Forecasting in the airline industry can be hazardous at any time, but rarely has it been quite such a dangerous occupation. In the immediate aftermath of 11 September, markets simply could not be predicted and although the world now appears to be righting itself, the industry has yet to emerge from the other side of this latest crisis. The intriguing question today is whether the world into which the mainline carriers will eventually emerge could be fundamentally different in terms of supply and demand.

What has already become clear is just how dramatically traffic collapsed. All major passenger markets were down 20-30% almost at a stroke and the losses for US carriers on their international services came closer to 40%. The declines are still there going into 2002, but they are now at least moving in the right direction after having hit the floor. As wary US forecasters have noted - even a dead cat bounces.

IATA has just put out initial estimates for international passenger traffic in December showing a decline of just under 10%. Although hardly comforting in itself, that compares with a low of over 24% in October. How quickly the industry makes up the lost ground remains an open question. The closest, albeit imperfect, experience is that of the Gulf War at the start of 1991. Then traffic took the best part of nine months to turn positive but the fallout in a weak economic environment continued to inflict severe financial damage on the airline industry for another year or more, making 1992 the low point for losses despite an apparent return to growth.

Even if traffic growth has returned again by the summer it is unlikely that the year overall will show much growth. Peter Morris, who heads IATA's research unit, points out that as a matter of sheer mathematics it is going to be tough to show absolute growth in 2002, given that traffic opened the year 10% down. The best guess is for passenger growth of perhaps 1% for international operations this year, following on from an estimated overall decline of 4.3% in 2001. Provided that growth then stays above 3.5%, the industry should be back at pre-crisis traffic levels for 2003.

However, any overall growth is likely to disguise lingering difficulties on the two big long-haul markets of the transatlantic and transpacific. Traffic on the North Atlantic ended 2001 down by double digits and is expected to fall by another 4-5% this year. It could be 2004 until the losses are recaptured. The transpacific market is no better, influenced by Japan's malaise as well as the US economy's stumble. "We cannot see any sign of the patient jumping out of the bed yet," says Morris.

Where the better news might come is from a relatively buoyant intra-Asia market, where there are hopes of seeing 4% growth this year. Intra-Europe passenger traffic too is expected to show only a small decline, despite the bankruptcies which have already more or less stripped two players out of the equation.

Excess capacity

However, the focus on traffic growth comes with the usual warnings. It is always possible to stimulate traffic if the price is right and the industry has indeed consistently sacrificed yield in order to fill excess capacity. Low-cost carriers have gone further still in developing whole new markets through the offer of consistently low fares.

It was in order to help strip out this price stimulation effect that Airline Business has worked with Commerzbank over the past couple of years to model the underlying traffic demand which is driven by economic growth rather than price. The model effectively indicates the level of growth which could take place without an impact on yields - other factors being equal.

But it is clear that today other factors are far from equal. Not only has traffic fallen off a cliff, but capacity too is being slashed by some 10-20% as the USA and European majors attempt to adjust to the new conditions. In short, the industry is searching for a new point of balance between supply and demand, and therefore between cost and yield. And as this search continues for the new point of profitable equilibrium, there are at least four key factors which will determine how quickly it is achieved: the economy; confidence to fly; cost levels; and cumulative excess capacity.

The industry has accumulated excess capacity of around 30% over the past 20 years as seats have been added (and filled) much faster than the rates of underlying demand related to growth in the world economy. That translates into a large volume of seats on which there is constant pressure to discount. The gap appears to have been steadily widening throughout the 1990s (see graph over page). In the current climate there is clearly an opportunity for the network carriers to strip out that accumulated excess and some have already shown a willingness to do so. A series of airline failures around the world also offers the chance for the industry to slim down a little further. The question is whether this resolve to cut capacity will stick.

In the Gulf War experience there was relatively little room for manoeuvre. Although ageing aircraft were indeed retired from the world fleet, a record backlog of new airliner orders meant that the new capacity kept arriving. The result was a drive to drop fares and fill seats. This time there is not the same overhang of new deliveries waiting to enter the market and despite discounting to fill seats in the immediate aftermath, there appears a concerted attempt to tackle overcapacity.

However, there are real dangers that this consensus could yet break down. As the first shoots of traffic recovery begin to show through, carriers may once again be tempted to reverse their announced cuts and throw seats back on to the market. Despite the early and almost universal declaration of a 20% cut in capacity among the USmajors, there has since been some anxiety about whether all are actually playing by the new rules. If the network carriers do let too much excess capacity flow back, then they risk a further collapse in yields.

Even with the announced capacity cuts, it is not clear to what extent average fares will have to fall further to reach the point at which there will in effect have been a re-calibration of the industry around new levels of supply and demand.

On the other side of the equation, there appears to have been a fundamental downward shift along the demand curve. In other words, for any given fare level there is now a lower level of demand than there was in the environment before 11 September. That could emerge as a lasting difference in the environment in which mainline airlines have to operate.

The steep decline in business travel has already caused a weakening in the mix of premium traffic. At British Airways, the rate of decline of premium traffic in December was some 18% or twice that in economy. Some downtrading from premium to economy may already have taken place among corporate clients. On short- or medium-haul services the likelihood is that this now represents a structural shift that will not snap back quickly even after the markets recover. Certainly low-cost carriers both in the USA and Europe have moved quickly to establish new, lower benchmarks on business fares.

It is possible that there could be a stronger than expected swing back in business travel next year as businesses make up some of the ground lost during a year of uncertainty. IATA's corporate travel survey shows that business travellers who postponed trips during the latter part of 2001 may be prepared to fly once again. "People are starting to come out of their foxholes," says Morris.

Business confidence in the US market does appear to have recovered from its dive after 11 September: business confidence among US purchasing managers is at its most optimistic for a year (see table left). In fact, it is clear that US business was preparing itself for a slowdown in the US economy as early as September 2000. That showed up in a host of negative news on traffic and yields throughout the early part of 2001. The jury is still out on how soon the US economy will return to health. After the glory days of 3-5% annual growth over much of the last decade, the most realistic outlook now is for growth of no more than one percentage point. With Japan in outright recession and most of Europe also down from its peak, there would seem to be little prospect of the airline market being lifted out of danger by an economic boom.

Capacity constraint

Even without the events of 11 September, such an economic outlook would create the need for industry capacity constraint. Running the Traffic Demand Indicator (TDI)model on such numbers would mean that the underlying growth for 2002 would be at 2.1% on the North Atlantic. That compares favourably with last year's experience of a 1% traffic growth through to August and -10% for the full year. However, it has to be read in the context of a market which starts 2002 some 20% down on the year before. The same is true of the market from Europe to South-East Asia which should stand underlying growth of 3.1% this year, but which is down by some 10%.

The fact that the model indicates positive fundamental demand should not come as a surprise. The current traffic experience is unhinged from economic growth - it is more a reflection of consumer behaviour in the wake of the attacks on the USA. Negative expectations and uncertainties cloud the picture of underlying demand. Moreover, the model needs to be rebased to start at the new levels of capacity and fares which are sustainable for the mainline carriers as they go forward. That will not be clear until the current rollercoaster comes to rest.

In short, the focus now is on identifying this point where a profitable balance is restored between supply and demand. Despite the traffic being stimulated by the present flurry of discounting, there seems little question that reaching this point is likely to require a further fundamental reduction in capacity. Airline fears about being overtaken by competitors and not being ready for the recovery when it comes are misplaced. The need is to seize the moment and fundamentally transform the economics of this industry. The question is who will step up to the mark and take a lead and who will not.

Source: Airline Business