are suddenly feeling fat and happy, they are in no mood to pass on their swell feelings to you. They get the Dom Perignon; you will be lucky to get water.

It’s hard to imagine any other service industry being run like the airline business—but then there is no other business like the airline business.

Warren Buffett, the shrewdest investor who ever lived, looked at the economics of the airline business and said, “A durable competitive advantage has proven elusive ever since the days of the Wright brothers. Indeed, if a far-sighted capitalist had been present at Kitty Hawk he would have done his successors a favor by shooting Orville down.”

Flying is the single most miraculous thing ever to happen to human movement. It is now performed commercially on a scale and at a level of safety that ought to be appreciated as remarkable—and would be, were in not for the dual miseries of airline customer service and airport anomie. At the same time, anyone looking at airline balance sheets over the last 60 years, the current lifespan of modern air travel, would have to conclude, like Buffett, that only a crazy person would decide to invest in the business.

In those 60 years, the world-wide airline industry had profit margins of less than 1 percent on average. In the U.S., since deregulation in 1978, airlines collectively lost $60 billion. At the same time, domestic air travel exploded, from 278 million passengers in 1978 to 717 million in 2011. So deregulation achieved its purpose of democratizing air travel, but also for the airlines led to what economists call “wealth destruction.” In 2012, until now regarded as a pretty good year, on domestic U.S. routes the airlines earned just $4 for every passenger carried.

So now we have a novel opportunity to see how airlines behave when, suddenly and much to their surprise, they find themselves with a business model that is working. If making a profit is a new experience for them, what effect will that have on their behavior?

First, let us consider why the numbers have been transformed.

There has been a steep change in the efficiency of jets. Beginning with the Boeing 787 Dreamliner, the combination of lighter but stronger composite materials in structures and a quantum leap in engine efficiency, using far less fuel, has slashed operating costs per airplane by as much as 30 percent.

In the last year, this windfall has been boosted by the large decline in oil prices.

However, these dual benefits are not being evenly spread either among airlines or continents. Airlines stuck with fleets of older airplanes are not getting these benefits. Fleet age has become far more decisive in deciding an airline’s profitability, particularly true in the U.S.

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The three major U.S. legacy carriers—American, United, and Delta—failed to get in early to order the new generation of airplanes—the 787, the Airbus A350, revamped versions of the Boeing 777, the Airbus A320, and the Boeing 737—and allowed European, Middle Eastern, and Asian competitors to become first adopters and, thereby, reap the benefits of lower fuel costs.

The average age of the jets in the American fleet is 12.3 years; for United 13 years; and for Delta 17.2 years.  It won’t be until at least 2020 that they can finally dump the oldest of their airplanes. (American has actually been delaying the delivery of some new jets that it ordered.)

Age doesn’t mean that an airplane is unsafe. Properly maintained 20-year-old jets are not in danger of falling apart. The frequency of flights determines retirement age more than years and the smaller single-aisle jets used on domestic routes age the fastest because they are making up to seven flights a day.

The most ancient of these are the MD-80s, fundamentally a 1960s design. United and Delta still fly hundreds of them. They are noisy, gas-guzzling clunkers with cramped cabins, long since retired by European airlines.

Age may not be dangerous but it sure registers with passengers when it contrasts with the comforts they encounter in the new generation of jets with their better cabin climate and quieter engines. So it’s not surprising that when airlines show up with all-new fleets as well as gracious cabin crews people start wondering, Why can’t it always be like this?

It’s also not surprising that the major American carriers are now trying to stop those airlines from coming to an airport near you.

The game-changers are the three national airlines based in the Persian Gulf: Emirates, Etihad, and Qatar. (The fleet age of Emirates is 6.6 years; Etihad 5.5 years; and Qatar 6.1 years).

The three now serve a total of 13 major U.S. airports, with 2.7 million seats available. The most aggressive of them, Qatar, is adding Atlanta, Boston, and Los Angeles to those locations it already serves, Chicago, Dallas, Houston, New York’s JFK, Miami, Philadelphia, and Washington Dulles.

This assault is being resisted by United, Delta, and American, who allege that the Gulf airlines enjoy huge government subsidies. They have asked the U.S. government to stop further expansion by the Gulf carriers in the U.S. In truth, it’s a complex debate because the Gulf airlines claim in response that the U.S. airlines have also benefited enormously from using Chapter 11 bankruptcies to shed huge legacy costs and restructure.

The most combative of the Gulf airline chiefs is the CEO of Qatar Airways, Akbar Al Baker. Al Baker pulls no punches in the argument, accusing Richard Anderson, the head of Delta, of being a “bully and a liar” following Anderson’s allegations that the three Gulf airlines had received subsidies worth $42 billion over 10 years.

Al Baker promised to open the Qatar Airways books to disprove the case (he hasn’t yet done so and said it would take two years to prepare a dossier).

“I think Mr. Anderson has never seen a CEO that will be that direct, so insulting and absolutely to-the-point to expose him,” said Al Baker.

He got that right.

In any business of this scale, with a truly open market there ought to be two kinds of competition: price and quality. There is no argument that the Gulf airlines set the bar on quality. They are particularly appealing to business-class passengers because they deliver such polished and pampering service. But, of course, that choice is there only for passengers on international flights where Emirates, Etihad, and Qatar provide highly competitive services to Europe, the Middle East, and Asia.

When it comes to price and the domestic U.S. routes, not only are prices not coming down but there is persuasive evidence of price-fixing. The veteran investigative reporter James B. Stewart described this market as a classic oligopoly in a penetrating piece in The New York Times .

Stewart cited a report sponsored by the Travel Technology Association, representing air travel websites, that found “minimal price and capacity competition among the major legacy carriers.”

However, this is far from being a new phenomenon. These tactics began long before the final round of consolidation mergers when US Airways was swallowed by American Airlines in 2013. They have merely been continually refined to the point now when the airlines, suddenly enjoying profits, have responded not by lowering fares but by tightening control over the number of seats available and cutting back on flight frequency and destinations.

The reality is that the airlines don’t need to expose themselves to charges of collusion on fares and the operation of a hidden cartel that mutually governs capacity. That’s so 20th century.

These days their key tool is “yield management”—being able to precisely calculate how many seats should be available on any given route at any time of the day or night and adjusting the price hour-by-hour according to demand. This algorithm has become so refined and the market so controlled that each of the major airlines ends up looking at the same numbers on their computer screen. No human intervention is needed. In all but name it is a cartel—but one run entirely by unaccountable robots.

So?

We live in the world’s most vigorously capitalist marketplace. What’s wrong with airlines trying to make a decent profit, for once? And what is the point of them flying empty seats around the skies?

Economists who look at this game have a new term du jour, “return on costs of capital.” Airlines are a capital-intensive business. New fleets of airplanes cost billions of dollars. And the International Air Transport Association (IATA) says that the current boom is allowing the airlines’ return on capital to exceed their cost of capital for the first time since they began using the term in the early 1990s.

Here is Willie Walsh, the CEO of the International Airlines Group (IAG), the parent of British Airways and Iberia Airlines:

“It is unacceptable that the industry is only just earning its cost of capital.”

But I come back to my earlier point: How do these airline executives behave when, joy of joys, they find their balance sheets deeply in the black? Like a lot of other corporate minders they think a lot more about their shareholders than their customers. Short-termism rules. Wall Street responds to quarterly earnings, not patient long-term strategy.

A good example is Jet Blue. This airline was a rare example of a successful startup based on a maverick idea: super-chummy cabin staff and generously spaced seating. A new CEO (previously schooled by the stingy bean-counters at British Airways) is undermining that spirit by jamming more seats into the cabin and raising baggage charges, all at the behest of shareholders.

Not all of these guys, though, are of the same stripe. Sir Tim Clark, the chief of Emirates, for example, warns: “The money should go into product, giving people fair value, not treating them as commodities.”

Amen to that.

The problem is that the people running airlines in the U.S. have one part of their brain missing, the part that provides the service ethic. As well as fare-gouging they’re space gouging in the cabins. Even with the newest jets like the Dreamliner they are packing more seats into coach than the airplane designers (or nature) intended.

It’s illuminating, therefore, to compare the airline business with the hotel business.

Hotels serve many of the same people as the airline business. And, like the airline business, hotels operate at carefully considered price levels. But unlike the airline business there is fierce competition between hotel chains and even within the chains between their different brands.

What has been the result? A consistent raising of standards across all categories of the market. Even budget hotels have amenities and levels of staff engagement that 20 years ago would have been found only in higher price brackets, while the refinement of luxury hotels far outstrips anything any airline delivers in first class let alone other cabins. 

The hotel industry has achieved something that seems totally beyond the wit of airline managers. It is a model of how a truly unprotected and open market is supposed to function. It makes a decent profit. (Marriott, for example, manages hotels ranging from budget to super-luxe and had a 39 percent rise in profits last year.) And at the same time it treats customers as people, not inconvenient cargo.