Forecast: Good Times Or, As Good as it Gets

2006 should produce the best results the industry has seen since 2000.

By J.A. Donoghue
Air Transport World, January 2006, p.26 Buy this issue

Viewed with altered expectations, 2006 will be at or near the top of the current economic cycle and should produce the best financial results the industry has seen since 2000. Passenger traffic, on a steady rise since the 2001-02 period, will ride a still-buoyant global economy to continue its ascent at rates a bit higher than the long-term trend, but this time with some improved yields, especially in the North American domestic market where 2006 capacity should decline.

Cargo traffic, suffering in 2005 in comparison to an exceptionally strong 2004, is poised to resume its steady growth (see story, p. 38). The price of oil will improve graduallyif luck holds. And manufacturers serving the industry, coming off a boom year of new orders in 2005, are expecting 2006 to be another strong year, with deliveries ramping back up.

Last year, for a change, there was some industry familiarity with the source of diminished bottom linesthe price of oil is the devil we know, famous for nasty surprises. But the cause of spiking prices was new: Not embargoes or war or terrorist attack but horrific hurricanes that ravaged the oil-producing and processing centers along the southern US coast that piled added price pressure onto a curve already rising on increased global demand.

But some aren't willing to let airlines shift the responsibility for their losses to oil prices. "That's conventional thinking," says Peter Morris, chief economist and head of Airclaims' Transport and Tourism Consultancy. "We see [some] carriers [always] making profits when times are tough. In addition, people like Ryanair . . . actually secured a degree of comparative advantage. You can look at their rate of growth and profitability and say it is driven by the fuel price surcharges put on by the network carriers, fuel price effectively becoming a differentiator in how it is passed on due to the inherent profitability of the underlying carrier. Berating fuel prices is as pointless as saying the passengers are choosing the wrong kind of tickets. You have to work within the framework the market gives you."

Nonetheless, fuel, airlines' second-largest cost component, threatens to become the largest. With the certain uncertainty of fuel prices, many carriers are producing multitiered business plans stratified by fuel price. Brian Pearce, IATA chief economist, told ATW in December that 2005 looked to end "a bit better" than the $7.4 billion world loss he predicted in August. Since then, "Oil prices were seen to curve down. We had thought the average price per barrel would be $57, but now it looks like $54-$55, coupled with quite a strong revenue environment," allowing IATA to cut its loss estimate to $6 billion.

It was in the US where most losses were found. With a combined net loss estimated by ATA at around $10 billion and a $3 billion operating loss, this group clearly pushed the rest of the world into negative numbers. Pearce says the global industry will lose $4.2 billion next year, with the US market alone remaining $6.5 billion in the red.

Success has continued for the most reliably successful group of airlines, the Asia/Pacific carriers. The Assn. of Asia Pacific Airlines reported for the most recent fiscal year ended June 30 that its members made a $3.5 billion net profit on revenues of $65.5 billion despite a 38% jump in fuel costs. "Systemwide yield improved by 7.8%, or 4.8 cents, to 66.1 cents per RTK in 2004-05," notes AAPA DG Andrew Herdman. System load factor was "up 1.6 points to 68.2% despite a 10.5% jump in capacity."

In Europe last year, profits generally prevailed, aided by strong oil hedging programs and fuel price surcharges, despite the growing impact of low-cost carriers in intra-European markets. Looking into 2006, most airlines plan healthy capacity increases, albeit in different markets.

The best news from 2005 came in two parts. First, load factors rose around the world as demand outran capacity in every major market, and second, the demand persisted even as fares began to rise. This most important positive development seems likely to continue into and perhaps through 2006.

A Profitable Year

With a continued focus on costs, the world airline community in 2006 may break into profits. Since the financial losses reside in North America, this means that this market must come closer to breaking even. The big swing factor remains the price of oil.

A remarkable change this year will be a decline in US domestic capacity in the face of record load factors and strong LCC growth, with 2006 domestic ASMs dipping as much as 2%-3%, according to ATA figures. Fitch Ratings predicts a drop of as much as 5%. Oil prices will influence this number as well, with cheaper oil pushing capacity into net gains and more expensive oil cutting flying even more. The thinning or elimination of Independence Air will ease some pressure, but the largest part of the capacity fall will come from network carriers shrinking fleets during bankruptcy and/or redeploying domestic aircraft to international routes in search of safer yields.

Adam Pilarski, senior VP at the Avitas consultancy, says, "The US I think will have the first profitable year since 2000. What will turn it around is the upward trend in yield and traffic that continues growing."

Pearce, meanwhile, sees "an improving 2006, but not for the industry as a whole," with the US staying negative. "We expect a [world] profit in 2007 if oil slides down to $50, but we still see losses coming out of the US at $50 a barrel," he says.

"Based on summer 2005 demand levels and a favorable macroeconomic outlook, the foundation for strong domestic and international traffic patterns in 2006 appears solid," Fitch Reports states about the US market.

According to John Heimlich, ATA VP and chief economist, "Domestic passenger volume growth will continue to exceed changes in capacity and I expect load factor growth to continue." The result: "With tighter capacity and relatively strong demand, the environment is improving for domestic yields to grow. International ASMs will continue to grow, but not at the robust double-digit rates we have seen in 2005we are talking 6%-8% ASM growth. I expect international demand [RPMs] to lag ASM growth. As such, we are looking at a slight decline in [international] load factor."

"Simple supply and demand will see downward pressure on [international] yields," says Pearce, reading similar tea leaves.

Morris says, "I don't see the factors producing the 8-1/2% [growth in 2005] getting any worse, especially if oil prices are going down and these new waves of deliveries are coming in. The US is a bit of a wild cardthere still seems to be the stated intent to put capacity on international because yields are better, and so one can expect to see an attempt to pull in double-digit percentage growth on international by the Americans that will then lower the price, stimulate the demand and so on."

Wrong Question

The question of how much capacity is too much is the wrong question, says Heimlich. The question should be what kind of capacity. "If unit costs [CASM] were lower, then the amount of capacity would be fine. If the question is 'Assuming no change in CASM, would a reduction in capacity help increase airline pricing power?' then the answer is yes." An IATA spokesperson says it in a slightly different way: "There is too much capacity in the system at one level of CASK, too much high-cost CASK."

The recovering fortunes of US carriers are not based simply on capacity reductions, says Pilarski. "We are beginning to have some sounder pricing policies . . . The craziness of [poor] yield management is that you're not really maximizing your profit but maximizing the number of people in your planes. Inappropriate yield management was filling airplanes, but that's not the best way to maximize profit. I think airlines are beginning to realize that maximizing profit is what they should be doing."

Robert Milton, chairman, president and CEO of Air Canada parent ACE Aviation Holdings, says that "yields have firmed up considerably," helped by Jetsgo's failure taking 30 aircraft out of the Canadian market. "They were doing typical death throes fare schemes as low as $1," he says. When the LCC failed, "we saw a much more rational approach return to the marketplace."

Canada's load factor trends mirror the US experience: "With 19 consecutive months of record load factors, I think single digits in [2006] traffic growth, maintaining load factors at historic high levels," Milton predicts. He is optimistic about yields "firming or staying firm."

On the other side of the Atlantic, network carriers harbor similar thoughts about growing demand. "There is no overcapacity on long-haul routes; the increase in load factors is spectacular," Air France-KLM tells ATW. "Air France is convinced that, unless something exceptional happens, we will not be in an overcapacity situation in the long-haul sector. On the contrary, we may even find ourselves in a slight undercapacity situation." The carrier plans 8% ASK growth in the winter season on long-haul routes and 4% up in the number of long-haul seats for the year en route to a 20% gain by 2009.

Maurice Coleman, head of commercial strategy at Aer Lingus, agrees, saying his airline's LCC-like pricing on the North Atlantic produced a 21% RPK increase in 2005 and has the carrier expecting 13% growth on those routes this year, more if it can find additional good, affordable airplanes.

The AF-KLM story changes for the medium-haul routes where LCCs dwell: A cautious growth of only 2% in winter ASKs and 2% in seats for the year, and a total medium-haul fleet net gain of only 3% by 2009, with contingency plans to cut up to 20% if needed. Unlike AF-KLM, the new Aer Lingus is riding with the LCCs instead of against them, running monthly intra-Europe passenger counts more than 50% ahead of the same month 12 months ago. "We don't really face overcapacity," says Coleman, "but we do face unprofitable carriers who shouldn't be operating."

CSA Czech Airlines sees its future in Eastern Europe impacted by capacity going onto international routes: "We expect the worldwide yield to keep on falling," the company tells ATW. Air New Zealand also is worried: "Capacity is expected to continue to grow globally, which will impact on yields in some regions as airlines seek to maintain current load factors. Overcapacity is a very significant problem for this industry."

Japan Airlines agrees: "In general, there is too much capacity." However, even the failure of a major carrier on Pacific routes would bring only temporary relief; "airline operations abhor a vacuum and should there be any drop in transpacific capacity as a result of a failure, it might soon be restored [as] other carriers take up the slack." JAL expects its international yields to rise going through 2006.

Varig is optimistic on yield rising with demand: "Our expectations for the demand traffic in 2006 are conservative. We foresee about 10%-15% in the domestic market and 7%-10% in the international market." The company says it will maintain its current load factors. Divining The Future While capacity is completely within an airline's control, oil is not. Divining the future price of oil has become the Holy Grail of airline planning.

About 2006 oil prices, Milton says, "There is reason to be hopefulfamous last wordsthat we wind up back in the $40s in the next year or so." Dave Ulmer, JetBlue VP-planning, says, "We've seen it come down a little bit. Between geopolitical events and natural disasters, I hope we see a pretty constant state of oil. None of the industry can be supported on over $2 [per gal.], the LCCs included."

ANZ says, "Jet fuel will remain high until sufficient refining capacity comes on-stream. This is likely to take a few years at best."

Milton notes that crude price was not the only problem. "Beyond just the raw price of the product, the crack spreads," the premium placed on the production of jet fuel, "have gone through the roof; spreads [went] up almost 10 times, but they're calming down."

Herdman also lashes out at the crack spread, saying he "had no idea it cost so much to refine jet fuel. Airlines are struggling to cope with the burden of skyrocketing oil prices. Adding salt to the wound, refiners have taken advantage of supposed tight supply conditions to engineer a threefold increase in refining margins for aviation jet fuel."

A consequence of the crack spread saw airlines that hedged jet fuel prices making out much better than those hedging crude prices.

Ironically, one of the reasons for hope on fuel costs is that the world economic growth that powers traffic gains also will be slowed by high oil prices, reducing the demand for oil. Pearce sees those signs: "We see fuel prices starting to edge down next year. We're starting to see some signs that economic growth is starting to slow down."

British Airways CEO Willie Walsh says, "Looking ahead, we should be much more cautious. Oil prices are very high and this is normally a drag on the global economy. There are also signs that in some countries consumers are spending less. Our industry is very cyclical, and if there is a global slowdown it is bound to be affected."

Herdman says: "The concern remains that this prolonged period of high oil prices is beginning to weigh more seriously on the global economy. Given recent rises in interest rates in the US and other developed economies, there are some signs of weakening consumer confidence that may not augur well for 2006." Pearce notes that European carriers' hedging programs are diminished for 2006, resulting in rising costs for those carriers as the spot market declines.

Predictions vary. Heimlich says, "We are currently projecting an average of $57 crude oil over the year, plus a jet fuel crack spread of $10 to $15. Hedging is possible for some carriers, though generally at prices in the $60 range, and often hedges do not cover the exposure to the crack spread."

Pilarski sees oil prices "driven by political events." In the absence of big events, "I don't see oil prices really going up; 2006 prices more likely will be below $50 than above $60."

Cargolux Senior VP-Sales M. van de Weg states that the future of oil pricing is "impossible to say, although we expect that the prices will remain relatively high compared to a couple of years ago." Cargolux's hedging program remains active. CSA expects stable prices, "with the potential for a modest decline."

The chances of industry consolidation increase apace with the price of fuel in many estimations, with $60 per barrel seen as a crucial breakpoint for some carriers vanishing either through outright failure or, more likely, through merger. If the predictions for 2006 prices hold, the odds are against a significant failure. However, there is a consensus in the industry that consolidation is inevitable in the nearing future.

Poised For A Comeback

There also is a belief that the tough decisions many network carriers have taken to face up to the succession of challenges since 2000 are creating a new generation of companies that have shrugged off the negative trappings that came with the "legacy" airlines label while retaining the powerful parts of the systems. These carriers, some believe, are poised for a comeback.

"In the US we will see the legacies turn out okay through the restructuring because they have those legacy aspects to fall back on; they have the gates and the slots and the routes that give them the financial maneuverability to get through the restructuring," says Milton. "And when they get their costs right, the ones that will be under pressure will be the LCCs who have been the darlings of the past several years. Unfortunately, the legacy guys that have not restructured will struggle."

As an example of legacy value, Air Canada's spun-off frequent-flier program Aeroplan is "publicly traded with a market cap of over $2 billion, worth more than the US airline industry combined." says Milton. "Let's face it, we'll never have a labor cost advantage against [new LCCs], so we're going to have to figure out every other angle we can come at this on a safe, efficient basis."

"Legacy and low-cost carriers are two totally different business models," AF-KLM says. "We are targeting different categories of customers." The company has concluded that "65% of the total difference in unit costs boils down to two factorsdenser cabin seating configurations and the utilization of aircraft," with seating giving LCCs a 15% edge and utilization 24%. But AF-KLM found that higher utilization is possible only with "a very smooth, linear schedule, whereas legacy carriers aim to cover peak periods of demand, particularly where business travelers are concerned. Further, our medium-haul network feeds our long-haul network and [is] restricted by the connecting banks."

"As we grow, we will hit up against lower-cost carriers," affirms Ulmer, "and the Majors are becoming lower-cost carriers as well. They need to circle the wagons at the hubs. When they have tried to fly where they don't have a hub or a network to support their volume, they have to rely on price like the rest of us, and that price is not sufficient [for them] to make a profit . . . They are the dominant players and they can defend . . . and they have the international feed that is more lucrative."

Legacy change is forced by LCCs. "The low-cost carrier business model is a consolidated trend worldwide," Varig tells ATW. "The Brazilian market is not different. The largest domestic low-cost airline, Gol, is expected to increase its operational fleet by 29% over the next year, therefore being able to expand its network both domestically and internationally."

Ominous Trend

The LCC business model is shifting in various ways, but one new and ominous trend is the proliferation of free tickets. Michael O'Leary has been saying for more than a year that he plans to develop ancillary revenue streams so strong that eventually all Ryanair tickets will be free; the airline already has given away millions of tickets. Late last year, AirAsia announced 2 million free tickets. Coleman notes that Aer Lingus's reliance on ancillary revenue allowed it to skip the fuel surcharges other European network airlines leaned on.

Regional Status

US Regionals are another successful group, but their status is due for a change. "The Regional story in the US is not in equilibrium," Pilarski says. "Something has to give. You can't have legacy carriers losing money year after year [as their Regional partners make profits]. You can't continue to have a cost-plus type of relationship. I think legacy carriers will move away from a system in which they assume all of the risk; they will push off some of the risk, and possibly some of the reward, onto the Regional carrier."

Perhaps one of the basic assumptions of the airline industry, the inevitability of losing money in the down cycles, is ready for a change. Pilarski notes, "A rational industry would make a lot of money in the good times, make a little in the bad times. Our history has been to make a little money in the good times and in the bad times lose a lot. Maybe the added rationality means that even if the economy goes bad we'll still make a little money."

Coleman agrees: "We've got to stop accepting cyclicalitythat's the challenge to airline management."

Milton believes otherwise: "I think the bottom line is, as in the [Robert] Crandall quote, 'you are only as smart as your dumbest competitor' when it comes to pricing, and I think that's the issue. There are low barriers to entry, there is always someone with the latest, newest idea . . . and invariably you wind up in a condition with all the aircraft that float around and all the brilliant ideas and just enough money to start the latest crazy airline concept that you never get that level of stability."

ATW

Channels