CAPA's Aviation Outlook 2015: A year when everyone can make money - but liberalisation under threat


No commercial event in 2015 can have an impact as massive as the recent, continued, slide in fuel prices. Oil’s fall from grace in 2014/15 will influence global airline profits more positively than any single event in modern history, at least for now. 

The slump in price has been so rapid and so welcome that for most airlines it has been like winning the lottery. Even if the price does not descend as far as previous lows, most airlines have adjusted to being profitable with oil at USD100/barrel, so the windfall should flow straight to the bottom line.

But there will also be a great divide; some airlines have hedged aggressively and will be paying almost twice as much as some of their unhedged competitors – equivalent to a net margin of 10% and more, a massive differentiator.

This CAPA Outlook 2015 is based on the global report contained in Airline Leader, Issue 26. This 92 page report embraces detailed outlooks for every world region, prepared by CAPA's world leading analysis team.

To read the full CAPA Outlook 2015, please see:
Airline Leader Issue 26

2015 CAPA Outlook - A confrontation between lower costs and slackening demand

Fuel prices will be the dominant feature of industry economics for the first part of the year, although the threat of slackening consumer demand may cast a long shadow. Whatever happens, judgments taken on future hedging now are likely to influence the next two years’ performance. (Less happily, it may also lock in cost escalation, as various stakeholders seek to share in the gains.)

There is another fundamental that offers less cause for enthusiasm: in an industry dominated by largely arcane economic regulation, there is an ominous eruption of protectionism which threatens to undermine the healthy trend towards a more open system.

Fuel – hanging onto the tiger’s tail

Although it promises short-term riches, the recent decline in oil prices since mid-2014 casts some shadows over the global economy. Long-term historical data show that changes in oil prices are closely related to GDP growth – although which is the trend leader is less certain. The current oil price slump was triggered by excess supply, but a persistently lower price also indicates weaker demand. 

All other things being equal, lower oil prices (and therefore lower jet fuel prices) are positive for airline profitability – but weaker economic growth is most definitely not. In Jan-2015, the IMF has reduced its growth projections previously made in Oct-2014, signalling its expectation of slower growth. The global figure is reduced by 0.3% for both 2015 and 2016. 

The oil price outlook provides the most important source of macroeconomic uncertainty facing the airline sector in 2015. Initially at least, the impact will be extremely positive, as the cost savings flow immediately to the bottom line.

The fall in oil prices has been so substantial that it will affect basic airline strategies, not just bottom lines

routes will become viable when they weren’t before; old aircraft will find a new lease of life; fuel efficient aircraft will manage longer sectors economically; and new aircraft will be even more economical. 

But it is a sad reflection on an industry that a vital input cost can so drastically alter its very foundations. Fuel hedging can deliver some predictability, but in extreme circumstances it can deliver disadvantage. Meanwhile, airline cost saving programmes threaten to become mere sideshows when fuel prices can wash through like a tornado and push costs up 30% in a matter of months – or, more happily, drop by half in just a matter of months.

The only consolation for airlines in this wild ride is that they are all affected similarly, so the vast fluctuations mostly don’t discriminate. Other features, such as currency fluctuations and the strengthening of the US dollar, do however come into play – as does each airline’s status on hedging.

Only a handful of airlines won’t benefit at all, but there will be many happy winners as the industry fuel price slumps from around USD120 a barrel to USD60 in the space of four months, trailing oil, now down below USD50.

In the immediate term, the greatest beneficiaries are the airlines who have no hedging in place

For them the drop in prices flows immediately through to the bottom line. For the more conservative majority (at least of the full service airlines), it must be frustrating to watch their outstanding hedges washing through as they pay an extra USD50-60 a barrel – or perhaps an additional USD50,000 for a 15 hour flight. 

But such is the price of buying planning certainty; it works both ways. Many have 25% or more of their fuel hedged until the end of 1Q2015 and perhaps into 2Q and beyond at the USD100+ levels; it would probably have been a higher proportion had the earlier wisdom not suggested price stability of that magnitude. 

Some airlines are already taking the opportunity to buy longer term hedges at the new low price

This should guarantee a new low platform for performance over the next year, or even two. Others prefer to remain open. Getting long-term hedges right can be highly profitable. Southwest Airlines booked in a series of hedges in the early part of this century, so successfully that, in the decade from 1998, it saved USD3.5 billion against market prices, accounting for more than 80% of its profits during that period.

The implication is clear. Many airline boards will now be giving long and careful attention to hedging strategies that could guarantee lower costs for the long term – and fundamentally change their future. The arguments against hedging at this time are strong too: locking in at this level, while the sentiment is for further downward price movement, could equally be a burden in the short term. 

Other leading beneficiaries include (some) low-cost carriers

The intrinsically lower cost base of LCCs means that fuel accounts for a larger proportion of expenditure. For a long-haul low-cost airline such as AirAsia X, for example, that proportion was 50% of costs when oil was at USD100 a barrel. As prices halve and hedges unravel, this can accordingly generate as much as a 20% net saving on costs. Emirates too, one of the lowest-cost long-haul full service airlines, is reportedly unhedged, allowing the benefits to flow immediately. Those benefits are substantial – and bankable.

Across the world, the fuel price reduction will accentuate the advantages that LCCs have over legacy airlines. This could be doubly important in the event that demand softens and price sensitivity increases.

The “Southwest Effect” could be a market mover in 2015

Now is when many of the hedging bets come home to roost – and they can have major implications for the competitive dynamics of the industry, at least in the short term. 

Norwegian, Europe’s third biggest LCC, does not hedge; so it is an instant beneficiary of the cost windfall, shaving as much as 20% off its overall costs. Yet an airline such as easyJet, unfortunately as it turns out, is heavily hedged. Only 20% of its fuel in the FY to Sep-2015 is unhedged and estimates that “less than half” of its fuel in FY 2016 will be able to be priced at current levels. 

Arch rival Ryanair, after a brief period when it was unhedged leading into the GFC, has 90% of its fuel hedged at around USD96 a barrel until the end of the current financial year. Also, according to its 1H2015 results, it had extended those hedges to 90% for FY16, “at approx. $93 per barrel”.  At that time Ryanair was also looking “for opportunities to extend our fuel hedging programme into FY17 to lock in future cost savings”. Currency, another wild card, is likely to be kinder to Ryanair: “We have also extended our Capex programme to September 2017 at an average exchange rate of €/$1.35 which locks in substantially lower costs for the new aircraft deliveries.” In the short period since that report in Nov-2014, the Euro has slipped to EUR1.24.

Lufthansa typically hedges some 80% of its fuel for six months ahead, so should be starting to look good in early 2015.

Southwest Airlines, although it perhaps sits uncomfortably these days as a “low-cost” airline and now largely free of hedges, anticipates USD1.7 billion in fuel cost savings for the full year of 2015 compared with 2014.

Then there are the airlines with older, thirsty aircraft...

Virgin Atlantic is in the sweet spot in this respect; as an exclusively long-haul operator, it has the longest average stage lengths of any airline. It also has a fleet whose core 747s average 16 years of age according to CAPA’s Fleet Database, as well as fuel-heavy A340s. Its fuel cost per passenger is the highest in the business, so its fuel bill should reduce dramatically. Virgin Atlantic is not a listed company so there are no data, just a relatively opaque generic statement to media: “...a limited range of hedging instruments, principally vanilla put and call options, collars and forwards, with approved counterparties and within approved limits.” But there is no indication of what “approved limits” means.

Ironically too, Virgin’s 49% owner Delta will be a disproportionate beneficiary of the lower fuel prices – once its hedges unravel. Delta’s average aircraft age of over 17 years makes its fleet one of the oldest – and thirstiest - in the world. Consequently Delta’s average fuel consumption per ASK is several percentage points higher than, for example, JetBlue’s. 

But undoubtedly some sad tales will quietly emerge – or not – over the next few months, where airlines have had to book the downside costs

The risk flows from the fact that their hedge only covered them on the upside. The impact can be very destructive to bottom lines. Fortunately most airlines have learned their lesson on how to hedge and covered themselves on the downside as well as the upside. 

Cathay Pacific’s then massive “mark-to-market” loss in 2008 of nearly USD1 billion was one of the low points in that game, as the jet fuel price slumped from the ugly USD150+ highs of the 2008 price spike, down to USD47. Cathay was hedged (ie committed to buying) at the higher level to protect against further rises – but not insured for a price fall and was obliged to pay the gap.

Such was the consensus that oil prices had stabilised around USD100 a barrel, that there was no “expert” predicting a significant downside, let alone more than halving in price. Hence the apparent need to cover for downside risk would have seemed minimal and suggests that a few treasuries will be scrambling to unravel some potentially caustic downside losses.

In the US, the American Airlines executive suite is now dominated by US Airways people, who were similarly badly burned in 2008/09. As a result, they have since disavowed hedging, so American has been unhedged throughout the recent slump, making it an immediate beneficiary of the savings from lower priced oil. American projects a whopping USD5 billion in fuel savings for 2015, assuming prices at current levels.

Delta was, however, exposed on the downside, reportedly being forced to book a USD1.2 billion mark-to-market loss in 4Q2014. However, that figure needs to be qualified by the complex arrangements and accounting procedures that make comparisons difficult, if not impossible. The line between accounting and actual cash can become very blurred. That loss however probably does not sit well either with its outside-the-square investment in an oil refinery in order to stabilise its fuel expense.

The positive is that the industry has adapted to being able to make profits even with oil prices above USD100 a barrel

With that conditioning, there should be plenty of breathing space to make money, even when fare reductions are passed on to the consumer – entering the virtuous circle of stimulating further demand. All that assumes they are able to maintain their previous cost discipline – but in that respect history is not on their side.

And finally, a word of caution: a year ago when we looked ahead at 2014 in our Outlook, a survey of analysts and experts produced a consensus view that oil prices would continue in the range of USD100 per barrel. A swing in sentiment now could just as easily result in oil rising to USD150 a barrel by Jun-2015. Expert forecasts for the next six months range from USD20 to USD200 a barrel. The reality is, no-one knows.


2015 CAPA Outlook - Consolidation, profits and prices in the US

The night and day transformation in US airline profitability since the major consolidations of the past five years has been made possible by a simple combination of ramping up fares and rationalising routes.

At last the pointers are there to suggest airlines can actually behave like other industries and make substantial returns on invested capital (ROIC), something that is essential to attract equity. The industry has never had much trouble buying debt; cash flow and debtor priority have made it possible to meet the needs of potential creditors. But equity investors have typically stayed away in their droves, recognising that airline stocks were only good investments for traders.

The shape of demand: generally insipid

As the US economy shows signs of improvement, the rest of the world is looking decidedly shaky, prompting the IMF to downgrade its projections for global growth. China is slowing, a major influence on Asian economies as well as globally; continental Europe continues to be troublesome, with outliers like Greece ensuring continued instability – although a new round of quantitative easing should help at least to paper over the cracks; the BRICs are looking shaky, with the exception of always-surprising India; and the slump in oil prices is showing an ugly side too, as producing countries adjust to a new environment.

Even in the US, some of the airline majors are talking of a softening of domestic demand, although that could be temporary.

It does seem clear that global economies are going to remain insipid throughout 2015, with little in the economic climate to indicate significant strengthening in demand.

However, on the supply side, where fuel-led lower costs offer room for hope, there is potential for demand stimulation with lower fares, with at least part of the gains passed through to consumers.

This upside is perhaps not as significant as it might have been a decade ago. In the meantime the profile of travellers generally has descended into a lower, more price sensitive bracket. 

2015 CAPA Outlook - Where to now with labour relations?

Whenever a significant change occurs to any input influence, a variety of effects is created – and they are usually unpredictable. Each part of the system, be it senior management, airline staff, suppliers and even travellers, sees and feels the impact through their own periscope. And, with major change, perceived opportunities and threats arise.

The impact of a sudden additional flow of cash to airlines’ bottom lines reverberates immediately across these multiple interests. And everyone rightly feels they should have a piece of the action. Unsurprisingly the various pieces of the action invariably add up to more than 100%. 

In short, the immediate good news from fuel prices could actually spell bad news in the long term, where some irreversible cost effects are locked in as everyone seeks more than their share. 

The object lesson is a vivid one. Twenty years ago the airlines started on a cycle of improving yields and low fuel prices; one variable that also became embedded was that a cycle of wage increases began, notably for pilots.

The combination of less than perfect management and salary inflation as employees shared in the booty led to bloated airlines in most parts of the world. They just weren't prepared for the inevitable downturn in this always "cyclical" business. In North America it generated a series of Chapter 11 bankruptcies and all of the airlines that constitute the three leading full service airlines went through that process in the first part of this century.

Through Chapter 11, the US majors were able to reverse a decade's wage inflation, as well as cancelling contracts that were no longer competitive, emerging fresh as roses into a new world of mergers. Elsewhere, where the law is not so generous to management and mergers are not possible, the fat that came with this era is still hanging loosely on many airlines, where their management hasn’t been able to trim costs and inefficient practices. For others it has taken years to slim down – and it is a continuing dietary requirement.

The sudden burst of cost reduction from lower fuel prices will act as a beacon for wage demands. 

Although things have changed in the past 20 years, human nature hasn’t evolved a lot. Hopefully management standards have improved a bit, but the quite reasonable pressures for staff to share the proceeds of their efforts (even if the benefits arise from reduced external costs) are already escalating.

North America’s labour relations are (apparently) more stable this time around

It would be premature to say that this cycle no longer exists, but some differences have emerged in the current cyclical upswing, particularly contrasting North America with Europe. In North America, the airline industrial relations environment seems to be more stable than at the equivalent stage in previous cycles, while the major European continental airlines are confronted constantly by strike threats and actions.

At first sight, this contrast is surprising, given that North America’s airlines are more profitable currently than those of any other world region and more than they have been for many years. IATA’s EBIT margin forecast for North America in 2015 is 6.0%, which would be the region’s best result since 1999. On another measure, of Return on Invested Capital, that figure is typically now in the high teens. This level of profitability might be expected to prompt unions to make extravagant pay claims. This has not become a torrent yet, but there are rumblings.

As ALPA president Lee Moak said at CAPA’s World Aviation Summit in Antwerp in Nov-2014, the widespread use of performance-based compensation has been an important instrument in aligning the interests of employer and employee. Mr Moak also referred to his union’s programme to educate pilots in airline industry economics and this illustrates the desire to promote an understanding of the industry’s challenges and labour’s role in facilitating improved financial health.

But perhaps the US airline environment is about to enter a new experimental phase of labour relations

With the industry’s history of labour relations it would be extraordinary if all were as rosy as it appears – and if today’s apparent stability can be maintained. Aside from the perceived vested interests of the different employment sectors, each airline has its own issues, even where profitability is soaring and, as it appears, the US economy is in an updraft.

A common feature is that most legacy airlines worldwide will have around a dozen different bargaining groups, usually in separate unions - in turn representing other non-airline groups. (Exceptions are many airlines in Asia and the Gulf).

Consequently, airlines are in almost constant negotiating mode, renewing sometimes-annual or biennial contracts. And each group is anxious to enhance its own position relative to the others, or at least to ensure that relativities do not work against them.

So, although there is today apparently a new plateau in US airline-employee relationships, it is less than stable. As the post-bankruptcy/consolidation era begins, new dynamics emerge. It is simply too early to tell whether this new evolutionary process will lead to more stable labour relations.

The divergence of positions occurs in how, as well as the extent to which, employees are remunerated

The risks inherent in raising salaries and adding cost in the good times that can’t be shed when demand softens has been illustrated time and again. This is an inherently cyclical and competitive industry and not even the greatest optimist will be prepared to project beyond a medium-term horizon.

Hence, instead of increasing wage levels, the idea of linking profitability to performance bonuses makes a lot of sense; if profitability declines, so do wage costs. Both United and Delta have been following that course. It sounds good in theory; it keeps a lid on costs, and indeed works well as long as profitability persists. For the time being that is apparently the case.

American Airlines, however, is departing from the course being laid out by its two biggest competitors. In Dec-2014, as reported by Reuters on 23-Dec-2014, American CEO Doug Parker circulated a letter to staff in which he provocatively argued, “There are many ways to share success, but when it comes to compensation, we believe it is best to reward (workers) with industry leading wage rates – not lower wages supplemented by compensation that varies with airline profitability.”

Mr Parker laid out this position as he announced that flight attendants would be receiving a total of around 14% increases in their new agreements. He made clear that this would position them some 7% better paid than their counterparts in Delta or United. That will add USD200 million to 2015 costs.

American breaks ranks as it catches up, in a "complex and involved process"

But the story inevitably goes deeper than that. American, having recently merged with US Air as it emerged last year from Chapter 11, needs to play market catch up to Delta and United, both of whom have had time to establish themselves in their newly consolidated forms. So it probably feels the need to differentiate. And, in turn, the competitive cycle will most likely renew.

Also, American is effectively in dispute with – no surprise – its pilots. The US Airways executives running the merged airline are no strangers to pilot difficulties; when the airline took over American, the US Airways flight crews were still operating separately, a hangover from a previous merger with America West.

American’s pilots  completed a ratification vote on a pay proposal agreed with their union in late Jan-2015. This gave them A 23% pay increase, backdated to 2-Dec-2014, plus another 3% on top backdated to 1-Jan-2015, with another 3% beginning in 2016.

This added a further USD650 million in costs, or about 2.5ppt of consolidated unit cost projections. Non-acceptance would have resulted in binding arbitration, which in turn would have meant no salary increases at all, pursuant to a dispute clause in the union agreement. Despite these seemingly extravagant increases, the market felt relieved that resolution had been achieved - and, remarkably in the circumstances, one third of the pilots voted against approval. From a distance, the whole process has disturbing parallels with the past.

Southwest Airlines’ website concisely describes the wage fixing process: “Like all other US-based airlines, Southwest Airlines and our Employees are under the Railway Labor Act (RLA). The collectively bargained agreements (CBAs) covered under the RLA do not expire; instead, they become amendable. Once a CBA becomes amendable, the two parties come together to jointly work through any changes, additions, etc. that might be desired or needed. This is a complex and involved process, made more so by the nature of the industry.”

2015 CAPA Outlook - From BRICs to bricks:
Brazil, Russia, India, China: spot the odd one out!

For the BRICs that were riding high just a couple of years ago, only India is looking shiny still. Two years ago, India was the missing I in BRIC, as its economy floundered and its airlines drowned in red ink. Today, mostly thanks to a change of government, along with an increasingly mature airline market, India is the pick of the BRICs, while the others fizzle.

Brazil’s airline industry suffered a bad year in 2014

It was hit not only by a slump in business travel during the football World Cup, but also the double whammy of an election too. Despite hopes of an improvement in the latter part of the year, 2015 begins on a negative note. Inflation is up, consumer confidence is at historic lows, economic growth is forecast at almost zero and the government is on a track of raising interest rates and reducing spending. Not a great platform and certainly not a world leader in outlook.

Russia is also suffering a double whammy, but an even more severe one than Brazil’s

Oil exports – the core of its economy - have been hit by slumping prices, and Ukraine-related sanctions have combined to drive the rouble down to half of its 2014 value against the US dollar. To add to the misery, Standard and Poor’s downgraded the country’s credit rating to junk status in Jan-2015, increasing the cost of borrowing even further. It will be some time before investors are swarming to be in the Russian party.

China marches to a different drumbeat from other major countries

China's 2014’s 7.4% economic growth was the slowest in two decades, albeit most economies would never reach those heights; but the fact is the world’s second largest economy is now slowing, as an overheated real estate market rapidly deflates, government spending slows and consumer demand falls. This effect has flowed through to its many trading partners. China’s aviation system does still have steam in it, notably as the government decided formally to encourage the establishment and expansion of LCCs, but the reduced rate of growth promises a more sombre short-term outlook.

India is the world’s third largest economy, albeit a long way behind China

India's flight to grace is magnified by the depths it has plumbed over recent years. And while there will be many who, having been burnt more than once, will wait a little longer before plunging back in, they may well find that this time they will be late to the party.

With a new anti-corruption - and seemingly intelligent and active - administration now in place following the decision of 800 million voters to deliver Nahrendra Modi’s BJP an absolute majority, India’s outlook is as bright as it has ever been.

The World Bank projections imply a high level of confidence that Mr Modi’s early performance will continue to steer India along the new road to success, after its 5.5% growth in 2014. The Bank would have India growing faster than China by 2017, when India will be increasing by 7%, as China slips just below that level.

In the aviation sector, through a combination of commercial actions (Etihad’s investment in Jet Airways; Star Alliance admitting Air India to its ranks; and new well-funded startups, like Vistara) and government measures, there is a fresh smell of success and hope.

Airport development is about to surge and largely ill-judged policies restraining the aviation sector are being removed or recalibrated.

But India loves to regulate...

The aviation sector is no exception, with a comprehensive list of regulations that have largely either protected the interests of favoured parties or seem merely to have been invented to demonstrate innovation in regulation.

These negatives are positive once the tide turns, because their removal or rationalisation can quickly create strong updrafts. Indian government measures:

  • 6 major airport tenders
  • Possible IPO of the Airports Authority of India
  • Reduced fuel taxes
  • Admitting new entrant airlines
  • Modifications to the outdated route dispersal
  • Likely removal of the 5 year/20 aircraft rule for international services

Liberalisation is under fire, mostly unfriendly

Innovation is not a word that sits easily in the regulatory structure governing global aviation. The various forms of cross-border joint ventures, holding structures, alliances and partnerships are testament to the corruption of sound global commercial practice.

In 2014, the battlefront defining the innovators and the defenders of the status quo widened. Etihad and Norwegian were the prime movers in pushing the boundaries drawn by “ownership and control” rules enshrined in thousands of bilateral agreements. 

The Etihad Equity Partnership forged new territories, both geographical and conceptual and has drawn fire from reactionaries in both Europe and the United States. Meanwhile, similar cross-border partnerships, moulded into the form of franchises, spread like wildfire across Asia, almost entirely without controversy, as governments recognised the value they brought.

Norwegian’s trans-Atlantic low-cost airline venture was seemingly a modest innovation in a marketplace blanketed by three major partnerships. Despite being supported by the European Commission, it drew remarkable reactions from US pilot unions and – in their thrall – some of their employer airlines.

Battlefronts on each of these wars will generate much heat in 2015 and, in doing so, the regulatory outcomes will probably determine the medium-term future of  liberalisation.

Only medium term because, as the much more entrepreneurial and pragmatic Asian marketplace gradually dominates global thinking and practice, the tawdry old regulatory concepts will surely go the way of all dinosaurs. But for the next year, this promises again to be a major conflict.

CAPA'S Americas Aviation Summit 2015 in Las Vegas will welcome global senior airline executives, aviation regulators, pilot bodies and other interested parties for a high level discussion of the assault on liberalisation.
See: Americas Aviation Summit 2015, April 27/28 Las Vegas

2015 CAPA Outlook - beware the grasshopper and heed the ant

As always, 2015 will herald few dull moments in an industry which continues to be buffeted by the strain on its archaic regulatory roots and the excessive and uncontrollable impact of external costs.

But for once there is some welcome breathing space as fuel prices hover at levels where most airlines should be banking healthy cash and even laying down hedges that will secure lower prices for a year or more.

But like it or not, the airline business is populated by many grasshoppers of short term vision - and not many ants.

Diluting gains through fare discounting and adding to costs by escalating wages threaten to abbreviate the good times, leaving little in store for the inevitable winter that follows. There should at least be a few welcome months of respite.

In a field one summer’s day a Grasshopper was hopping about, chirping and singing to its heart’s content.

An Ant passed by, bearing along with great toil an ear of corn he was taking to the nest.

“Why not come and chat with me,” said the Grasshopper, “instead of toiling and moiling in that way?”

“I am helping to lay up food for the winter,” said the Ant, “and recommend you to do the same.

“Why bother about winter?” said the Grasshopper; “we have got plenty of food at present.”.....

(Aesop's Fables, The Harvard Classics)

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