Beware the minefield of 2012 – It will be a terminal year for some airlines

There are two ways of reacting to adversity. One is to strive to seek out opportunities; the other is to protect the status quo. One has a future, the other only a past. In this respect, 2012 presents a minefield in which the baggage of the past will become too burdensome to wear.

As 2012 progresses, one thing is certain: there will be no shortage of adverse signals. In such an environment, opportunities abound, but much airline attention is focussed on two main external developments over which the industry has no control: the high and rising price of fuel and the likely global economic impact of Europe's financial problems, temporarily patched up, but not solved.

The US' doubtful economic equilibrium still prevails, although it is showing some positive signs, as another presidential election looms. Asia, inevitably affected by the global uncertainty, has slowed too and there are suggestions (unlikely) of a Chinese bubble deflating. The Middle East continues strong, despite the backwash of the Arab spring in Syria and Iran; Latin America has appeared oblivious to world negativity; and off its small base, Africa is again leading the world in growth rates thanks to demand for its mineral resources.

The industry in 2012 will embrace a range of reactions across the spectrum of aviation activity, from staff (notably pilots), through airline strategy and government interventionism, with each area showing strong indications of conflict. For pilots and other unions, the status quo will typically be the favoured course; for airline managements this will mean severe constraints on available options, as change and adaptation remain essential. From Europe to Australia, union action has challenged management capabilities.

There will be change in 2012, there will be conflict, as slow or even negative demand growth provokes zero sum market share battles, and there will above all be opportunities.

One pointer to the year 2012 for Europe's industry is in the developments of late 2011. A creaking and often archaic international aviation system ended the year with significant moves in Europe towards consolidation and rationalisation, as Etihad acquired a significant holding in airberlin and IAG bought bmi from Lufthansa. More recently, in Feb-2012, Air France-KLM, one of the staunchest opponents of the new long-haul breed, concluded a codeshare agreement with the enemy, Etihad, hinting at a potential tectonic shift.

Whatever the partnership moves, a prolonged slowdown in growth can only intensify pressures on a full service airline industry which is confronted by aggressive low-cost competition. Already Malev has succumbed to the inevitable, prevented from receiving more government subsidy, but there are others in a similar if slightly less critical position. Market exit, a healthy part of any open market, is still constrained artificially, at least where government owned airlines and/or flag carriers are involved.

Across the Atlantic, American Airlines finally succumbed to the bankruptcy process that had been predicted for so long. Foreign airlines regard this process of court-assisted cost reduction as unfair competition, but within US territory, it is almost inevitable for any major airline that wishes to remain in business. American's recuperation process will cast a shadow over US airline activities for much of the year, as well as potentially disrupting the triangular global alliance system, in which it is a major oneworld player.

In Asia, where high growth has become the norm, China is looking more fragile and India's industry has to breathe deeply before its next spurt, but low-cost airlines and intra-regional expansion are being progressively fuelled by liberalisation. No less than seven new LCCs (mostly JVs between existing LCCs and full service airlines) will enter the market this year, making for a total of 50 in the region, far more than in any other. This is a unique force in global terms; independent LCCs have more than 1000 aircraft on order in Asia Pacific and Indian markets.

For the longer run, 2012 too will prove in retrospect to be the year that China's full service airlines started to make their mark as an international force; still relatively small abroad, they are starting to influence markets as they expand. Tellingly too, more than 18% of some 600 Chinese airline orders are for homegrown aircraft.

The Middle East and Latin America continue to offer highlights, even despite slowdowns in their source markets. The Gulf airlines continue to expand, mostly profitably, despite detractors; Etihad moved into profit in 2011 for the first time and Emirates plans to receive an average of 30 new widebody aircraft annually for at least the next five years. In Latin America, where growth follows low fares and higher incomes, the global alliances will watch (actively) while LAN and TAM decide on their future joint allegiance, most likely with oneworld, and foreign airlines hasten to establish a presence while potential partners remain.

Jet fuel and crude oil proce (USD/barrel): May-2007 to Feb-2012

Source: Platts, RBS & IATA

But it is external features that promise to provoke the major problem in 2012, both in terms of added cost and slacker demand, as well as in accelerating the evolutionary process of the airline industry overall. It is often difficult to dissociate the broader impacts of input costs and consumer demand behaviour, but they can create a vicious cycle. Political unrest, with often direct impact on oil production, is elevating fuel prices, seemingly established on a new plateau, ready to climb again - and consumer demand, as we saw in 2008, eventually declines as oil prices surge.

The big difference in 2012 is that whereas passenger fares in early 2008 held up well, amid strong economic conditions - when it was largely demand that drove up oil prices - it will be harder this time around to impose compensatory fuel surcharges, in what is a much softer market. Higher prices are being driven by political instability, even while the economic climate is cool.

Two other features make this trend of greater concern in 2012

(1) There is a dangerous undertone in the prospects for yield profile. The share of premium seats as a portion of total travel continues to decline, with premium seat share falling back towards the lows of early 2009, when it touched 7.5% of total traffic, according to IATA. The Association attributes this to the continued growth in economy travel, with a degree of substitution away from premium travel to economy, as businesses seek to cut costs in difficult economic conditions.

This changing seat class mix will undermine yields, and hence profitability, just as stagnant international trade and fragile business confidence points to further weakness in business travel and a challenging profitability environment for airlines.

(2) Fuel prices at current levels start to challenge the viability of some low-cost, low-yield models. In other words, once certain thresholds are reached, many airline models are threatened. In leisure markets that are entirely price driven, service will be reduced and the airlines involved suffer. But where the opportunity exists for the affected airlines to intrude into higher yielding markets to offset their higher costs, full service airlines will feel the impact of greater competition, against airlines that still have a lower cost base overall.

The graph opposite illustrates the wide disparity in the impact of fuel prices on different airlines. The highest cost carriers suffer a lower burden from higher prices - Lufthansa for example at 25.0% against Ryanair's 43.1% of total; or AirAsia's 45.8% against All Nippon Airways' 22.7% - each an impelling case for the line to be blurred between their respective markets, as fuel costs hurt the LCC.

Meanwhile, air freight trends continue to point to a difficult environment. In the last months of 2011, typically the period when retailers are stocking up with goods for the holiday period, the Grinch stole Christmas, according to Cathay Pacific CEO John Slosar: "Somebody cancelled Christmas as really the cargo volume hasn't been there." Cathay, for which freight is a substantial earner, shed nearly 10% of its revenue tonne kilometres in Dec-2011 compared with Dec-2010, despite increasing ASKs by 4%.

Overall, travel markets continued to send conflicting signals about what was happening, even into 2012. According to IATA, both premium and economy markets continued to recover in Dec-2011, rising 3.7% and 7.3% respectively above Dec-2010 levels. Over the full-year 2011, premium travel markets rose 5.5% and economy travel by 5.1%. More unexpectedly too, and despite the uncertainty across the euro zone, IATA reported intra-European traffic rose 5.1% across the year.

Some reports of softening in leisure traffic forward bookings early in 2012 only add to the inconsistency of indicators, although given the embedded economic uncertainty in Europe, the tendency is to favour the prospects for relatively flat traffic growth rate in the mature markets of the world.

The global airline balance continues to shift on its axis, as long- and short-haul competition intensifies. Meanwhile it is not only the short-haul LCCs in Asia that are expanding rapidly. A flurry of orders for the A320neo and Boeing's 737MAX (and other new gen aircraft) has pushed the US airlines up the list somewhat, but the shape of long-haul, twin-aisle aircraft order books makes it clear where the future lies in hub growth. Asia and the Gulf carriers are laying the foundations to dominate the long-haul markets as the decade progresses.

Selected airlines fuel cost (% total operating costs): 2007 to 2011

Source: CAPA - Centre for Aviation & airline reports

This may not be intentional strategy for the European and US airlines, but it will occur by default. They continue to concentrate on the longstanding and valuable Euro-US and North Atlantic markets, where extensive ATI now exists for joint operations and, after all, this is where all the old relationships and network routes exist. Thus, even though recent orders have greatly increased the number of aircraft expected to be delivered to US airlines, they consist almost entirely of narrowbody next generation types.

Primarily designed for domestic service, aircraft such as the 737 MAX and A320neo are perfectly capable of flying medium- to long-haul trans-Atlantic routes, but are not suitable for trans-Pacific operations. The entire North American industry has less than 20 widebody aircraft for delivery in the next two years. The number could well increase if conditions require, as leasing companies hold slots that might be applied. But the more important point is that US airline thinking is currently not looking towards what are still generally lower yielding Asian markets.

Asia Pacific airlines by contrast have more than five times as many widebody deliveries arriving during these two years; even the Middle East airlines alone have four times more widebodies to be delivered in the next two years than the US carriers.

The Europeans tend to be typically more adventurous. Several European airlines, now including low-cost models such as airberlin and Norwegian, are planning long-haul futures which rely on Asian expansion, while the majors entrench their positions by seeking to exploit partnership opportunities. SkyTeam in particular, now strongly positioned in the Chinese market with China Southern and China Eastern as partners, is leveraging these relationships effectively.

Chinese airlines too began to push more actively onto international routes and in 2012 are now beginning to influence competitors' bottom lines and responses. Cathay Pacific, the nearest and most reliant on the Chinese market of any airline, has been among the first to call this issue; the Chinese majors, as well as some smaller airlines, are starting to compete for sixth freedom traffic. These are, for the time being only, hints of what a burgeoning Chinese airline industry will mean in terms of changing the world. A sign of the scale of these changes: projections are for 100 million outbound Chinese tourists by 2020.

This shift in the balance of aviation makes planning complex and increases the likelihood of aggressive addition of capacity. With 900 new aircraft due for delivery in Asia Pacific by the end of 2013, there is a constant likelihood of imbalances in matching supply and demand. The fact the region is also one of the few attractive economic environments currently has also meant European and Middle East airlines are finding Asia Pacific a rare opportunity for long-haul operations to see upside. The only other region expecting large scale new arrivals is Europe, where another 500 are due over the next two years.

Nowhere is the impact of the Gulf carriers more significant than on routes between Asia Pacific/Indian subcontinent and Europe. The leading airlines by seat numbers per week non-stop between Asia Pacific and western Europe are the major European and Southeast Asian hub carriers: Lufthansa (52,000), Air France-KLM (46,000 combined), Thai Airways (31,000), Singapore Airlines (31,000) and Turkish Airlines (29,000). Meanwhile the Gulf carriers between them offer 182,000 seats from the region to the Middle East (of which 134,000 emanate from South Asia) and 174,000 onwards to western Europe, according to Innovata.

Total widebody orders by region

Source: CAPA - Centre for Aviation & OAG Fleet iNet

The inevitable one-stop service involved in transitting the Gulf is a handicap for those carriers, albeit often offset by the immediate access to non-hub airports in Europe. As the global system changes, disputes over who is applying too much capacity become academic; progressively, the market decides. In the meantime, the added potential competition adds a complex new dimension to route planning and capacity management.

The EU's Emissions Trading Scheme (EU ETS) and the Boeing-Airbus World Trade Organization dispute are provoking dissent between leading aviation nations. The fragile path towards liberalisation is easily disturbed by confrontation over aviation related issues. The seemingly endless saga of the dispute between Boeing and Airbus over manufacturing subsidies threatened to stimulate high emotions on either side of the Atlantic, but appears now to be overtaken by the global clamour of opposition to the EU's unilateral imposition of an Environmental Trading System - or, as many simply describe it, a tax.

Legal action, threat and counter-threat, retaliation and service suspensions are all part of the rhetoric streams generated by the EU's action. Seemingly taken aback, where previously not an inch was to be given, the EU is now murmuring about exceptions, but retrieving the situation will not be easy. The parallel, but separate, resistance by some airlines and their governments to the expansion of the Gulf carriers further raises the potential for dispute, fuelled by economic disorder.

A growing "concession fatigue" among unions of legacy airlines presages widespread discontent, especially as European growth stagnates. The phenomenon is emerging as serial cost reduction measures have required continued concessions from unions and staff. Legacy airlines, which have been trying for several years to adapt to a new environment, still remain adrift from the cost levels they need to be sustainable.

So their staff and unions come to see little prospect of an end, to cost reduction programmes; or to moves to outsource short-haul operations; or establish low-cost subsidiaries. Competing with low-cost airlines has become the priority on short-haul and the issue will simply not go away.

The concession fatigue builds progressively, moving from an irritation to a central issue, but the risk is that the movement is building towards a threshold, beyond which the process can accelerate dangerously.

In Europe, both Air France and Iberia have been confronted by continuous strikes, usually led by pilots. Lufthansa's pilots too are constantly close to the edge as their employer uses operations of some of the neighbouring airlines it has acquired, either as replacements for the higher cost Lufthansa operations or to take up new opportunities. British Airways, Iberia's partner in the recently merged International Airlines Group (IAG), went through a period of confrontation two years ago and appears to have resolved most of its problems in this regard.

In the US, at least a substantial part of the reason for American Airlines seeking the protection of the courts under Chapter 11 bankruptcy provisions in late 2011 was the inability of management to agree with the airline's pilots on a new contract. The carrier had already been through a sort of "virtual bankruptcy" in the early part of this century, achieving agreement on substantial salary reductions with pilots, flight attendants and other unions.

American's pilots for example took 23% salary cuts in 2003 and flight attendants reduced salaries by 33%, along with sick leave and holiday reductions and increased rostering. One of the conditions for the pilots was that their pay levels would be restored within five years, but that became impossible as the airline slipped further behind. Most of American's competitors had meanwhile gone through the Chapter 11 crash diet, greatly reducing their cost bases and keeping a step ahead of American.

As an indication of the impact of new LCC competition in the US domestic market, traffic growth since 2000 has been entirely on those new carriers. US legacy airline passenger numbers have actually been declining for most of the past decade as a result.

In the global world of airline unions - most notably the International Federation of Airline Pilots Associations (IFALPA) - these issues are contagious. In its worst manifestation, "concession fatigue" can lead to an irrational rejection of any further change - even where it is clear that non-agreement will almost certainly lead to the failure of the airline.

This intransigence was seen recently for example in Hungary's state owned flag airline, Malev, which ceased operations in Feb-2012 and is an integral part of the industrial disputes occurring among western European network airlines.

Then there is another category of airline where discontent is mounting, but with similar underlying issues. Unlike the US and European network airlines, two end-of-the-line legacy flag carriers, Qantas and Air Canada, do not have the luxury of being able to cross-subsidise their short-haul services by profits from their long-haul connections. Sixth freedom intermediate operators remove that luxury, so the problem intensifies - both carriers have endured lengthy labour disputes; for Qantas this meant a total shutdown of the airline in Oct-2011, as staff were locked out, provoking invocation of legislation requiring an arbitrated determination.

With Air Canada, the Government moved first, in Mar-2012 passing legislation obliging management and the pilots and engineering unions to undergo compulsory arbitration. In each case the underlying concern was over jobs being shifted into a cheaper alternative, either in a lower cost subsidiary, or outsourced.

Legislated outcomes may serve as temporary solutions, but they are typically accompanied by conditions which compromise management's freedom to respond to market conditions - and most likely without solving the core problem.