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Sweet fuel deals ending for Southwest
No. 6 carrier has benefited from low-cost contracts but now fuel prices -- and fares -- set to rise.
April 14, 2005: 2:34 PM EDT
By Chris Isidore, CNN/Money senior writer.

NEW YORK (CNN/Money) - Southwest Airlines has long been the envy of the airline industry due to its low costs, cheap fares and strong profits.

What's been less well known is that the nation's No. 6 airline -- alone among other major carriers -- has used low-cost, long-term fuel contracts to achieve those goals.

The better-than-expected profit the Dallas-based carrier reported Thursday morning would have been a loss without the benefit of fuel savings it locked in years ago.

But with oil prices soaring, all cheap fuel eventually comes to an end, even for a savvy company like Southwest (Research). That means lower profits for Southwest -- and higher fares for flyers across the U.S. industry -- are almost certainly on the horizon.

Southwest CEO Gary Kelly told investors during a conference call Thursday that Southwest is expecting its fuel bill to be $300 million to $500 million higher next year, and that the airline would look at ways of boosting revenue including "modest fare increases."

And when low fare leader Southwest raises fares, others in the struggling industry are likely to follow.

"And if you have a fare leader like Southwest raising fares, yes, other fares could go up," said Brian Hayward, airline analyst at Zacks Investment Research.

Southwest did boost fares $1 to $3 a flight on most routes in the first quarter, said industry analyst Samantha Panella at brokerage Raymond James. That was due greatly to the 13 percent year-over-year rise in jet fuel prices it saw in the quarter, even with its long-term fuel purchase contracts.

Southwest is virtually alone among U.S. airlines in its fuel purchase strategy not because it was smarter about the direction of oil prices, but because it had the money available to lock in the lower prices.

A track record of 14 straight years of profits has helped Southwest swell its cash on hand to $1.9 billion at the end of the first quarter -- while most larger airlines have already burned through much of whatever cash reserves they had after four straight years of deep losses.

"You have to have a strong balance sheet to do it," said Hayward, talking about Southwest's fuel purchase contracts. "Most others don't have anywhere near that balance sheet strength."

Fuel contracts costing more

Fuel is the No. 2 cost for airlines behind labor. Southwest saved $155 million in the just completed quarter with its fuel contracts. That savings is more than double the $76 million or 9 cents a share, it earned in the period.

Southwest's earnings easily flew over the consensus analyst EPS forecast of 5 cents a share and up from the 4 cents a share it made, excluding items, in the year-earlier period.

Shares of Southwest rose about 1 percent in midday trading Thursday following the report.

Southwest said it is well positioned on fuel costs in the near term. Better than 80 percent of its fuel needs for the rest of 2005 are capped at the equivalent of crude oil prices of $26. That's just over half of the market price for oil in Thursday trading.

But going forward, the amount of fuel it gets under lower-cost contracts is falling while the average price cap keeps rising. Its $26 a barrel fuel contract is quickly becoming a relic of the past.

The airline said 65 percent of its expected 2006 fuel purchases are capped at $32 a barrel levels, while more than 45 percent of its needs for 2007 will cost a maximum of $31 per barrel. Only 30 percent of its planned 2008 fuel purchases are now locked in at $33 per barrel; while 25 percent in 2009 is capped at $35 per barrel.

Panella estimates that Southwest's per gallon fuel costs will jump to $1.13 a gallon next year, up about 22 percent from the 93 cents a gallon she estimates it'll pay this year.

Still, Panella said that large fare hikes, even in the face of cost increases, have generally not been Southwest's style in the past. She would expect another round or two of $1 or $3 fare hikes.

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