Fuel-price fluctuations, the rise of the low-cost carrier and industry consolidation are set to become the issues of the year

Recent moves by Russia and other non-OPEC (Organisation of Petroleum Exporting Countries) members suggest that the decades-old oil cartel could be weakened or even destroyed if outsiders who have hitherto co-operated with the organisation's production limits decide to flout them.

While a truly free oil market might lead to lower prices, it could also make them more volatile. And fuel costs could also increase as a proportion of overall expenses as airlines cut other overheads in response to the downturn, since cost-cutting does not necessarily reduce fuel consumption.

Aviation fuel prices closely track crude-oil prices. Airlines will therefore be more vulnerable than ever to the vagaries of the oil market, which is as sensitive as ever to the hyperactive politics of Central Asia and the Middle East.

Larger carriers may respond to this by putting hedging deals in place to ensure a steady fuel supply, as Air France has done. But they will need to hurry if, as seems increasingly likely, the USA follows its war in Afghanistan with an attack on Iraq. Oil prices will soar again as they did a decade ago, and passenger numbers will also be affected. This would be more bad news for an industry that has already been hit hard in recent months.

The same would occur, to a less extent, if the war spread elsewhere, with military action against or within Indonesia, the Philippines, Somalia, Sudan or Yemen - or if the situation in the Middle East were to worsen, for example, with Syrian military intervention against Israel or the collapse of the Palestinian Authority. In addition, various aircraft crashes since 11 September, though unrelated to each other or to Al Qaeda, have done nothing to tempt passengers back into the air. Any carrier tempted to cut safety spending by increasing flying hours or cutting cabin-crew runs the risk of just making the situation worse.

The most remarkable news, as the downturn has deepened over the last year, is the success of low-cost carriers, as opposed to the rather gloomier picture emerging from mainstream airlines. Whether the economy at large recovers or sinks into recession, it seems likely that the airline market has changed for good.

The rise of the low-cost carriers may or may not have come solely as a consequence of people - and companies - having to cut back on travel expenses. What is not in doubt, however, is the fact that it has permanently transformed the face of the airline business.

Another major change, increased security, especially at US airports, is unlikely to affect low-cost airlines more than mainstream carriers. The most significant cost for budget airlines is turnaround time, and this will remain unaffected, regardless of whether passengers board immediately or after a long security clearance.

However, the structure of the airline network could alter: it is probable that passengers transferring at hub airports will have to go through security checks again, making hub travel much less attractive than point-to-point. This would appear to be a vindication of Boeing's forecast of fast low-volume point-to-point traffic (using Sonic Cruisers), rather than Airbus's vision of large volumes of traffic moving between a few hub airports(ideally aboard A380 ultra-large aircraft).

However, this holds only if intensive security checks are limited to passengers. If new measures also involve thorough checks on aircraft, there will be two consequences. First, operational expenses will increase - and this will affect low-cost carriers more than mainstream airlines, as turnaround time is a key element in determining operating costs for the budget carriers. Second, it will limit the number of departures per day from an airport, encouraging airlines to offer fewer flights on larger aircraft to maintain revenue levels.

It seems odd, after the dramatic bursting of the internet bubble, to talk about irrationally overvalued companies - but, by some measures, the apparently flourishing low-cost sector may go the way of the dotcoms. Of course, they have a far more solid business model, but their valuations are still extraordinarily high at a time when mainstream carriers are trading at or below their net asset values, with price-to earnings (P/E) multiples of between 10 and 20. The low-cost carriers are valued at three or four times their net asset values with P/E multiples of 20-30.

Admittedly, this is small beer by the standards of and But the combination of high predicted growth and high valuation as compared with more established airlines, along with supposedly revolutionary technology and business strategy seems familiar. Although the no-frills carriers will continue to prosper and grow, a revaluation may still be on the way in the next year to 18 months.

Single European sky

Early next year the European Court of Justice (ECJ) is due to give the European Commission (EC) powers to negotiate operating rules with the USA - powers currently belongng to European Union member states. The EC will then start to break down the network of bilateral operating agreements between European nations and the USA. This, in turn, will bring closer the EC's objective of a "single European sky" and the ambition of US airlines and politicians for a single, non-restrictive EU/US aviation agreement.

This will then open the way for US antitrust immunity to planned alliances between bmi British Midland and United, and American Airlines and British Airways, currently awaiting clearance from the US Department of Transportation. The speed at which all this happens will, of course, depend on how fast the EC moves after receiving ECJ go-ahead.

All airlines, including flag carriers, risk consolidation - the new industry buzzword for any process that finishes up with fewer carriers than it started with. One possible method of consolidation is bankruptcy - as with Sabena and Swissair. Others will probably follow this route. In the case of flag carriers especially, it is likely that European governments, forbidden by EC rules from intervening directly, will try to set up successor airlines - often struggling with huge debt burdens, overmanning and an undersized domestic market.

In any other industry, less successful airlines would certainly be taken over by rivals - indeed, some analysts suggest that this will happen on a massive scale, leaving only three mainstream airlines in Europe by the end of 2003. However, this is to ignore the legislative obstacles to such mergers. Many European carriers are prevented by national law from being more than 49% foreign-owned, and many are still largely in the state sector. Removing these barriers would make the task of negotiating open skies look almost easy.

Next year may see the "hollowing out" of airlines, with the subcontracting of maintenance, distribution, catering, and even fleet ownership to other carriers, so cutting overcapacity one area at a time. Smaller national carriers may choose to become more like virtual airlines, subcontracting maintenance from one airline; sales, distribution and catering from another; and leasing aircraft from yet another. They would ultimately consist simply of a few employees, a pilot cadre and a brand image. Given that airlines within the same alliance have already harmonised many of their operations, this process is more likely to happen within alliances rather than between them.

Source: Flight International