There are worrying signs of a return to over-capacity in Europe, writes Chris Tarry of CTAIRA.

The start of a year is a time not only to look forward, but also to look back at the previous 12 months. In this respect it is useful to look at both the number of orders taken by the aircraft manufacturers and their delivery plans for the forthcoming year. In terms of the order intake there were few surprises down on the record levels of 2006, but still relatively strong.

It is however important to look behind the headlines and the global figure at the volume end of the market Airbus was 10% behind Boeing with 673 orders for its A320 family, compared with 739 for the Boeing 737. Elsewhere, orders for the A330 (104) and the Boeing 787(160) were into three figures.

As ever, there was a year-end flourish, with Boeing recording 20% of its full-year orders in December and Airbus some 23%. It remains to be seen how many will be delivered overall and how many will be delivered to the customer that placed the original order.

Placing an order is one part of a process - equally, if not more, important is the next stage the profitable deployment of the aircraft into service. As this column has often argued, the airline industry is subject to even the most simple rules of economics and the effect of supply relative to demand on price - or in the case of the airline industry, fares and yields.

For any airline its traffic reflects market growth and traffic taken from a competitor. The relative importance of this varies widely. However, the greater the capacity relative to underlying demand the greater the pressure on price.

A particular concern remains over the short-haul market and Europe in particular, although there are some specific concerns in other areas of the world too. Looking at the forecast deliveries to European airlines for 2007 and 2008 for the A320 and 737 families it appears that there will be 220 deliveries in 2007 and 240 deliveries in 2008.

In broad terms this is equivalent to 7-8% of the fleet measured by aircraft numbers. All well and good some may suggest, given that total intra-European traffic growth (AEA members and low-cost carriers) was around 8% for 2006.

Just as a comparison of the headline figures for the orders of each of the manufacturers is misleading, so is the figure of 7-8% for the number of short- haul aircraft in the fleets of European airlines.

The majority of the aircraft to be delivered are going into the fleets of the "new model airlines" where the number of seats per aircraft is greater than for a "traditional airline". This means the increase in the number of aircraft is likely to translate into an overall increase in European capacity - measured at the level of all airlines - of 10-11%. EasyJet, for example, has a target of increasing capacity by 15% a year.

So much for the supply side what about demand? Although the most recent surveys suggest a generally upbeat view of the near-term economic prospects, for Europe they are not universally positive. There may well have been a positive swing in expectations in Germany over the last month, but the outlook for France is not overly positive. In the UK the concerns over inflation may well result in a further increase in interest rates and an accompanying effect on consumer demand of which leisure air travel is one element.

Against this it is reasonable to conclude that underlying demand at the price levels that prevailed in 2006 will be weaker in any event in 2007. Add to this the fact that capacity entering the market is likely to be significantly greater than underlying demand and downward pressure on fares is perhaps inescapable.

There are other interesting dimensions that are worth mentioning examining. For instance, ancillary revenue has become fundamentally important for all airlines and not just those in the so called low-cost segment. This revenue can for some make the difference between profit and loss at the operating level. For easyJet's last full financial year ancillary revenue was equivalent to almost 9% of the average fare revenue per passenger up from 7% in the previous year. There is a considerable focus on how to increase both the scope and scale of revenue from these sources but there are limits to this too, which may be manifest through passenger resistance.

The real risk for some of the low-cost carriers is that the ability to generate revenue from these sources cannot offset a decline in fares in an environment where all the evidence points to the re-emergence of excess capacity in the intra-European marketplace.

Source: Airline Business