Demand destruction. More than grazed shins ahead for some airlines

The resilience of downward pressures on oil prices in the face of Hurricane Gustav - which a few months ago would have had the futures traders worked up into frenzy - suggests that the speculators are now taking a back seat in determining trends (or they are shorting the market, entrenching the downward pressures).

At the same time, as demand quickly softens, pointing the way down for most global economies, the good news of cheaper fuel confronts the bad news of impending lower yields - and soft yields are algebraically much more painful to the bottom line than higher costs are.

A story made famous by Gerard Hoffnung offers a graphic metaphor. A bricklayer holding onto a rope suspended over a pulley, with a much heavier barrel of bricks on the other end explains, after he was hoisted off the ground by the barrel: "When the barrel hit the ground, it burst its bottom... allowing all the bricks...to spill out. I was now heavier than the barrel...and so started down again...at high speed. Halfway down... I met the barrel coming up...and received severe injury to my shins!"

The story continues, with further pain ahead. The impact of slowing demand will hurt a lot more than grazed shins for some airlines - even if the (oil) barrel does continue southwards.

Demand destruction - enter the next phase of the airline crisis

Thus the global economic slowdown threatens to usher in the next - and potentially more damaging - phase of the airline industry crisis: demand destruction. IATA stated yesterday that strong traffic growth had allowed the industry to partly absorb the rise in fuel costs from 2003-2007, but this is "no longer the case".

This accompanied IATA's revised forecast of combined industry losses of USD5.2 billion in 2008, based on an average crude oil price of USD113 per barrel (USD140 for jet fuel). The projected 55% increase in oil prices will push the industry fuel bill up by USD50 billion to an expected USD186 billion this year, accounting for 36% of total operating costs, up from just 13% in 2002. Even if prices slump now, earlier high levels mean the year average will remain well above USD100 per barrel.

North American carriers are expected to post losses of USD5.0 billion in 2008, making them the hardest hit by this industry crisis, while European profits will tumble from US$2.1 billion in 2007 to US$300 million in 2008. IATA's first profit estimate for European carriers for 2008 (back in Jun-07) had seen profits this year of USD3 billion. The new estimate is a 90% downgrade from the original forecast - such has been the impact of rising fuel prices and slowing demand on the outlook.

Evolution of IATA's 2008 industry profit (loss) forecast by region (USD billions): Jun-07 forecast to Sep-08 forecast

Source: Centre for Asia Pacific Aviation & IATA

IATA Director General and CEO, Giovanni Bisignani, stated, "the situation remains bleak. The toxic combination of high oil prices and falling demand continues to poison the industry's profitability".

IATA has also issued its first profit outlook for the full year 2009, suggesting an industry net loss of USD4.1 billion, and noting, "most economies are expected to deliver even weaker economic growth next year, which will negatively impact air travel and freight". Oil prices are projected to average USD110 per barrel (USD136 for jet fuel) in 2009, while traffic growth is expected to be weak. The 2009 fuel bill is expected to rise, as hedging offers less protection, to USD223 billion, comprising 40% of operating expenses.

The good news of the barrel falling reflects the bad news of a sharp slowdown in the global economy, evidenced in recent airline traffic data. IATA revealed worldwide international passenger demand growth fell to 1.9% in Jul-08 - the lowest in five years, while capacity increased by double that amount, pushing average global load factors to 79.9%, down 1 percentage point.

IATA international passenger (RPK) and freight (FTK) growth (% change year-on-year): Mar-06 to Jul-08

Source: IATA

But European capacity (ASKs) in Jul-08 (+3.7%) outstripped demand (RPKs) (+1.3%) much more substantially, leading to a reduction in load factor to 80.6%, while freight volume (FTKs) dipped 1.2% year-on-year.

The full year traffic outlook for Europe (measured in tonne kilometres performed - TKP, including passengers and cargo) is for a 3.2% increase, again outstripped by capacity (available tonne kilometres - ATK) growth of 3.9%.

As a result of the weaker economic outlook, IATA has now significantly revised downward its traffic forecast for domestic and international markets combined. Global passenger traffic is now expected to grow on average by 3.2% (previously 3.9%) and air freight volumes by just 1.8% (was 3.9%). This is only half the pace of expansion seen in 2007.

GDP growth forecasts by region (%): 2008 and 2009

Source: IATA & Economist Intelligence Unit

Reflecting weaker economic conditions, European traffic (TKPs) is predicted to slow to 2.9% in 2009, matched by an ATK increase of 2.8%, according to IATA.

What the IATA financial forecast does not reflect is the fact that a combination of lower fuel costs and slowing demand will however offer ideal conditions for airlines with a lower cost base. If the economy takes this direction for a year or more, we can expect to see some significant changes in the industry's structure as the next cycle comes around.

As fuel prices fall, the hopeful analysts and investors looking for quick upside in airline stocks will need to be selective in assessing which companies meet the right profile for these new conditions. Not everyone is going to benefit - or suffer - equally.