At this time last year, U.S. airlines were developing ambitious growth plans for Cuba after it became legal to offer scheduled service to the Caribbean island nation for the first time in more than half a century. As the top airlines in South Florida, American Airlines (NASDAQ:AAL) and JetBlue Airways (NASDAQ:JBLU) had the most ambitious plans for flying to Cuba.

However, U.S. airlines haven't had much success during their first few months of operating scheduled service to Cuba. As a result, American Airlines announced capacity cuts in Cuba back in November. Last week, JetBlue joined its larger rival in slashing capacity there.

A JetBlue Airways airplane

JetBlue will cut its capacity in Cuba in early May. Image source: JetBlue Airways.

A giant land grab

The recent wave of capacity cuts in Cuba has a lot to do with the circumstances under which U.S. airlines entered the market last year.

Under the U.S.-Cuba aviation agreement signed a year ago this week, U.S. airlines are allowed to operate up to 110 daily flights to Cuba. This consists of 20 daily flights to Havana and 10 daily flights to each of nine other international airports.

The U.S. Department of Transportation ran a competitive route allocation process to determine which airlines would be allowed to fly which routes to Cuba. This sparked a "land grab" of sorts in Havana, as airlines tried to obtain as many of the limited slots there as they could justify.

Indeed, American Airlines and JetBlue each requested authority to fly 12 times a day to Havana. Ultimately, both got less than half of the Havana flights they had requested. By contrast, there wasn't much demand for route authorities to the other nine international airports, so American and JetBlue received the rights to all of the non-Havana routes they had requested.

Trouble in paradise

While airlines were eager to introduce service to Cuba last year, they have found that making a profit there isn't easy. U.S. residents still aren't allowed to visit Cuba as tourists, which cuts off the greatest potential source of traffic. To visit Cuba, you must certify that your travel falls into one of 12 permitted categories, including visiting family; educational, religious, or humanitarian activities; and participating in various cultural programs.

As a result, there hasn't been nearly enough demand to fill the massive amount of capacity that has entered the market. In late November, American Airlines announced that it would drop one of two daily flights in three secondary cities it had only recently begun serving in Cuba. These cuts will be implemented this week. American also hopes to switch to smaller aircraft on a few routes.

An American Airlines airplane

American Airlines is slashing capacity on routes to secondary cities in Cuba. Image source: American Airlines.

JetBlue has had just as much trouble filling its flights at sensible fares. It doesn't plan to drop any routes for now, but it recently downgraded all of its routes to Cuba to smaller aircraft. Flights to Havana will now use 150-seat A320s instead of 200-seat A321s, while flights to other cities in Cuba will use 100-seat E190s, down from 150-seat A320s.

No big surprise here

Some pundits have attributed the recent flight cuts in Cuba to overly optimistic demand forecasts on the part of U.S. airlines. That's certainly true, to some extent.

However, the DOT allocation process also encouraged airlines to "overbid." In other recent route allocation proceedings, the DOT has shown a clear preference for carriers that promise to use bigger aircraft. For example, wasn't surprising whatsoever that the DOT rejected tiny regional carrier Silver Airways' proposal to fly 34-seat turboprops to Havana.

Thus, JetBlue and American Airlines (and their peers) had a strong incentive to request more flights than they wanted, with larger airplanes than they needed. This essentially allowed them to reserve scarce route authorities to Cuba, which could become extremely valuable in the long run -- especially if the tourism ban is ever lifted.

Now that the dust has settled, JetBlue and American have started to right-size their operations in Cuba. Outside of Havana, there are plenty of unused route authorities. This allowed American Airlines to reduce the number of flights on its routes to Holguin, Santa Clara, and Varadero. If demand improves, it will have no trouble reinstating service.

The situation is more complicated in Havana. While the market is oversupplied right now, it's not feasible to cut flights, because other airlines would take over any unused slots in order to profit from the long-term growth of U.S.-Cuba travel.

However, now that JetBlue has demonstrated a good-faith effort to make service with a 200-seat A321 work, it can easily downgrade service to a smaller A320 for as long as necessary. It has taken the same approach outside of Havana, cutting capacity by switching to smaller airplanes rather than operating fewer flights.

Flying to Cuba could become an extremely profitable enterprise a decade from now. But at the moment, it's a loss-leader. Investors should expect to see further capacity rationalization in Cuba this year as airlines try to mitigate their losses while continuing to develop the market.

Adam Levine-Weinberg owns shares of JetBlue Airways and is long January 2019 $10 calls on JetBlue Airways. The Motley Fool recommends JetBlue Airways. The Motley Fool has a disclosure policy.