Analysts sound grim warnings

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The world’s leading airline experts are united in their gloomy assessment of industry prospects

One word summed up the mood of the dozen global airline analysts polled in the run-up to IATA’s annual gathering by Airline Business editors about the industry’s prospects: pessimistic.

“It’s going to be ugly,” says Peter Harbison, executive chairman of the Centre for Asia Pacific Aviation. According to Chris Tarry, chairman of CTAIRA: “This downturn has the potential to be orders of magnitude worse than it was after 9/11 and more pervasive.”

In the US, where soaring fuel prices have already pushed several carriers out of business, “we are in the worst crisis since 9/11, though this is worse”, says John Heimlich, the chief economist of US airline group Air Transport Association. “In 2001, we were responding to a single catastrophic event; now we are suffering in response to a lengthy catastrophic process in the form of oil prices.”

Asia-Pacific carriers were not hit anywhere near as hard as western ones by the crisis caused by the 2001 terror attacks, but will feel the pain as this downturn bites. “This is probably the most challenging environment since the 1970s,” says Damien Horth, head of Asia transport research at UBS in Hong Kong. “If jet fuel stays at these levels [$130 a barrel] it does fundamentally change the industry.”

There is massive uncertainty over where the price of oil goes next, which will have a major bearing on how bad things will get. “It is very, very hard to anticipate what will happen this year,” says Andrew Lobbenberg, airline analyst at London’s ABN AMRO. “If oil potters on down to $100 it will be a bit of a challenging year, while if it remains at $130 it will be a seriously challenging year,” he says. “But at $150 it will be a car crash, or worse.”

The culprit is fuel
Although it is clear the industry has been slowing for some time, the rise in the price of fuel is the single main factor behind today’s turmoil. “This downturn is different because it is primarily cost driven rather than demand driven – at least so far,” says Rigas Doganis, the academic and consultant.
If oil stayed at $125 a barrel and airlines did not alter capacity, this year the industry could be facing $65-70 billion more in fuel costs, estimates Tarry. “How do you -adjust to that?” he asks.

“This calendar year has been quite unique,” says Emilio Posada, the former head of Colombian carrier Avianca, IATA board member and head of the Latin American Airline Association ALTA. “Fuel has increased much faster than carriers could increase revenues, and numerous airlines were no longer properly hedged to cover such unprecedented oil prices.”

The need for swift cutbacks is seen by all analysts. “Any responsible boardroom is going to be looking at the need to cut back on capacity and looking at marginal routes,” says Harbison. “The downturn may mean some drastic surgery of networks – which airlines find difficult to do,” says Doganis. But as recent moves by several carriers, including American and Qantas, show, action is already being taken.

Commenting on the US market, Jamie Baker, the JP Morgan analyst, says: “It may sound callous to frame fuel’s rapid ascent against the far greater tragedy of 9/11, [but] the math is indisputable. At current fuel prices, a similar attack on the industry’s profitability appears underway.” The fuel bill for US carriers in 2008 is likely to exceed that of 2007 by at least $15 billion, Baker says. “To put this in context, $15 billion roughly approximates the operating impact the industry withstood as a result of the 9/11 terrorist attacks.”

After a gradual recovery in traffic since then, Heimlich now notes that “we are seeing demand softening. It may be too early to get a good read, but the yield increase is slowing”. In fact, premium traffic in North America was down by almost 9% in March, IATA said in late May; premium traffic on the North Atlantic was down by almost 1%, both marking the -sharpest decrease since 2003.

This creates a vicious cycle, of which Michael Levine, the former Northwest Airlines executive who is now a distinguished research scholar and senior lecturer at the New York University School of Law, says: “The United States airline market is unique in the world in its integration of convenience-sensitive and price-sensitive customer base. The volume of price-sensitive traffic is a major factor in supporting the scope and scale of the co-ordinated network, greatly enhancing its value to convenience traffic. The growth of both segments has been a virtual cycle for 30 years since deregulation.”

But now, “as costs rise, prices must rise. As prices rise, leisure demand shrinks, exacerbated by the weak economic environment. As leisure demand shrinks, the network shrinks, delivering less value to business travellers even as prices rise. The result may be a vicious cycle.”

And Levine notes that consolidation alone will not address this. “Consolidation by itself will not reduce supply and may only slightly increase convenience demand overall, although network airlines may benefit by preserving network scale and scope relative to competitors. The real question is where and how supply will be withdrawn and how many firms can survive this process.” As Baker says, consolidation in the USA is not likely to advance the -industry toward the required level of downsizing of about 20%.

Losses mount
Baker does not see the pressure abating any time soon. Instead, he sees losses of about $7.2 billion for the year for US carriers, up from an earlier forecast of $4.6 billion – if demand stays more or less constant. Heimlich is also forecasting likely losses in that range, but will not be drawn out into next year in any such detail. Baker, though, sees 2009 as showing an operating loss of $8.1 billion, and that is with a modest revenue recovery.

So far Europe has not seen a big failure this time round. But, according to Andrew Light, aviation analyst at London-based Citigroup, several private low-cost and smaller government-owned flag carriers are at the highest risk. “We would not be surprised if -several of these default – especially in the low-fare sector,” he says.

Most believe the old adage of the strong getting stronger and the weak growing weaker will apply. “It’s fairly straightforward. The three main flags [Air France-KLM, British Airways and Lufthansa] and the two main low-cost carriers [easyJet and Ryanair] will come out of this crisis stronger,” says Lobbenberg. And while the crisis broadly accelerates the process of global airline consolidation, “for the strong carriers it’s going to be a tempting opportunity to sit on their hands and let the weak carriers fail”, he believes, rather than open their cheque books.

For Doganis, the “key year is 2009” in Europe, as this will be when leisure demand could nosedive if prices rise. “Travel spending is no longer discretionary as it was 20 years ago. This year people cut other things in order not to give up their holiday,” he says, which has meant leisure travel has stayed solid.

Asia not insulated
Asia will by no means be insulated from this downturn, but its economies are expected to keep growing at reasonable rates keeping demand higher. For now, load factors and forward bookings remain strong. In some markets, such as China and India, healthy demand has raised the prospect of oversupply. “It is the old bogey monster of the industry,” says Horth of UBS.

And over the last couple of months, the region’s growth engine – China – has surprised some as domestic traffic growth pulled back from double-digit rises to just 3-5%. “Everything in China is really on hold until after the Olympics,” says Harbison, with the effect of the global sporting extravaganza being to delay some inevitable changes and merger activity. “There will be a pincer movement between high costs and reduced demand which will provoke some really strong action.”

India is a market where rapidly slowing growth and overcapacity will prompt a “fairly predictable” shake-up and more consolidation, says Harbison.

“It comes down to who’s got the strongest balance sheet and who’s got the greatest pricing power,” says Horth. In Asia that boils down to the big three: Cathay Pacific, Qantas and Singapore Airlines. “UBS has only SIA and Qantas profitable with $150 jet fuel. Everyone else is debatable.”

Restrictions on cross-border ownership mean mergers are tough to do in Asia, but “if oil stays up there we will have to rethink a lot of things, so I wouldn’t take that off the table”, says Horth. One of the bad side-effects of a protracted crisis is that governments could be tempted to step in and rescue their flag carriers, he notes. Keeping these “zombie” airlines afloat distorts the market and makes it difficult for the rest.