Mary Kirby & Brendan Sobie
Airlines ended 2007 on a positive note, with record profits and traffic despite the highest oil prices in 30 years. But the party is about to end. The US credit crunch will have ripple effects throughout the world, resulting in a drop in demand just as aircraft deliveries reach record numbers and fuel prices continue to escalate. As a result the outlook for 2008, which only six months ago looked bright, has suddenly become darker.
"Our outlook for 2008 is looking markedly more gloomy," says International Air Transport Association chief economist Brian Pearce, "2007 looks like to have been the peak of the cycle for profitability and traffic."
While airline profits are not expected to fall off the cliff like they did early this decade, they almost certainly will decline from the estimated $5.6 billion chalked up in 2007. IATA is projecting $5 billion profits for 2008, compared to the $7.8 billion forecasted in September and $9.6 billion forecasted in mid-2007.
While $5 billion may seem healthy, especially in the eyes of labour unions hungry to get back concessions made in the aftermath of September 2001, it is discouraging that the peak of the cycle has passed without the traditional span of profits. The operating profit margin of 3.3% generated in 2007 pales in comparison to the operating profit margin of 5.6% generated during the 1997 peak. The industry was also collectively in the red for an unusually long time, posting net losses every year from 2001 to 2006. The latest peak simply was not high enough and did not last long enough for most airlines to repair their balance sheets.
"The peak of the business cycle is probably over and something we shouldn't forget is we are still $190 billion in debt. So we could be headed for a downturn with little cash in the bank to cushion the fall," says IATA director general Giovanni Bisignani.
For US carriers, this is particularly worrying. It took nearly six years, several bankruptcies and a series of drastic restructurings for US carriers to recover from the shock of September 2001. North American carriers turned about $2.7 billion in profits in 2007 but that is nothing compared to the losses of the last few years.
North American carriers are now expected to achieve $2.2 billion in profits in 2008. That is simply not enough to keep them immune from takeovers. Making matters worse, many US carriers will have to negotiate new contracts with major unions in 2008, with the threat that wages will snap back to pre-2001 levels.
Pearce warns that the debt-to-cash flow ratio at US carriers is "uncomfortably high". He adds those airline may find it difficult to finance long-overdue fleet replacements in this environment and will likely have to turn to the leasing market "as a way forward".
The US credit crunch will disproportionably affect US carriers but it will undoubtedly also be felt by carriers in Asia and Europe. IATA projects profits in both regions to fall about $100 million compared to 2007 levels.
European carriers with large Asian networks will likely continue to post healthy profits as the Europe-Asia market remains strong. But those European carriers with more links to US market will likely see their profits fall.
Profits in Asia already have been on a slow downward slope since 2004 due to tremendous capacity gains in the region. Profits will continue to go down as new aircraft continue to pour into the region and the recent rash of start-ups have an impact.
Aircraft are also pouring into the Middle East. But profits in this fast-growing region are expected to remain stable as the leading Middle Eastern carriers continue to find profitable ways to expand their networks. It is not all rosy, however, in the Middle East. After Emirates the region's carriers were collectively in the red in 2007 and will remain so in 2008.
Airlines may be in denial for the next few weeks. Carriers throughout Asia, Europe and North America reported record profits for the third quarter of 2007 and expect the same for the fourth quarter. Many carriers claim they see no signs of a slowdown and that forward bookings remain very strong. But Pearce warns "there is always a lag in these things" and "we expect to see a softening in the New Year".
As well as a likely softening of demand in early 2008, many carriers' fuel hedging programmes were expiring at the end of 2007, Pearce warns. IATA expects its members will pay an average of $78 per barrel in 2008, up from $72 in 2007, although still about $10 less than the current price. Six months ago IATA was projecting an oil price of only $60 for 2008. The latest spike in oil prices added $14 billion in costs, driving up the industry fuel bill to $149 billion. Back in 2003 the industry's fuel bill was only $40 billion.
It is amazing that airlines have been able to absorb a $100 billion increase in fuel costs and return to profit. But Pearce emphasises the outlook is not nearly as gloomy as the credit crisis of 2000. He expects a "dip" rather than a "drop" and "not a recession but a slowdown". While "his crystal ball is rather foggy at the moment", he thinks profits will go back up in 2009. "It will be a short-lived downturn," Pearce predicts. "We see a renewed upturn in 2009." n