Demand is the issue for 2016

Airline Leader

For 2015, the pivot was cost, as fuel prices astonishingly slumped by some 50%. In those circumstances a lot of inefficiency could be disguised, allowing widespread profitability. Prices have remained low, still defying anyone to predict where they will go in 2016. No-one predicted the slump, so everyone may equally be overlooking the signs that predict a surge.

  • Fuel prices have significantly dropped in 2015, leading to increased profitability for airlines.
  • The demand for air travel in 2016 will be driven by the state of the global economy.
  • Economic slowdown in emerging economies like China, Brazil, and Russia is weakening demand for air travel.
  • Cost-controlled airlines with strong market positions and participation in immunized joint ventures are likely to succeed in 2016.
  • The Asia-Pacific region is expected to see a strong influx of new aircraft deliveries in 2016 and 2017.
  • The aviation industry is experiencing changes in aircraft leasing and ownership, with Chinese lessors entering the market and consolidation among leasing companies.

The consensus, for what it is worth, suggests a gradual increase in prices - although that has been the belief for some time and still prices slide. At the end of 2015 the price of crude oil was in the low USD40s.

So, many airlines should continue to be profitable in 2016, even unusually so, although 2015 is likely to have been the peak, perhaps of all time.
Whatever happens on the cost side of the ledger, one thing is clear. In 2016, the driver will be demand, or lack of it.

The economy is the big unknown for 2016, with its all-embracing impact on airline growth. Until now, despite slow economic growth, air traffic has continued relatively strongly by historical standards. The decline in oil prices has generally benefitted airlines, but lower commodity prices are weakening demand and disposable income in many countries, most notably some of the emerging economies and Brazil and Russia in particular.

Aside from the US, which is showing signs of modest expansion, the indicators elsewhere in the world are not particularly positive for the demand side as 2016 gets under way. Even in 2015, the signs have been there, as airlines in most regions have been forced to respond to the softness, either by holding fares down, or more often watching yields decline.

The US, which has delivered the great bulk of the world's aviation profits in 2015, has achieved that on the back, not of higher fares - in fact a common refrain is of yield dilution - but of ancillaries. The US airlines' profit margin only slightly exceeds the gross revenue from non-fare charges like baggage fees and booking changes; meanwhile, fares have generally weakened.

IMF GDP 2015 Growth forecasts

China's slowdown is part of a major structural redirection, as domestic consumer consumption begins to dominate - and much of this, fortuitously for the airline and travel industries, is in the service sectors. Shanghai is at the cusp of the growth, and average incomes there are now in the region of USD15,000, well into the bracket where international travel is an expenditure item.

This, accompanied by a government policy to encourage China's airlines to venture forth internationally, has led to an almost 50% increase in Chinese airline seat capacity in 2015, a trend which is likely to continue through 2016.

That said, economic growth in China is slipping well down into single figures as export revenues decline. Along with the other emerging economies which helped fuel the post-Financial Crisis recovery, these growth engines are stuttering. Both Brazil and Russia are in deep recession, dragging down their respective regions; South Africa is in seemingly perpetual decline and geopolitical concerns in the Middle East and Africa add to the weakness. Of the BRICS, only India is projecting high growth, but its economy is not yet large enough to be widely influential.

Europe too continues to look uncertain and will at best deliver modest growth overall. The overhang of public (and private) debt, the refugee crisis and increased geopolitical instability are having their impact on economic growth.

In these circumstances, it will be the cost-controlled airlines which prosper. Two other ingredients will go into who succeeds in 2016's slow demand environment: airlines which have strong market positions in their domestic markets and those that participate in substantial immunised joint ventures.

The US domestic majors, still benefitting from the consolidations of the past decade, remain relatively cost competitive across the board, even as labour pressures are pushing levels up. The size of the US domestic market is such that international routes can be weak while the majors still remain profitable. And the largest international market, the North Atlantic is safely immunised for the three main airlines, Delta, American and United.

In Europe, effectively a domestic area for market access purposes, it is the two large LCCs, Ryanair and easyJet which are managing to leverage both lower cost and higher yields as restructuring of the two main continental legacy airlines remains incomplete; British Airways and IAG are the exception, with a solid cost base and strategy in place.

Otherwise only a few airlines fall across more than one category. Qantas in Australia, whose first half profits point to an AUD2 billion (USD1.4 billion) profit for the full year; although Canada's domestic market is larger, the dominant half of that country's duopoly, Air Canada, has not fared quite as well, despite being part of the North Atlantic JV; In India, newly floated IndiGo, an LCC which controls nearly 40% of India's cluttered domestic market (although it is yet to spread its wings internationally) is both low cost and highly profitable; the Lion group, which occupies almost 50% of Indonesia's domestic market (albeit undertaking strategic expansion outside its home country which attracts some risk); and, probably, some of China's airlines, large or small.

Then of course there is the airline that defies this classification, Emirates, which delivered a profit of nearly USD5 billion in 2015 and looks set to continue on its successful route in 2016. Its large neighbours in the Gulf are still in growing mode and do not yet display the same bottom line, although their influence globally is extensive.

In Asia generally, while this is the traffic growth engine of the world, airline dynamics are such that the expansion is not always allowing profitability at the levels of well-established and often closed markets. Here the proliferation of new entry and relative liberalism creates turbulence. In late 2015, some stabilisation, particularly in Southeast Asia, began to show, for LCCs and full service airlines alike, but margins will not approach the levels seen in mature markets, even despite some of the lowest cost operations in the world. Cathay Pacific, least affected of the full service airlines by the Gulf carriers, is perhaps the region's exception in continuing to produce solid profits.


The new aircraft market promises a strong influx in 2016 and 2017. At the same time structural changes are occurring in the leasing market, as Chinese lessors enter the scene with major acquisitions. Unsurprisingly, as the market has surged, orders are following suit. Over 1,800 aircraft are due for delivery (to airlines and leasing companies) in 2016, nearly twice the number delivered in 2006.

The bulk of aircraft orders is destined for Asia Pacific, where, despite a considerably smaller in-service fleet, total orders are approximately as large as Europe and North America's combined. The delivery profile tells much about the respective markets. Almost half of the orders in both Asia Pacific and Europe are destined for LCCs; this is in contrast to North America, where only about one third are on order by LCCs. The order profile of long haul, widebody aircraft orders is also telling, in predicting the likely future of long haul travel. Over 1,430 are from Asia Pacific and Middle East airlines - this contrasts vividly with the combined 750 from European and North American airlines.

This is clearly an industry in transition.

Also changing is the way aircraft are bought and sold, as leasing companies jostle for the lead in orders. But more importantly, the lessors themselves are consolidating and changing shape, notably as Chinese interests in the sector increase. One transaction in particular is indicative: Avolon, a sizeable global leasing company, agreed to sell to Bohai Leasing at a premium of over 30% to its share price. When completed in early 2016, this will make Bohai the ninth largest lessor in the world, with a fleet worth USD8.5 billion.

In Asia, where a small number of LCCs have very large order books to allow them to expand rapidly into growth markets, some of the airlines concerned are also entering the leasing market, as a means of distributing risk. Lion group currently has over 500 aircraft on order; IndiGo has 430, the AirAsia group over 400.

While noting the strong fundamentals of the sector at present, Fitch Ratings in late 2015 noted that "over the long term, aggressive growth and high competition among aircraft lessors, combined with the cyclical nature of the aviation industry, could expose creditors to performance volatility."

Liberalism and open skies came under heavy attack in 2015, ironically from some of the biggest and most powerful airlines in the world.
At a sectoral level this is important, but it also may be reflecting a wider trend away from more liberal trade. A multilateral (non-aviation) trade agreement in the Pacific rim - the Trans-Pacific Partnership (TPP) - has been a major exception to a more general drift back towards protectionism.

This is undoubtedly fuelled by low economic growth levels globally, at around 3% overall and much less in many countries. It is perhaps no coincidence that the Pacific - where growth promises to be above global levels for some years to come - is one region where liberalism appears alive and even vigorous.

There, a Southeast Asian multilateral open skies agreement, under the umbrella of an ASEAN Economic Community was due to come into full force by the end of 2015. It has not yet achieved its ambitious goal completely, but restrictions on third and fourth freedom operations between national capitals have now been removed (although rapid growth has meant that infrastructure restrictions are now a greater constraint on expansion).

With a population of over 600 million, ASEAN's potential market is larger than the EU or North America; and it has, unlike China, a young demographic. But, despite accounting for 7% of global exports, trade between ASEAN nations is still very low. This is changing and much of Asia is wholly reconciled to a new world where liberalism and relaxed market access relate more to consumer and economic needs than to maintenance of the status quo.

But the EU and North America have broadcast no similarly liberal sentiments - even casting doubt on the future of open aviation markets. Since the multimillion dollar "White Paper" was issued to much fanfare in early 2015, there has been a mass of media hype, aimed at stopping the growth of the Gulf airlines, but also generating an atmosphere that has prompted some governments and airlines to consider becoming more restrictive on market access, especially in their dealings with the US. A casualty of the process has also been Norwegian, whose application to operate under an Irish AOC has remarkably been sat on by a reluctant administration.

The White Paper has, paradoxically, been effective mostly in advertising the Gulf carrier products to a previously unknowing US customer base.
Meanwhile, the Gulf airlines have continued to add and announce new routes to the US. A ponderous bureaucratic process to examine whether some action should be taken to stop the Gulf 3 is still under way. Most other US airlines announced opposition to the proposition, most notably the world's biggest freight carrier, FedEx, which has a hub in Dubai. Meanwhile, in Europe there are similar divisions between airlines, as Lufthansa and, slightly less vocally, Air France-KLM have lobbied the EU Commission hard to stop the Gulf airlines "stealing" their sixth freedom traffic flows. International Airlines Group, which has both partnered with Qatar Airways and invited the smaller Gulf carrier to join Oneworld, withdraw from the Association of European Airlines arguing differences of opinion - just as Delta has left A4A.

Yet, behind the overtly nationalistic clamour of the Big 3, there was never any clear end goal to be achieved. It was always highly unlikely that the open skies agreement would be unilaterally terminated (and subsidy, real or contrived, is not grounds for termination). It is hard anyway to find a major airline which cannot be accused of receiving "subsidy" in some form.

Once the noise level diminishes - and hopefully the US DoT and DoS decide not to rise to the bait in their tortuous review - this is likely to become very much a problem of 2015. 2016 will be a different story. And, swept up in all the anti-liberalisation backlash have been some relatively minor fifth freedom routings, for example an Emirates service from Milan and Ethiopian Airlines 787 services between Dublin and the US.

One very unfortunate outcome of all this noise has been to cast a pall over the momentum towards global liberalisation and open skies.
Foreign governments, who were often reluctant in the first place to open their national airlines up to competition from US and other airlines, are beginning to wonder if they too should be more selective in opening their skies.

In this complex of change, airlines are constantly looking for ways of expanding their international coverage, constrained as they are by having to operate out-and-back from their home territory. Ownership and control restrictions prevent airlines from gaining worldwide coverage organically; yet exerting a presence in markets beyond their own third and fourth freedom operations is today essential. With seemingly little chance of serious disruption of these "archaic" bilateral constraints, the approaches tried will proliferate; some will be dead ends, others will help point the way to more practical outcomes.

As methods have evolved, from multilateral interlining in the IATA framework, to more bilaterally based arrangements, limits still remained on brand exposure outside the home market and, perhaps, one or two others.

Codesharing took this a step further, allowing the brand to become more visible in foreign markets; then the establishment of global branded alliances created a platform to develop this more easily among "club" members. Codesharing is still very much a bilateral activity, even where several members use the same metal to offer their code.

So bilateralism among airlines too is still the primary resort for expanding an airline's code.

And, as questions are constantly raised about the imminent demise of the BGAs, the instinct for bilateralism fuels that flame. The reality is that the Branded Global Alliances (BGAs) are not about to collapse; they are too valuable in a confining world. But they are having to adapt, however slowly. One of the less popular (among the wider alliance membership) moves has been to establish closed joint ventures among handfuls of the bigger members, such as on the North Atlantic.

These exclude the smaller members, but they entrench the ties between the JV participants; meanwhile even the smaller members continue to pick up more traffic through partnering, backed by joint frequent flyer programmes. Star has however taken a step towards embracing LCCs, previously effectively excluded; a small step, but important in its context.

Group establishment, effectively quasi-mergers, along the various lines of the Lufthansa group, Air France-KLM, LATAM, have also been partial steps along this route. But this model has limitations, mostly geographic. From BGAs, through the range of multilateral and bilateral arrangements, all airlines will continue to review their partnership needs increasingly actively - and those results can be to disrupt longstanding arrangements, as well as spawning new forms of relationship.

Cross border JVs are one form of this; just as metal neutral JVs within a BGA are opportunistic ways of chipping away at the old constraints. And as airlines explore the limits of equity ownership, new issues arise. These mostly relate to "control" and, in particular, who wields it. But what's best for one airline isn't necessarily best for others.

The more acute focus on individual needs has been accelerated by the impact of LCCs in local markets and the Gulf airlines in global markets. The "best" interest is becoming the common denominator, so that bilateral links which deliver precise results are increasingly favoured. As achieving tailored outcomes becomes more important, largely passive branding roles are diminishing in importance. This feature is also being accompanied more and more by explorations of the power and value of equity ownership.

Etihad has led the way with an extensive minority equity strategy, in its equity partnership; this has more of the signs of a multilateral partnership, with one dominant buyer. Others have recently established purely bilateral equity holdings internationally, like Hainan Airlines, across various markets. A cashed up Delta has been more specific in its acquisitions, entrenching links (and market share) in markets it directly serves, from the North Atlantic (Virgin Atlantic), to Latin America (Gol and Aeromexico), and to China (China Eastern). Qatar Airways, after acquiring 10% of IAG in 2015, is already looking at more foreign investment opportunities, with Royal Air Maroc identified as a target.

The value of minority investments such as these can vary widely, but collectively they chip away at the rock of "ownership and control". The amount of control that can be exercised is partly a factor of the size of the minority stake, partly of the relative status of the airline being bought. The expectations that come with a 10% share are necessarily very different from a 49% holding. One is little more than a friendship ring; the latter is more than an engagement ring.

The largely Asian cross border JV concept will undoubtedly continue to expand its coverage, as new entrant airlines proliferate. There are undoubtedly more equity acquisitions to come in 2016. If there is one thing that the upheavals in areas of the sharing economy like taxis and accommodation rentals have shown, it is that artificial market access controls are prime targets for disruption.

The house will not fall in 2016, but the winds will continue to blow.