FORTUNE — Herb Kelleher and “éminence grise” shouldn’t really go together. But the Wild Turkey 101-drinking, chain-smoking founder and chairman emeritus of Southwest Airlines (LUV) is now 82 and knows more about the airline industry than practically anyone else on the planet.
A former lawyer who famously created the business model for Southwest on the back of a (cocktail) napkin, Kelleher is one of those rare birds: an entrepreneur who managed to create a successful startup, then stuck around to build it into a huge corporation and a perennial on this magazine’s Most Admired Companies list. Fortune’s Jennifer Reingold sat down with him in his office at Southwest’s Dallas headquarters to get his take on airline consolidation, the book he’s writing, treating employees right, and basically anything else he felt like discussing.
Q: You’ve always talked about how important committed employees are to the success of a company. How did you make that work at Southwest?
A: Well, the people did it. I just stayed out of their way.
But that’s a big part of leadership, isn’t it?
I think so. Be there when they’re having problems, and stay out of their way when things are going well.
Has it been hard for you to give up power?
Power should be reserved for weightlifting and boats, and leadership really involves responsibility. The end result of that is that if you regard being a CEO as important because it’s a powerful position, you’re always going to regret that at some point you had to step down. If you regard it as a responsibility to others, you may say, “Whew!” You know? “At last, I don’t have those responsibilities anymore!”
You’re still here every day. Sometimes, especially with a big personality and a founder, isn’t it tough for a successor to do his job?
I never interfere. If I have any comments to make, which are very few, I send them a personal note. And they’ve been few and far between because [CEO and chairman] Gary Kelly is doing a terrific job in my estimation. And I deliberately decided in deference to Gary’s leadership that I should take a much lower profile. It involves, for instance, not going to a number of company events, like the chili cook-off, because I didn’t want anybody to think that I was competing for attention with our new leader.
And that’s why I stepped down from the board too, incidentally. Because I didn’t think it was fair to Gary and the new leadership as a totality to have me sitting there at the board table with a dyspeptic look on my face — you know, like I needed some Tums.
Gary has handled the transition beautifully. He’s got a great presence. He’s an excellent speaker. He’s highly intelligent. He’s very diligent. And I think now probably everybody says, “Wow! He’s one heck of a CEO! And who’s that old guy with the wrinkles sitting in the balcony?”
Talk to me about the incredible consolidation in the airline industry.
The airline industry is a very fragmented industry compared with other industries. Very fragmented compared with the automobile industry. I use that as an example, where you had Ford (F), GM (GM), and Chrysler basically at that time. And deregulation involving competition was bound to produce a smaller number of airlines. Anybody who was realistic about it anticipated that that would be the case because the Civil Aeronautics Board for 40 years had kind of coddled and protected the existing airlines from competition. So there was going to be some fallout. That happened. A lot of the great old names vanished, like Pan Am, TWA, Eastern, etc. Now, you can carry that, in my opinion, to a reductio ad absurdum — you know, where you only have, say, two carriers in the United States.
How many do we have?
Well, we’ve got a good many, with some newcomers coming along strong, like Spirit (SAVE), like Allegiant (ALGT), like JetBlue (JBLU). So even though you’ve seen some fading at the top, you’ve still got some very vigorous new contenders. It’s kind of like getting a fresh injection of red corpuscles, I guess.
Another thing that’s significant is that you’re talking about businesses whose principal capital assets travel at over 500 miles an hour, so they’re ready to be competing anywhere in the United States in a very short period of time. You know, when the fish factory closes down in Seattle, you can’t move it to San Antonio in three hours and have it competing there. But the airline industry is very competitive in terms of mobility, of course. And as soon as someone detects a weakness, they tend to move in. I’ll give you the best example I can think of. Braniff ceased operations on the afternoon of May 12, 1982. At eight o’clock the next morning there were two or three new carriers serving [Dallas Fort Worth] airport.
How are you feeling about the political system these days?
I’ll be honest with you — I was a little disappointed in the Supreme Court’s [Citizens United] decision. I think the bigger the role that money plays in elections, the more people in America feel they don’t really have a part in it, and they become kind of disaffected, or at least indifferent. So I’m worried about that aspect of it. And, you know, my own impression from talking to people in business is that probably uncertainty as to what’s going to happen in Europe, as to what’s going to happen with respect to the fiscal cliff, where the Middle East is going, has made people very wary of making investments, and particularly longer-term investments.
As a former airline executive, where do you stand on the debate about expanding oil production in the U.S.?
I’ve been working with a group on Capitol Hill, the Energy Security Leadership Council, volunteers led by Fred Smith from FedEx (FDX) and Gen. P.X. Kelley, the former commandant of the Marine Corps. And it’s basically retired military and business leaders that are saying we need a grand bargain, that producing more oil in the United States of America is a good thing. It improves our balance of payments. It keeps that money here at home instead of sending it abroad, in some cases to hostile regimes. It provides jobs, directly and derivatively. And it provides additional revenues for local, state, and federal governments.
But we say you need a grand bargain, which is that, in addition to drilling more and producing more in the United States, you need to reduce consumption. We are such a voracious consumer of fossil fuels in the United States that we’ve got to do both. And one of the points that we’re trying to make is that oil is a global commodity. So that’s why we say that in order to reduce our economic vulnerability, our military requirements related to keeping the pipelines open and the ships sailing, and really to, I guess, give us more freedom in terms of foreign relations, we need to not only produce more at home, but also consume less.
Our group actually goes up on the Hill and lobbies in person. I want the natural-gas producers to be very successful. And I believe that, in my own mind, we could use natural gas substantially more than we do, particularly for fleet operations, because there the problem is infrastructure. You’ve got the infrastructure in place for liquid fuels, but you don’t for natural gas. But if everybody’s refueling at the same place, like the post office, the bus company, or even over-the-road trucks that go to truck stops, it’s possible to fuel them with natural gas. So I think natural gas is very helpful to us. It’s holding down utility rates as utilities switch to natural gas.
I’ve always tried to look a little bit ahead, at least when I’m sober — and when I’m not, I look way ahead. [Laughter.]
Are you sober now?
Yeah, but not for long.
Break it out!
Does it make your group’s job harder because people feel the pressure’s off with so much domestic gas production?
Well, yeah. Yes. It does. And that just means you have to work harder to get your story across, because it’s a long-term vulnerability that we’re talking about. It’s not a short-term thing.
It’s hard to get people to think about the long term, though, isn’t it?
Well, you know, it’s tough. It’s really tough. After the Arab oil embargo in ’73 and ’74, the government stepped up to bat, made some very, very substantial innovations or gains with respect to reducing consumption in the United States. Then of course prices got real low, and everybody said, “Well, we don’t have to worry about that anymore.” And then of course it came along again and again and again, at least once a decade. Just like a huge tax on the American economy is what it is.
How does this all affect the airline industry?
Well, I think that the industry now is establishing kind of an equilibrium because it used to be a fixed-cost industry. Fuel was very inexpensive, and your airplanes were the biggest fixed expense that you had. So under those circumstances, you tended to keep flying your airplanes even when they weren’t returning a profit, but they were generating some revenue as opposed to no revenue. With fuel prices higher, variable costs have come into play. And in some cases, the cost of flying a route simply in fuel — I mean, forget the ownership costs of the airplane, the route costs, and everything else — makes it unprofitable. Now, this has produced to my mind, at least, a newfound — for the industry, not for Southwest Airlines, because we’ve always been this way — a newfound discipline. As demand diminishes, the industry is reducing capacity.
So I hear you’re writing a book.
I was going to start on Oct. 1, 2001. I had a contract — offer of a contract — from a publisher. Guess what happened? 9/11. All hands on deck. Forget about book writing. Now I’m working on it. It’s really about my upbringing and certain things that happened and how that coalesced, in many cases serendipitously, to lead to the creation of Southwest Airlines and what happened thereafter.
I hope that you are going to talk about the focus on people at Southwest.
I’m going to tell you something that I have a theory about. We held Corporate Day for many, many years, and we had a good many companies that came in. And they basically wanted to know how we hired, how we trained, and how we motivated. And so we would tell them. And many of them, I think, were looking for some formula, you know, that you could put on the blackboard. The concept is simple, but the execution takes a lot of work and a lot of attention. If you’re going to pay personal attention to each of your people, for instance, and every grief and every joy that they suffer in their lives, you really have to have a tremendous network for gathering information.
We want to show them they’re important to us as who they are, as people. And by the way, one ramp agent — I have not disclosed this — sent me a note one day which I’ve never publicized, and I think you’ll understand why. He said, “Herb, I finally got it. You’re making work fun, and home is work.” [Laughter.] I think you’ll understand why I did not publicize that widely.
It’s not formulaic. The way I describe it is this huge mosaic that you’re always adding little pieces to make it work. And it’s not a job that you do for six months and then you just say, “Well, that’s behind us.” It’s something you do every day.
You can still do this in a giant company, right? Because the other thing that people always say is that you can do this in a small company when you know everybody, but once you get to the point where you can’t physically interview everyone, then …
I have heard that probably 38,000 times over the years. Seriously. But if it’s job No. 1, you still are able to do it. Some people will say, “Well, this is not a strategy,” because they like the word “strategy.” You know, it sounds important, like the Strategic Air Command. And I’d say, “Well, here’s how I differentiate.” I think it was Tolstoy, if I remember correctly, who said, “How does Napoleon march onto a balcony in France and get a whole bunch of French troops to march into Russia to their death?” And I said, “Well, the strategy involved was his imperial ambitions, right? But what made the troops march? The culture.” And I said, “It’s the troops marching that defines the culture.”
And what happens in bad times? You have still never had a furlough or layoff at Southwest, correct?
Yeah. Oh, yeah. We’ve never had a furlough. We could have made more money if we’d furloughed people during numerous events over the last 40 years, but we never have. We didn’t think it was the right thing to do. And you know, one of the disciplines is not furloughing. I didn’t realize this at first, by the way, so it came as somewhat of an insight to me. You know, suddenly a little synapse clicked, and I said, “You know, not furloughing is really a great discipline with respect to hiring.”
How did you learn this stuff? Did you actually have a philosophy when you started?
I think it’s a product of your values and your philosophy. And by the way, there’s one other comment I might make. I don’t want you to yawn when I say this. But I’ve always thought that having a simple set of values for a company was also a very efficient and expedient way to go. And I’ll tell you why. Because if somebody makes a proposal and it infringes on those values, you don’t study it for two years. You just say, “No, we don’t do that.” And you go on quickly. So I think that contributes to efficiency.
What are your thoughts on executive compensation these days?
Most of my compensation came in the form of stock options, which are worthless unless the company succeeds.
And are you still a believer in that? We’ve seen options also be abused …
Oh, yeah. This is a different day and age. First everybody was recommending that tying you to the company’s fortune through stock options was the way to go. Of course, then the awards became humongous. We got into, at some companies, repricing, so if the company didn’t do well, you simply lowered the price of the options. And all of a sudden it became an entirely different type of currency than it was when I started out.
So if you were starting out now, what would you do about compensation?
The same thing.
You’d still do it?
Oh, yeah, absolutely.
But with more responsible tranches of options.
Well, you know, I turned down 500,000 options one year because I thought it was too much, not a good symbol for our people.
Do you have a plane?
No. Heavens, no. As a matter of fact, I established a policy that we would never have a corporate airplane. I said, “That’s rather unbecoming for an airline.” I charter, but I pay for it personally — not the company — when I do it.
Another thing we decided as a matter of policy years ago was that we wouldn’t do anything that wasn’t connected with the airline business. I guess what we were saying in kind of a humble way was, “We don’t know everything about everything. We know about one thing.” I have seen other airlines make mistakes, buying radio stations, hotel chains, rental car businesses, and so forth and so on. And I thought, We don’t want to get into thinking that we’re almighty because we’ve done pretty well. And that’s still the policy today.
This story is from the January 14, 2013 issue of Fortune.