Pierre J. Jeanniot
O.C.,C.Q.,B.Sc.,LL.D.,D.Sc.
Industry Overview and Issues
Industry Overview and Issues
September 2015 >>
For the airline industry, 2014 was a great year. IATA reported a global net profit of some 19.9 billion USD.
This optimistic picture is continuing thus far in 2015, with a forecast industry net profit of 29.3 billion USD.
However, we have yet to see the impact on the world economy of the most recent Chinese financial crisis – and of the current reduction in oil and basic material investments.
The major slump in fuel prices has been the most recent dominant factor influencing the airline industry’s economics.
Airlines had been adjusting their operations, further trimming their costs to achieve profitability under the assumption that oil prices were to remain around the 100 USD/barrel level.
And thus, the rapid decrease in oil prices contributed directly to their bottom line.
For the foreseeable future, as the fundamental law of supply and demand dictates, the current conditions are likely to remain relatively unchanged.
“Supply is up – and demand is down”.
In a nutshell, the U.S. oil supply was recently increased, and the OPEC nations – led by Saudi Arabia -refused to slow production.
Regional instability in the Middle East has not proved to be a significant factor to affect traffic, nor to reduce oil production.
China’s economy is slowing down, and Europe’s is at best lethargic.
Although lower fuel prices are a positive cost factor for the airline industry, the resulting weaker economic growth will eventually have an impact.
The fall of oil prices is also having an impact on airline strategies, with old airplanes finding a new lease of life – and some thin routes, previously uneconomic, may become viable.
But impacting the profitability of individual airlines in 2015, will be whether hedging has been a significant factor in the past and going forward.
Any airline which had decided to hedge fuel at around 100 USD a barrel for the current year will miss out on a great profit opportunity.
And then , the industry will have to deal with the somewhat controversial practice of fuel surcharge which, if not reduced by passing on to the consumer some of the fuel price reduction, will likely attract the attention of politicians and regulators who love nothing more than to regulate airlines.
The favorable profit climate projected by IATA will benefit all regions of the world although, as one would expect, not necessarily equally.
North America will be the biggest beneficiary, as the USA’s big three airlines continue to enjoy the benefits of consolidation, and the U.S. economy shows significant improvements.
European airlines have benefitted also from lower fuel prices, but the impact is limited by the strength of the U.S. dollar.
While long haul markets have been stronger, the region’s operating environment is hindered by regulations, high taxes, and infrastructure deficiencies.
The Middle East region, which has the highest rate of growth of almost 13% per annum, will still show a mixed profit picture – although everyone will benefit from lower fuel prices.
While demand will grow by more than 5% in Latin America, the region’s weak returns are largely a result of the poor performance of key economies such as Brazil’s, and exchange rate weakness against the U.S. dollar.
Finally, African airlines’ weak traffic growth will continue to be affected by weak currency and the various problems which have been disrupting tourism.
Worldwide, we have gone from worrying about what we should do if the price of fuel was to reach 200 USD/barrel – to what do we do if the price of fuel falls to 20 USD/barrel.
Looking at each region a little more in detail:
In the U.S.A., the impact of the rapid improvement to the bottom line is likely to stimulate the expectation of its many airline stakeholders.
It should not be surprising that everyone should feel that he or she would want to benefit from this sudden and substantial improvement in profitability.
Over simplifying, twenty years ago or so airlines were enjoying a somewhat similar situation, where yield was improving and fuel costs were lower. This triggered a series of wage increases – which ultimately contributed to a succession of Chapter 11 bankruptcies.
Regretfully, all the full service airlines went through that painful process – which led to a significant re-adjustment of their labor costs.
Today, the labor situation with the major airlines has the appearance of being relatively stable.
However, there does not seem to be a consensus on how in the future employees should be remunerated.
Some airlines believe that instead of increasing wage levels, setting up a scheme of performance-based compensation could make a lot of sense.
In this way, if profitability declines a variable portion of employee compensation should also decline.
Of course, such a scheme would need to be carefully designed and cover every employee level in a manner considered fair and transparent, from the lowest –paid employee to the CEO.
Both Delta and United have indicated their intention to follow that course.
American Airlines, however, disagrees and intends to follow a more traditional approach. Their stated policy is “to reward workers with industry- leading wage rates, and not lower wages supplemented by compensation that varies with airline profitability”.
As a result of such a lack of industry agreement, it would be most unfortunate if the competitive cycle that contributed to Chapter 11 was to get started once again.
Europe has the world’s most congested airspace, and thus far every effort to substantially simplify the administration of that airspace has failed.
There continues to be a lack of political will to confront the interest groups opposed to administrative consolidation.
However, good progress is being achieved through technical improvements, and SESAR (Single European Sky ATM Research) is hopefully going to produce some significant increases in capacity and reduction in fuel consumption.
Fuel accounts for a large portion of the expenditure of Low Cost Carriers, and the current low fuel price will accelerate their advantages over the legacy carriers.
To illustrate, Norwegian – Europe’s third biggest L.C.C., does not hedge fuel and was an instant beneficiary of the fuel cost decline, achieving an immediate shaving of 20% off its overall costs.
To address another major type of cost, Ryanair has locked up its Euro/USD currency exchange to protect its new aircraft deliveries at a substantially lower price.
The challenge for the legacy airlines – primarily the Lufthansa Group and Air France/KLM – is to continue building up their low cost presence in Europe to eventually stabilize their share of the regional market.
Air France/KLM is now hoping to establish a Transavia Europe – outside of the French and Dutch borders – given the recent willingness of their respective unions to consider and discuss this expansion.
Lufthansa is also hoping to achieve a comprehensive agreement with their pilots, which would enable a more competitive labor situation for Eurowings. The recent series of 24-hour strikes by the Pilot Unions is indicative that an agreement has yet to be reached.
Asia continues to be a great market for aircraft manufacturers.
The current Airbus forecast is for some 12,000 aircraft to be delivered in the Asia Pacific region over the next 20 years.
This is more than any other region of the world, and will place much pressure on the required expansion of infrastructure, airports and ATM.
The next challenge will be in the availability of skilled personnel to support their rapidly growing fleets.
The demand for air travel is driven by the substantial growth of the Middle Class.
Ten Asian countries have recently decided to implement an “Open Skies” Air Market Agreement, which should further stimulate the growth of air traffic among those South-East Asian countries.
China, the world’s second largest economy, has now discovered that it is not immune to the vagaries of the markets.
Its economy is slowing down, and it is suffering from an overheated real estate market which is deflating, and consumer demand which is falling.
The growth rate of the Chinese economy has now decreased to some 7% – and will continue to decrease. In fact it is now suggested that it will slow down to 5% this year.
It remains to be seen if the recent devaluation of the Yuan and the current Chinese financial crisis will have a significant impact on world economic growth.
Still, it is projected that over the next 20 years some 600 million Chinese will enter the Middle Class.
In India, the World Bank’s projection is assuming that Prime Minister Modi’s current good performance will continue.
India achieved a 5.5% growth in 2014, and the Bank projects that India’s economy will increase by 7% by 2017 as China is expected to slip below that level.
India could continue to enjoy an accelerated rate of growth, but it needs to accelerate its efforts to rid itself of its corruption culture which, fortunately, the current government is determined to change.
But India must also attack its unfortunate bias for excessive and needlessly cumbersome regulations, some of which are largely there to protect the interests of favored parties – or quite simply to illustrate its inventiveness in regulation!
Africa
Today, some 80% of the intercontinental traffic between Africa and the rest of the world is controlled by non-African carriers.
The Yamoussoukro Declaration, signed in 1999, pledged its 44 signatories to establish an “Open Sky” regime across the continent.
Such an agreement would have allowed for unlimited frequencies between any of the participating States, improve security by making it mandatory to apply ICAO safety standards, and encourage cross-border investment in air transport.
Unfortunately today ,State-owned national flag carriers continue to operate routes under fairly restrictive bilateral agreements.
Low cost carriers are struggling to make headway, having to fight the protectionist policies of the various national governments.
Clearly, African governments do not see aviation as a national asset nor a strategy of economic development as is the case for the Gulf States.
Despite those hurdles, the latest passenger forecast by IATA for Africa predicts that the continent should enjoy the second highest rate of growth of the various regions, at 4.9% per annum.
Despite the apparent reluctance to change, some progress is being made.
The African Union has a Common African Civil Aviation Policy which proposes a united position in its dealings with the E.U., advocating the replacement of separate African States bilateral discussions with a block-to-block negotiation.
But their proposal is not binding on its members.
A number of African airlines are modernizing their fleets and are buying new, fuel-efficient aircraft, which should improve both their quality of service and their operating costs.
Meanwhile, there are a few hopeful signs.
Senegal has made a formal offer to South Africa, suggesting that South African Airlines and Senegal Airlines take an equity stake in each other and work towards a common restructuring program.
In December 2006, Morocco decided to join Europe’s Common Aviation Area, and this led to a dramatic increase in traffic volume as European “low cost” airlines such as Ryanair and EasyJet aggressively compete to increase their share of this market.
Morocco’s objective was to attract at least 10 million tourists annually.
A report by Intravista, a group of independent consultants, concluded that if only 12 of the 44 nations party to the Yamoussoukro Declaration were to implement the decision, the liberalization of their key markets could provide an extra 155,000 jobs – and 1.3 billion US dollars in annual G.D.P.
With the population of Africa expected to increase by 50% over the next 20 years, the potential for a large increase in the Middle Class is excellent.
If it finally comes into its own, Africa could follow a similar pattern which we have seen in Southeast Asia during the past 20 years.
Latin America
Turning to the Latin American region, Brazil’s airline industry did not enjoy a good year in 2014.
Inflation was up, consumer confidence was at an all-time low, and economic growth was almost at zero. …
This negative situation continues.
Despite the country’s economic slowdown, IATA forecasts that Brazil will overtake Japan’s home market by 2022 and establish itself in the top three global domestic aviation markets.
Although both the Brazilian and the Argentinian economies have been weak, traffic growth in the Latin American region in total was robust.
The increase in trade activity has provided a boost to business-related travel, resulting in a year to date of +6.3% RPMs by mid-year of this year compared to 2014.
The lack of adequate, timely, and cost-effective infrastructure, security, airports , and airways will continue to be the biggest challenge.
The Middle East region continues to be the fastest growing area.
Middle East traffic is projected by IATA to grow at 5.1% per annum, reaching some 250 million passengers annually in 20 years’ time.
The on-going dispute over “Open Skies” and alleged subsidies may slow down temporarily the expansion of the three major Gulf airlines to European and North American destinations, but in my view it is unlikely to change their longer term strategy.
In the immediate, the dispute has poisoned the relationships within the “One World” alliance, more particularly between Qatar Airways and American Airlines. Qatar Airways has indicated that it intends to leave “One World” unless this dispute is resolved promptly.
While the spotlight has been on the “unfairness” of the alleged advantages enjoyed by each side – European and North American vs Gulf airlines – other carriers in the Middle East region have been growing rapidly.
Saudi Arabian Airlines (Saudia) has announced plans to increase its fleet to 200 aircraft, and will capitalize, in part, on the growth in religious travel to the region.
Other players in the region which have expansion plans include Gulf Air, Kuwait Airways, and Oman Air.
Not to forget the very successful and fast growing Air Arabia – the most important low cost.
Capabilities of the air navigation authorities over the Persian Gulf to cope with the rapidly growing traffic could be a major challenge.
Although the current dispute over alleged subsidies may be a temporary distraction, the inherent and continuing political instability of the region can have a local impact.
LCCs worldwide are migrating towards a hybrid model – and the Middle East is no exception.
Flymas, Saudia’s LCC, has a Business Class cabin with generous 48 inch seats; and Fly Dubai on its Boeing 737.800 fleet has a 2-2 seat configuration for its Business Class. The airline aims to increase its annual passenger numbers to 20 million by 2020.
Air Arabia, based in Sharjah, is the only major budget airline in the U.A.E. that has not upgraded its fleet to a Business Class.
With its net profit margin being about 14% – higher than Ryanair and EasyJet – Air Arabia has no incentive to alter its Business model.
ALLIANCES … THEN AND NOW
Restrictions on foreign ownership imposed by all nations was making it virtually impossible for all major airlines to increase their international reach by mergers and acquisitions, or by setting up foreign subsidiaries.
Alliances were developed to overcome this major hurdle, at least in part.
The first global airline alliance was launched more than 18 years ago. “Star Alliance” was formed in May 1997, and initially regrouped Air Canada, Lufthansa, SAS, Thai and United.
It was followed in 1999 by “One World”, then comprising American Airlines, British Airways, Canadian Airlines, Cathay Pacific and Qantas.
The 3rd major alliance, “Sky Team” , was launched in 2000, with Air France, Delta, Korean Air and Aeromexico as initial members.
A fourth group, called the “Qualiflyer Group”, driven by Swissair, was intended to bring together the various airlines in which Swissair had acquired a stake, namely S.A.A., Fly , LOT, TAM, AOM and LTU.
The failure of Swissair resulted in the liquidation of that particular alliance.
The three Gulf airlines had each chosen originally to go their own way and not join any alliance.
Emirates, the super carrier of Dubai with the world’s biggest fleet of large airplanes – particularly but not uniquely Airbus A.380 – pursued a strategy of going at it alone.
Emirates, however, was able to develop bilateral relationships with many carriers including Korean Air, South African Airways, JetBlue, Alaska and Virgin America as well as EasyJet.
The most extensive alliance of Emirates is now with Qantas, which makes Dubai the principal connecting hub for Qantas from Australia to Europe.
Although Qantas is said to continue to be part of “One World”, it is a fair assumption that its very close relationship with Emirates would have strained its relationship with several members of “OneWorld”, including Cathay Pacific and British Airways.
Changing drastically its position, Qatar Airways took a different route and decided to join “OneWorld” in a move that included getting a stake in IAG (owner of British Airways, Iberia and Vueling).
Taking yet another different path, Etihad decided to invest heavily in various smaller /medium sized international airlines such as:
- 20% of Virgin Australia
- 33% of Switzerland’s Darwin Airlines, recently rebranded as Etihad Regional.
Etihad then created Etihad Airways Partners which comprised Air Berlin, Air Serbia , Air Seychelles, Jet Airways, Etihad Regional and Etihad itself.
Etihad’s strategy, which it describes as an “Equity Partnership”, is strangely similar to the path followed more than 20 years ago by Swissair.
Hopefully Etihad will be more successful.
Etihad is not unique in following a strategy of buying shares in other airlines.
Some U.S. airlines have been looking abroad for investment opportunities to increase their presence in the global market.
Delta plans to invest 450 million US dollars for a 3.5% stake in China Eastern Airlines.
Previously, in 2011, Delta had invested 65 million US dollars to acquire a 4.17% stake in Aeromexico, and 100 million US dollars for a 3%share of GOL Linhas Aéreos of Brazil.
Delta has indicated that it plans to increase its share of GOL to 9%.
United has also announced that it will invest 100 million US dollars in Brazil’s Azul Airlines.
Both carriers expect to have a seat on the Board of those airlines – but unlike Etihad they have no illusions of being able to directly influence significantly the strategic direction of those airlines, but perhaps simply monetarize eventually their investments.
The principal objective of any alliance was to provide for its most valuable customers a service of equal quality whatever the destination.
Ultimately, the alliance would be able to offer customers a seamless product, from any part of the globe to any other destination.
This pre-supposes that the alliance partner would be able to harmonize their product in terms of quality of inflight service, cabin environment, passenger handling at airports, etc.
This also meant that these passengers would be able to accrue benefits on all airlines (mileage points), access lounges, enjoy similar seat selection, priority check-in, upgrades, etc.
For instance, in the case of a customer buying a ticket on Lufthansa on a flight which would be operated by Brussels Airlines, or All Nippon Airways – could his expectation be fully met?
Or a ticket sold by KLM on a code share operated by Kenya Airways?
Then there is the question of providing an adequate customer experience, when part of the travel is carried out by a low cost airline itself owned by an alliance member.
The problem is that the contract between the passenger and the airline is different depending on whether the airline is a L.C.C. or a full service carrier.
Is the passenger fully informed that the service provided will be significantly different from the airline – a full service carrier – … which actually sold the ticket which actually includes that part of the travel which will be carried out by a low cost carrier?
It is generally acknowledged that alliances have significantly extended the market reach of their members, as well as increased their presence. Joint ventures have been expected to improve their profitability on some of their key markets.
Customers have significantly benefitted from much improved connectivity.
But much remains to be done to provide their customers with consistency of service across the various alliance members.
Pierre J. Jeanniot, O.C., C.Q.
President & CEO, Jinmag Inc.
Director General Emeritus, IATA
September 2015
