Political uncertainty and overcapacity could sideswipe Middle East airline performance in 2017

Airline Leader

Aviation is fundamentally a business of cycles and the Middle East has been slowly transitioning from a long upswing in traffic growth and airline profitability into a plateauing that brings with it new initiatives in partnerships and profile.

Although the UAE and Qatari airlines are usually the focus of attention, it is a region with vastly differing attitudes and policies.

Persistent traffic growth, lower fuel costs and aviation friendly investment policies are keeping the underlying fundamentals in the Middle East generally positive. However, there are strong signs that the strong run of regional profitability is fading and growth rates have already retreated considerably. At the same time, Saudi Arabia is beginning to liberalise its market, perhaps promising a future larger global role.

The region is more exposed to oil price, conflict and instability influences than others and this is having its toll on GDP growth and, necessarily, on airline operations.

Emirates chairman and CEO Sheikh Ahmed bin Saeed Al Maktoum observed in Nov-2016 that a “challenging operating environment” was persisting, characterised by regional and international political uncertainty and lacklustre economic growth. Fares are falling, revenue growth is tepid and yields and load factors are declining. Emirates president Sir Tim Clark has been similarly dour about the outlook noting that a “bleak global economic outlook appears to be the new norm, with no immediate resolution in sight”.

Virtually all of Emirates’ traffic is international, and its network size and breadth make the airline a bellwether to changes in the global landscape. Traffic through Emirates’ hub at Dubai has remained persistently weak for most of 2016, even with the carrier’s flexibility to redeploy capacity away from weak markets and into stronger ones.

Growth at the hubs of the other Middle East big three (MEB3) carriers is better, but is also showing signs of waning. Abu Dhabi, home to Etihad Airways, has seen growth slow to its lowest rate in six years. Traffic through Qatar Airways’ Doha hub, while considerably more robust, is showing signs of peaking.

Dubai, Doha and Abu Dhabi passenger traffic growth rates: 2010 to Aug-2016

Smaller regional carriers and LCCs are also warning about the outlook. Sharjah-based Air Arabia chairman Sheikh Abdullah Bin Mohamed Al Thani said in Aug-2016 that although it delivered “solid financial performance and momentum growth”, there is pressure on yield and margins due to “excess market capacity” and challenges associated with the regional economic outlook. Similarly, Jazeera Airways noted that there is “excessive overcapacity”, which is placing “downward pressure on our yields”.

Since late 2015 slow global and regional economic growth and stagnating business and consumer confidence have converged with local and international security challenges, political uncertainties and the collapse of oil prices to put the brakes on Middle East growth. Regional RPKs trended down towards single digit levels in 1H2016, rates not seen since the end of the global financial crisis.

Even as growth rates have slowed, capacity expansion has accelerated. Regional ASK growth has outstripped RPK growth for 22 of the past 24 months, with load factors falling close to 5ppts. Based on aircraft forward delivery positions, airlines in the Middle East are scheduled to add around 200-220 aircraft in 2017, roughly matching the level of capacity addition in 2016.

With a youthful regional commercial fleet, retirements are comparatively rare and the combined regional commercial aircraft fleet is projected to grow to around 1,600-1,650 aircraft, an increase of about 15%.

Aircraft deliveries show the Middle East is a two speed market – better than 80% of 2017 deliveries are for Gulf state carriers, and the vast majority of these are either for the MEB3 or to Saudi Arabian Airlines as the Kingdom continues its fleet modernisation and expansion. Outside the Gulf states, deliveries are concentrated in just a few large markets, chiefly Iran and Iraq.

Middle East RPKS, ASKs and load factor (2011 to 2016, 13 month moving average)

Middle East 2017 fleet delivery forecast by aircraft category

Qatar Airways is projected to take delivery of a phenomenal 35 widebodies (including the first A350-1000) in 2017 and as many as 20 narrowbodies – depending on Airbus’ ability to meet the airline’s quality requirement. Meanwhile, Emirates will take around 25 widebodies, all of them high capacity Boeing 777s or A380s. Etihad Airways and Saudi Arabian are both scheduled to receive 10 widebodies, with Saudi also adding around 20 narrowbodies.

Narrowbody deliveries will also be concentrated with Gulf carriers – LCCs flydubai, Air Arabia and flynas are due to take about 20 aircraft between them. Smaller regional carriers like Middle East Airlines, Oman Air and Gulf Air are also adding to their narrowbody fleets.

2017 fleet deliveries earmarked for Iran and Iraq offer significant uncertainties. These are the region’s largest domestic markets outside Saudi Arabia, and both are in desperate need of new capacity, particularly regional aircraft and narrowbodies.

Key Middle East economies GDP growth and forecasts: 2015-2016

US WTI crude oil prices Jan-2004 to APR-2016

At least 50 new aircraft are scheduled for delivery to Iranian carriers in 2017, a much needed capacity infusion for a market shut out from aircraft purchases for 35 years. However, new aircraft orders (totalling more than 250 firm or under MoU) appear at the mercy of the direction the incoming Trump Administration decides to take with Iran.

Iraq is also due to add at least 25 new aircraft, almost all for Iraqi Airways, expanding its fleet by 50%. Filling these orders will depend on the country’s delicate security and political situation and its oil industry.

The fall in oil prices has helped regional carriers cut costs, but has hurt regional economies, particularly the vulnerable less developed oil exporting states. Most of the major Gulf economies – including the UAE, Saudi Arabia, Kuwait, Qatar and Oman – have experienced falling growth, but these states have mostly been able to keep spending up via accumulated cash reserves and expanding deficits.

However, less developed states outside the Gulf have been forced into austerity, cutting capital and discretional spending to counter declining export revenues. The World Bank estimates the fall in oil prices cut OPEC member export revenues by close to USD700 billion over the past two years.

The outlook for oil prices and regional economies in 2017 is improving, although recovery in both is expected to be back weighted for the year. Prices have recovered nearly 50% since their Jan-2016 low, and the value of Middle East oil export revenues is projected to climb in 2017, after a broadly flat 2016.

Led by Saudi Arabia, OPEC pushed for a cut to production in late 2016, which is projected to push prices back up to a range of USD50-70 per barrel for the full year. A recovery is likely to be weighted to 2H2017 though, due to current production plans and the record level of global oil stockpiles.

Regional GDP growth is projected to recover from 2.3% in 2016 to 2.9% in 2017. Growth in the key GCC states is still weak, projected to expand from 1.6% in 2016 to 2.2% for 2017.

Apart from oil prices, the Iranian and Iraqi economies remain major downside risks. Economic growth in Iran has recovered following the lifting of sanctions in early 2016 but any re-imposition of sanctions, particularly on oil exports, could have serious consequences. For Iraq, major structural reforms and continued international support, as well as an oil price recovery, are needed to deliver growth.

In addition, while the regional security situation has generally improved, hotspots of uncertainty remain in the Levant, Iraq and Yemen, and the related refugee crises will remain a persistent drain on economies.

International markets weigh heavily on the performance of the key Gulf carriers. Global macroeconomic slowness and declining business confidence in key source markets weigh on the prospects for Middle Eastern airlines in 2017.

European economic sluggishness and security concerns that are lingering in multiple states are slowing tourism and business travel. In addition, uncertainty about Brexit and low services and manufacturing sector confidence in Europe are all affecting outlooks for travel in one of the most important source markets for Middle Eastern carriers.

China’s economic and travel growth are slowing too. The country has been one of the expanding source markets for Middle East airlines, but its economy is forecast to expand a relatively modest 6.4% in 2017, compared to an average of 9% in 2011-2015. Chinese outbound travel growth has also slowed, partially in response to European security concerns – although numerically they are still significant.

The US economy is still struggling with stubbornly slow growth. GDP growth for 2016 is forecast at 2%-2.5%. There are signs of some acceleration (GDP +3.2% in 3Q2016), but the unusually high degree of uncertainty in the direction the Trump Administration will take the country is putting a dampener on business confidence and travel.

Europe and the US are also set to weigh particularly heavily on the regional outlook for 2017. Key aviation agreements are up for renegotiation in Europe, and the looming Trump Presidency could see a major upset to the current status quo. Then again it could put an end to the protectionist calls – this could go either way.

In mid-2016, the European Commission (EC) was mandated to negotiate bloc level Open Skies agreements with Qatar, the UAE and other Gulf states, replacing existing bilateral level relationships. These arrangements had produced widely varying levels of access for Middle Eastern airlines – states like the UK welcomed Gulf carrier capacity, while some other European states limited access and echoed US big three airline concerns about the Gulf airline operating models.

As one of the leading anti-Gulf voices, Germany might be expected to take a softer line now that Lufthansa has agreed an Etihad codeshare and wetlease deal with airberlin. But aviation policy has never been captive to logic.

Gulf states desire fully liberalised Open Skies agreements with the EU, while the EU member states want to ensure a level competitive playing field is maintained under liberalised Open Skies. Negotiations will likely pivot around the definition and interpretation of the phrase “fair competition”.

Complicating matters further is the Brexit – or not. The UK is the largest country market for Gulf carriers in Europe, and with the UK set to begin its extraction from the EU in Mar-2017, the Gulf states have lost one of their strongest potential allies in the talks.

As a work around for European bilateral agreements, Gulf carriers developed deep relationships with some European airlines. Qatar Airways used the post Brexit drop in stock markets to raise its ownership in IAG – parent of British Airways, Aer Lingus and Iberia – from 9.9% to 20%. Qatar Airways also plans to take a 49% stake in Meridiana, Italy’s second largest carrier, by early 2017, promising further acquisitions later in the year.

Meanwhile, Etihad Airways is struggling to bring its European partners to profitability. Etihad owns 49% of loss making Alitalia, and reportedly intends to pursue a major restructuring, shedding up to 2,000 staff and a fifth of its fleet.

Etihad has also negotiated a deal to help long time European partner airberlin, wetleasing 38 aircraft to Lufthansa. A deal has been made with TUI AG and NIKI to develop a new JV focused on travel and tourism in Southern Europe/Northern Africa.

More concerning than the realities on the ground in Europe are the uncertainties about the intentions of US President-elect Donald Trump. Mr Trump won the US election on a platform of reform and populism, including elements of isolationist and protectionist sentiment.

US and Gulf carriers have been engaged in a long running debate over Open Skies subsidies and access to the US market. Delta Air Lines and United Continental have led lobbying efforts to have the Open Skies agreements with Qatar and the UAE re-negotiated, on the basis that the MEB3 expansion in the US is state-subsidised competition.

These pro-protectionism arguments may gain more traction under the Trump Administration. However, any re-negotiation is still unlikely. It would face pushback from other US airlines, including FedEx which operates a key logistics hub in Dubai. There are also geopolitical concerns – Qatar houses the largest US military base in the Middle East. Saudi Arabia and the UAE are two of the largest purchasers of US military equipment.

In addition, Mr Trump and some of his new cabinet in waiting have expressed antipathy to the deal between the 5+1 powers and Iran, announcing his intention, via Twitter of course, to dismantle “the disastrous deal”. Republican lawmakers have already passed regulation through Congress to block the sale of more than 100 aircraft by Boeing to Iran and renew some sanctions against the country, but that was insufficient to prevent the transaction (which would lead to the loss of many hundreds of US jobs). US content rules also threaten the export licences recently granted to Airbus covering around 100 aircraft, and another deal for 20 ATR turboprops.

Cancellation of the JCOPA agreement would cast the Middle East’s third largest economy into renewed turmoil. Pulling the new aircraft orders would also threaten to derail the revitalisation of aviation in Iran, potentially the greatest untapped aviation opportunity in three decades.

Republican control of Congress also has potentially dire consequences for the fate of the US Export Import Bank, which has been a source of aircraft financing for Middle East carriers. Mr Trump has stated he is “against” the bank, labelling it as “sort of a featherbedding for politicians and others, and a few companies”.

Overall the regional outlook for 2017 is mixed, but aviation in the Middle East has been through this sort of dip before. A temporary growth slowdown may even be a blessing in disguise, allowing struggling regional airport and ATC infrastructure time to catch up.

The structural drivers of aviation in the Middle East remain intact. The region’s uniquely advantageous natural hubs, aviation friendly governance models, strong demographic drivers and the progressive expansion of regional trade and travel are all intact. Regional carriers are not pulling back on growth and will continue to add aircraft, passengers and routes in 2017.

But it is this same growth in capacity that may be the undoing of sustainable growth; signs are emerging of significant overcapacity in some markets and this could colour the shape of the Middle East industry in the coming year.