BEIJING (XFNews) - China's airlines are set for a challenging year as high oil prices, new charges and increased competition continue to limit their profitability despite record passenger volumes, analysts said.
But rising jet fuel costs have hit airlines so hard that even these record numbers will be unable to prevent a drop in operating profitability.
"It is very unlikely that oil prices will decrease significantly in 2006, so carriers are expected to face even tougher operation pressure," China Securities Co Ltd analyst Li Lei told XFN-Asia.
Guotai Junan Securities analyst Jim Lam agreed, adding that the outlook for China's aviation industry this year is worse than for 2005.
The price of jet fuel in China soared 25 pct last year to reach 5,133 yuan per ton at the beginning of 2006.
Two of China's three major airlines -- China Southern and China Eastern -- have already said they expect operating losses of over 50 pct in 2005, and they are unlikely to manage a reversal of fortunes this year.
The warnings come despite China Southern's record passenger numbers of 44.12 mln last year. Shanghai-based China Eastern registered 24.29 mln passengers in 2005.
China Eastern and Guangzhou-based China Southern will report their 2005 results on April 11 and April 20 respectively.
Air China is the country's only major airline expected to turn a profit for 2005, largely because it has more international flights from which to generate higher revenue.
The national flag carrier posted profits of 600 mln yuan for the first half of 2005 and expects an improved figure for the second half of the year -- the high season for travel, Air China spokesman Wang Kai told XFN-Asia.
Wang added that he expects Air China's fuel expenses to take up 30-35 pct of the airline's costs for 2005.
Air China will announce its 2005 results on April 12.
On average, aviation fuel accounts for around 40 pct of overall costs for Chinese airlines, compared with International Air Transport Association (IATA) estimates of around 24 pct for airlines worldwide in 2006.
Chinese airlines have to pay a premium to buy jet fuel at a set price from state-owned China Aviation Oil Holding Co Ltd (CAOHC).
The fuel pricing controls may soon be scrapped however as the National Development and Reform Commission, China's top economic planning body, said it will allow other major oil companies to enter the market.
But CAOHC will continue to dominate the market and the scrapping of the price controls is unlikely to lead to much change, Lam said.
"CAOHC has essentially dominated the market and has many ground facilities and oil supplying facilities under its control... new companies in the market will still need to cooperate with CAOHC," Lam said.
"I question whether opening the market will lead to a decline in the jet fuel price in the short-term," he added.
The CAAC last year allowed domestic airlines to raise jet fuel surcharges in order to offset the impact of rising oil prices.
Since August 2005, Chinese airlines have been allowed to collect 20-80 yuan per passenger each way on domestic routes, depending on the flight distance, and up to 40 usd on international routes.
But carriers may reconsider how much they charge in order to attract passengers in the increasingly competitive market.
Domestic carriers will soon face yet another additional cost in the form of landing fees, which are expected to be raised in the first half of 2006 in a bid to improve the profitability of China's small- and medium-sized airports.
The CAAC has drafted a plan which will increase landing fees paid by local airlines on domestic routes by as much as 70 pct.
"On average, for the three major domestic carriers -- Air China, China Southern, China Eastern -- each one will have more than 400 mln yuan in extra costs from landing charges," Lam said.
China also plans to unify landing fees on international routes by cutting charges paid by foreign carriers by 20-30 pct and raising fees for domestic airlines by 15 pct.
This realignment of charges is unlikely to be done in a one-off move however as regulators are aware that Chinese airlines will be hit hard by the new policy, Lam said.
The threat of avian flu also hangs over the industry, and an outbreak would hit airlines even harder than SARS, which saw led to combined losses of three bln yuan in China's aviation sector in 2003.
Domestic competition will also heat up thanks to China's open sky policy, which allows carriers to fly routes that were previously off-limits to them.
Low-cost carriers will be able to compete on major routes such as Beijing to Shanghai, but their limited fleet sizes will restrict them to specific areas.
Regional carriers like Hainan Airlines and Shandong Airlines however will pose a bigger threat to the market share of the major carriers, Lam said.
"The three major airlines face more competition from the regional, mid-cap airline companies than low-cost carriers," Lam said.
But Center for Asia Pacific Aviation (CAPA) analyst Derek Sadubin said that the main competitive pressure will be between the big three carriers, who are all vying with each other for market share in China's main hubs, Beijing, Shanghai and Guangzhou.
"The main competitive tussle will be between the big three... as we have seen in the past few years they are really trying to take market share off each other in the three main hubs," Sadubin told XFN-Asia.
"Air China is looking very aggressively to expand in Guangzhou, and China Southern is looking very aggressively at Shanghai and Beijing. They are really looking into each others' backyards to build their presence," he said.
Ambitious new carriers are also tempting key personnel away from more established airlines, a recent example being Li Kun, the former deputy general manager of China Southern, who was appointed general manager at Shenzhen Airlines, the largest private carrier in the country.
"Many pilots from major airline companies are changing their jobs to low-cost carriers as pay and prospects are often different to state-owned enterprises," Lam said.
"This is another major factor of concern. Pilots have been underpaid by the major airlines, but in future when foreign companies and private enterprises enter the market they may use high pay to lure pilots," he said.
But China still proves to be fertile ground for aircraft manufacturers despite pressures on operating profitability, thanks to the country's robust economic growth.
"A favorable condition for carriers in 2006 is that the total market value of the aviation sector will be growing by 10 to 12 pct due to the country's booming economy and relatively high GDP growth," Li said.
The National Bureau of Statistics announced that China's gross domestic product grew 9.9 pct in 2005 to 18.2 trln yuan.
"The thing in China's favor is that it's growing rapidly and has a strong economy which is creating new travel opportunities," Sadubin said.
"There is still a fair bit of growth in the market to look forward to, but there is so much capacity coming in with orders at record levels and it will continue to be a very competitive place," Sadubin added.
China signed commitments for a record of over 500 new aircraft last year, but such a large raft of orders is unlikely to be repeated in 2006.
Goldman Sachs warned that the rapid expansion of the market must be controlled at a measured pace to avoid overcapacity risks, particularly as carriers are experiencing ever-increasing debt and tighter operating margins.
"Chinese air travel demand is growing rapidly, fuelled by string secular drivers, but airlines must ensure supply growth does not overwhelm strong demand growth," Goldman Sachs said in a research note.
China Southern and China Eastern in particular have high gearing ratios, which will be exacerbated by new aircraft purchases.
The highly leveraged airline sector would benefit from a further appreciation of the Chinese currency as much of their debt is denominated in US dollars.
China revalued the yuan by 2.1 pct against the US dollar on July 21 last year, and is under pressure to allow the currency to appreciate further.
The government may also implement policies such as tax cuts on imports of aircraft equipment, but it is unclear if and when such steps will be taken, Lam added.
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