Pierre J. Jeanniot
A Perfect Storm?
Keynote address to the 21st Annual Canadian Airline Investment Conference
Toronto, June 2o, 2008 >>
Ladies and gentlemen:
Those of you who may have glanced at my biography have probably concluded that I have been in aviation a fairly long time.
Well to tell the truth, when I started in the airline – in those days Air Canada was called Trans-Canada Airlines – commercial jet travel had just become the latest novelty.
Over the many years that I have been in this crazy business, I have seldom experienced a dull day.
I feel quite confident that the airline executives participating in this event would support that observation.
I am thinking more specifically of Bob Deluce and Joe Randall. Indeed, I should thank them both for having done such a fine job some 25 years ago or more, in heading the two regional airlines which preceded Jazz.
In the case of Bob – Air Ontario; and Joe of course was heading Air Nova.
The creation of a number of regional airlines across our country was one of the important elements of my restructuring strategy which was required to make – what was at that time a Crown Corporation – privatize-able.
You will appreciate that setting up these regional airlines, each with a much lower operating cost structure than Air Canada, could provide good service with a fleet of Dash-8s to markets too expensive to serve with the DC9-30’s and Boeing 727-200s of the Air Canada fleet.
It was a sort of a win-win. Good and affordable air services were being provided at dozens of locations being abandoned by Air Canada, and the main airline was substantially lowering its domestic operating cost.
It is rather nice to see that the fledgling children we launched back then have become a solid and profitable airline, playing a very valuable role in this country.
By the way, another initiative launched at approximately the same time was Aeroplan!
But for this we have to blame American Airlines. My counterpart there, the famous Bob Crandall, had launched the American Advantage Bonus Plan.
Within weeks we had created our own response which was Aeroplan, but unfortunately, in the then highly regulated environment of the times, the Canadian Transport Commission turned down our proposal.
Following more than six months of frantic negotiations, we finally prevailed – but by then we had lost some 5% of our high-yield Transborder business class traffic.
Fortunately for us, Aeroplan became very successful very quickly, although no one would have ever imagined that it would become the important stand-alone business it is today.
Incidentally, I am not mentioning these two success stories merely for nostalgic reasons.
They are good examples of monetizing some of Air Canada’s hidden values, which is one of the important actions one should take, particularly in times of crisis.
And today the aviation world is certainly facing yet another crisis.
In Istanbul, at the IATA AGM a few weeks ago, some U.S. airline CEO’s were describing the current situation as a “Perfect Storm”.
This is because costs are going up while at the same time revenues are coming down.
This is most disappointing given the fact that we had recently experienced better than average traffic growth.
IATA reported that international traffic grew by 7.2% in 2007 – close to the 7.6% increases achieved in the previous year.
Most encouragingly, business travel was expanding at a fairly good pace during 2007, providing to the network airlines a great source of yield improvement.
Indeed, in the long haul markets travel in business and first class was growing faster than economy.
With capacity growing at a slower pace than traffic, load factors in both international and domestic markets reached the high 70s.
Airline revenues increased by some 7% in 2007 and profitability, although still very much insufficient, reached a 4.2% return on investment.
While this represented better results than the industry had been able to achieve for many years, this result is still far too low to attract capital and ensure financial sustainability in the long run.
In 2007, fuel started the year close to 50 USD a barrel, and then rose to hit 100 USD a barrel.
By the end of last year, it looked like many airlines were hoping that fuel had peaked and that – if the sub-prime crisis was contained – the economy would return to a reasonable rate of growth.
But the first half of this year has shown that this view was overly optimistic.
There is probably light at the end of the tunnel, but no one seems to be venturing a guess as to how long that tunnel may turn out to be.
With some markets undergoing rapid decompression, the likelihood of over-capacity at times of economic slowdown shows that once again we have not learned from the past.
Revenues of airlines are closely linked to economic cycles. Airlines tend to order airplanes at the top of the cycle…
All too often, unfortunately, the airplanes are delivered during a downturn.
Over the past two years, airlines have ordered an unprecedented number of airplanes.
With these airplanes about to be delivered at the time of decreasing traffic – and with the cost of fuel sky-rocketing – this amounts to a rather disastrous scenario.
I am told that at least one U.S. airline executive, totally bewildered by this situation and unable to decide what to do, finally turned to his local preacher for advice.
“Put your faith in the bible”, counseled his spiritual adviser, “and you should find an answer in there.”
Our airline executive, bible in hand, went walking on the beach, meditating.
Tired of walking, he sat down, placing the holy book at his feet.
Suddenly there was a strong gust of wind and the pages of the bible began to flip furiously. Then, just as suddenly, the wind dropped. Eagerly, our airline executive picked up the book and looked at where the pages had stopped flipping. It said “Chapter Eleven”.
Unfortunately, for many U.S. carriers it’s a case of “been there – done that”, and I am quite sure that they have no wish to go through that painful process again.
And thus the aviation world is facing yet another crisis, partly caused by the recent rapid rise in the price of a barrel of fuel and, to some extent, the sub-prime financial crisis which has started to undermine the confidence of consumers, primarily in North America.
On the basis of an average oil price of 120 to 130 USD per barrel for the current year, IATA is now forecasting an industry loss of $2.3 billion.
This is a major swing from their initial forecast of a profit of $6.8 billion based on last year’s expectations.
We are told that some 24 airlines have suspended operation, or gone out of business, in the past six months.
These include the three “business class only” airlines which emerged in the last three years, attempting to create a new niche across the Atlantic.
Year over year, in the first quarter of this year, global passenger traffic slowed down markedly, although the worldwide average has remained, for international traffic, at +5%.
At the same time, domestic traffic fell everywhere compared to last year over the first four months of this year.
The largest domestic market, the North American market, is definitely on a decreasing slope.
As a result of the worsening U.S. situation, “legacy” carriers have once again launched some major capacity reduction, taking the opportunity to ground many of their older airplanes.
United Airlines has announced that it will retire 100 mainline jets. This would include ninety-four of its B737s and six B747s. The cumulative mainline domestic capacity will shrink by 17-18%.
Continental Airlines plans to retire twenty-four B737-300s out of a fleet of forty-seven and thirteen B737-500s out of a fleet of fifty-five.
Some further reductions are planned for 2009, which will amount to a mainline capacity reduction of 14-16% in total.
Continental has announced that 3000 jobs will be eliminated.
American Airlines plans to retire forty to forty-five mainline aircraft, mainly MD80s and some A300s. This amounts to approximately 11-12% of capacity reduction.
The so-called “low costs” are also affected, slowing down their expansion.
Jet Blue Airways is deferring delivery of twenty-one A320s from 2009-2011 to 2014-2015.
Air Tran Airways is deferring the delivery of eighteen B737-700s from 2009-2011 to 2013-2014.
Southwest, while still taking delivery of twenty-nine new B.737-N.G. airplanes, is now planning to retire sixteen older B737s this year.
The price of fuel represents the largest percentage of operating costs for low cost airlines, in some cases in excess of 40%. This makes them more fragile and could lead to more failures and/or consolidation.
Although less affected at this point, the European low costs are responding as well to the cost challenge.
Ryan Air achieved a hefty profit at the year ending March 31, but it has announced plans to ground about 10% of its fleet during the winter schedule.
Air Berlin reported a net loss of close to 60 million euros in the first quarter of this year, and has embarked on a major cost reduction program.
Although the general weakening of the global economy is worrisome to all airlines, the impact of high fuel increases is somewhat less for European airlines because of the strength of the euro.
As well, most E.U. airlines have hedged a large proportion of their anticipated fuel needs for 2008.
As such, the main European international carriers – although continuing to look at ways of reducing cost – have not decided to dramatically reduce capacity as have their U.S. counterparts.
The structure of the world economy has changed considerably since the last financial crisis.
The rapidly growing Asian economies have increased their internal and intra-Asia trade, and are much less dependent on the U.S. economy.
China, India, and other Asian nations, as well as the Middle East, more particularly the Gulf States, are set to continue their expansion aggressively – at least for the time being.
But the outlook remains very much uncertain, with several unanswered questions.
Will the weakening of the U.S. economy cause serious damage to the economy of its trading partners?
Is the full extent of the sub-prime financial crisis now fully known – and contained – in the U.S. as well as elsewhere, given the fact that some of that sub-prime debacle was exported through the international financial network?
Is another bubble about to burst?
The Gulf airlines such as Emirates and Etihad have remained very optimistic in terms of their projected growth, and have not modified or delayed the delivery dates for their fleet acquisitions.
More particularly, Emirates recently stated rather clearly that it intends to continue to take delivery of fifty-eight A380s currently on order.
The Chinese airlines, led by Cathay Pacific, are enjoying participating in the growth of the Asian economy, and thus far have not felt threatened by the so called “slow-down” in international markets.
However, we should expect that there will be further losses and consolidations… in Southeast Asia and India, as a result of the recent proliferation of low cost airlines and the price wars that have resulted from the ensuing excess capacity. This current excess capacity situation is, of course, unsustainable and within the next year or two will lead to a rationalization of the situation.
The consolidation process which has been ongoing in Europe for some time is continuing.
The case of Alitalia would have been settled by now if it had not been become a political football during the last Italian election and temporarily stopped.
I would expect that even Prime Minister Berlusconi cannot escape the inevitable.
Shopping for a buyer for Iberia is continuing, and Lufthansa is now in a position to exercise its right to take control of British Midland International – and its very valuable London Heathrow slots.
In the U.S., we are all too familiar with the regrouping underway.
Delta and Northwest should soon be a “fait-accompli”, although there may still be substantial discontent by the Northwest Pilots which should be resolved as soon as possible if the integration is to be harmonious.
And then there is the question of whether or not United Airlines will be able to merge with Continental, now that getting together with U.S. Airways has proved to be impractical.
And we should not forget that American Airlines is also interested in the right merger.
Of course, size does not guarantee survival. If this had been the case, Eastern Airlines and Pan Am would still be around today.
And there is no doubt that many mergers and acquisitions have not resulted in increased shareholder value – sometimes quite the opposite!
Nevertheless, there have been examples of successful mergers, for instance U.S. Airways. Iin Europe we can point to KLM/Air France, and to Lufthansa/Swiss, both of which have worked out rather well.
With the actual seat occupancy factor for most airlines in the high seventies and low eighties – and many U.S. airlines cutting back capacity – very little room for revenue improvements can be expected from carrying more people on each airplane.
This means that the price of fares in the U.S. will inevitable need to go up significantly, given that all other cost components have been thoroughly reviewed – and reduced – to the extent possible in the last few years.
Elsewhere, the many new aircraft deliveries and increased liberalization are likely to continue to put pressure on yields. The high cost of fuel, however, should encourage the airlines to park or scrap older airplanes, and reduce the excess capacity.
It is somewhat unfortunate that the delivery of the latest types of aircraft being produced by both the major manufacturers – Boeing and Airbus – have been delayed.
They represent a significant improvement in operating cost, and in particular fuel consumption.
Their deployment would have considerably helped airlines to reduce their operating costs.
The fuel consumption per passenger-kilometer achieved by the Airbus A380 represents a significant reduction, but unfortunately the production rate of this new airplane is much lower than originally anticipated, which will prevent deliveries from taking place as planned.
Additionally, the continuing delay, of probably some two years now, for the B787 will prevent airlines from achieving a much better operating cost, and force the continued use of much less efficient, older B767s and Airbus A300s.
The U.S. carriers will continue to face a rather difficult time, given that they have some of the oldest fleets around and, unfortunately, their weak balance sheets are likely to be further battered by the current financial and fuel crises which will severely restrict their ability to modernize their fleets rapidly.
This will also likely prevent the U.S. carriers from taking advantage to the same extent as their European counterparts, of the opportunities arising from the recently implemented U.S.-E.C. air bilateral, which will provide a great deal of flexibility and encourage new services to be launched across the Atlantic.
A vigorous implementation by several carriers of the new Freedoms offered by this bilateral could further stimulate the market, and could act as a counter balance to the current down trend in traffic.
It is well known that new market opportunities always stimulate the market in general and create new growth to the benefit of the economies at both ends of the route.
The main Canadian carriers, WestJet and Air Canada, benefit from relatively newer fleets than their American counterparts, and this should hopefully provide them with a cost advantage when competing trans-border with the American carriers.
Thus with the rather strong Canadian dollar and a more fuel-efficient fleet, the Canadian carriers should be in a position to take advantage of the current difficulties of their American competitors.
Invariably, airlines place large orders for new airplanes when the economy is good and traffic is growing, but unfortunately – and frequently – inevitably delivery of those airplanes takes place when the economy is weak and traffic is decreasing.
We could be facing a similar situation once again.
Over the past two years, an unprecedented number of new airplanes have been ordered, both Boeing and Airbus. Admittedly, many of these were ordered by the so-called “BRIC” economies – Brazil, Russia, India and China – where air traffic has been growing in double digits.
If the current economic crisis – still somewhat focused around North America and the international banks – begins to resolve itself by the end of this year, the airline crisis may equally show signs of resolving itself – barring the fact that a few more carriers will fail and/or consolidate their operation.
However, should the economy worldwide show further deterioration, we would be faced once again with substantial overcapacity over the next couple of years, with the associated dire consequences of price wars and further bankruptcies.
The financing needed to cover this big order of new aircraft is considerable, and one may wonder whether the financial markets are able to respond adequately to this challenge, given the traditional fragility of our industry.
To state the obvious, those airlines which have a solid balance sheet – and good cash flow – will have little difficulty in meeting their financing requirements.
Unfortunately, this is unlikely to be the case for majority of the airlines, which may result in a still greater percentage of airplanes being owned by the leasing companies.
The regional airlines on a worldwide basis will continue to grow, although possibly at a slower pace, but the high price of fuel will also have an impact on their viability.
The current fuel crisis is giving new life to turbo props, which had continued to be out of favor with some consumers who wrongly believed that these airplanes are older generation than the jets.
Bombardier’s Q400 has re-gained some popularity with the consumer, and there are even questions of developing a stretched version.
With the acknowledged inability of both Boeing and Airbus to begin work on an eventual replacement for the A 320 family and the B737 family, the Bombardier C series may find itself in the fortunate position of filling that gap.
Neither Boeing nor Airbus is likely to produce a new single aisle airplane much before 2020, and if the C-series can actually be produced and become operational by 2012-2014 – and assuming it is able to deliver a 15-10% improvement in operating costs, including fuel consumption – it may well become a very popular choice both for the regional carriers and the mainline airlines for the larger 100-135 seat market.
A good part of that cost improvement depends, of course, on the success of the engine being developed by Pratt & Whitney, and on Bombardier gaining from the experience of the two main manufacturers on the increased use of composites for the fuselage and for the wings of that airplane.
Far from having to worry uniquely about fuel cost, security, and air traffic congestion, the airlines still have to contend with their “carbon footprint” and the proposals in different parts of the world, in particular Europe, to charge to compensate for the CO2 being released by aviation.
Biofuels, some believe, may be one of the giant steps the industry needs to take to achieve a significant reduction in CO2 emissions.
Richard Branson is one such believer, and has said that he intends to build plants to produce an environmentally friendly aviation fuel.
His Virgin Fuels subsidiary has formed a partnership with Boeing, GE Aviation, and Virgin Atlantic, to demonstrate the feasibility.
From a practical point of view, this in my view is more for the sake of appearances – to show that something is being done – than for practical results.
Incidentally, scientists calculate that it would take six million square kilometers – an area the size of Europe – to produce enough biofuel to totally replace jet fuel using soybeans.
And recently, the current agricultural crisis has put the spotlight on the disadvantages of crop-generated biofuel, and is likely to force a review of that approach.
Last year at the World Air Transport Forum in Cannes, I suggested that algae were probably the most likely – and least damaging – source of biofuel.
Recent research has shown that algae would do the same job with only 35,000 square kilometers. Not only do they absorb great quantities of carbon dioxide during their lifetime, but they are also a source of energy-rich oil that can be turned into fuel.
I understand the U.S. industry is now focusing more of its attention in this direction.
Fuels, engines, and aircraft are all critical components of the air transport industry in its drive for sustainable development.
All offer good promises in the long term.
In the short term, there are great opportunities for significant reductions in CO2 emissions by streamlining air traffic management.
Three fairly well-defined projects could delivery real results
A Single Sky for Europe
An efficiently coordinated and integrated air traffic control operation for the Pearl River Delta in China
And implementation of the next generation air traffic system in the U.S.
The Single European Sky alone could deliver a 12 million ton reduction in CO2 a year.
But governments are dragging their feet. With strong political will, a Single European Sky could quickly become reality.
Well truly, ladies and gentlemen, this industry has never faced a shortage of challenges – and we are unlikely to experience a dull day any time soon.
But… are we facing a Perfect Storm? And is this likely to be the worst crisis since the great depression, as some have suggested?
Naturally, the U.S. domestic air traffic situation – and the soaring costs of fuel – are good reasons for the U.S. carriers, both legacy and low costs, to be pessimistic.
As for the other markets, in Europe, Asia, and the Middle East, the traffic forecasts remain relatively strong for this summer.
Whatever happens to the U.S. economy in the next few months will be watched very closely, and there will be a temptation to reduce capacity for the Fall as a precautionary measure.
Having survived – with scars to prove it – through four or five major aviation crises to date, I am not prepared to declare this one as the worst!
My first experience goes back to the 1970’s, when the price of oil increased from 2 to 3 USD per barrel to some 12 USD a barrel over a relatively short time.
This caused much pain and adjustment.
But for my money – and without any doubt what-so-ever – the worst crisis I have ever had to face was 9/11.
We came close to a complete collapse of the aviation system as the skies over North America remained silent for some five days, and the economy almost came to a halt.
I was the Head of IATA at the time, and fully engaged in the struggle to get the system re-instated – urging the re-opening of air traffic, implementing security measures, keeping some aviation insurance available, etc.
The intensity, depth, and duration of that 9/11 crisis will hopefully never be matched.
This is not to say that I am unconcerned by the current situation – far from it. It is serious, and the end is certainly not in sight – but I would be tempted to say, as Mark Twain once said coming out of Wagner symphony…
“Perhaps it’s not really as bad as it sounds”.