Theme: The world’s airline industry has suffered a string of dramatic shocks during the last three years. The outlook for the industry remains clouded, and a number of regulatory and market issues have returned to the forefront of concerns.
Summary: The decline in air traffic produced by recession in 2001 was amplified by the security concerns triggered by the September 11 terrorist attacks. Hopes of recovery and a return to normality in 2002 brought some brief relief, but this was quickly eroded by economic uncertainty and pressure on oil prices during the run-up to the invasion of Iraq. Finally, the onset of the SARS epidemic in the wake of the Iraq war has plunged the world’s airlines back into turmoil. Currently, the industry’s outlook remains unclear, and a number of regulatory issues have come to the forefront of debates.
Analysis: By the peak of the 1990s economic boom, the airlines industry, particularly in the US, was quite well positioned as a result of the extremely profitable period between 1995 and 2000. Net profit among US scheduled airlines alone came to a cumulative $23bn during this period (in sharp contrast to cumulative net losses of $13bn during the 1990-1994 period and the less-dramatic, more stable record of the 1970s and 1980s). The net profit pattern was similar for the international industry as a whole, with cumulative profits in 1995-2000 reaching nearly $39bn, after net losses of $20.5bn in 1990-1994 and much milder cyclical swings during the two previous decades. By the end of 2000, cash reserves among US carriers totalled $11bn, the US industry’s net debt-to-equity ratio stood at around 70%, no major carriers were in bankruptcy and three held investment grade credit ratings.
Yet even before September 11, the international airlines industry had begun to experience trouble. In 2001, up to the time of the World Trade Center attacks, the global industry was already showing a net loss of some $3bn. As the economy went into recession in 2001, air traffic –a highly cyclical component of economic demand– declined significantly. By the end of 2001, world economic growth had dropped off sharply from 4.7% in 2000 to 2.2%, while the promise for recovery in 2002 also came up short (2.6%). More worrisome was the fact that during the four quarters following September 11, economic growth was much weaker than it had been during the four quarters following the 1991 Gulf War, when traffic managed to recover fairly quickly (even if profits took longer). This weaker demand scenario undermined the industry’s capacity to engineer a quick return to record profitability and signalled an underlying vulnerability to any future external shocks.
What would have been a typical cyclical scenario, however, was made much worse by September 11. First, there was the extra shock to air traffic, which continued to fall as the result of new fears of travelling and economic uncertainty. Even when the fear factor receded, traffic continued to weaken as a result of the “hassle factor,” particularly in the US, as passengers eschewed the long lines at security checks. However, not only did traffic decline more rapidly, but soon the effect of increased security requirements and heightened insurance premiums began to hit profit margins from the cost side and to undermine the financial position of many airlines.
Airline insurers –who stopped insuring against terrorist or war risk in the immediate aftermath of September 11– have since returned to the market, but only with insurance premia some four times higher than before the World Trade Center attacks. A number of governments stepped in to fill the temporary gap left by insurance companies, and the US government granted or guaranteed upwards of $16bn in stabilization payments and loans for the US industry in the aftermath of the terrorist attacks. For better or for worse, however, such intervention only helped the situation from deteriorating even further rather than improving it.
The Air Transport Association (ATA, the US airline industry association) estimates that the $5bn in stabilization payments granted to the US industry merely kept 2001’s net losses ($7.7bn for the US industry) from topping $12bn. However, these injections were nearly offset by the incremental impact of over $4bn in new pre-tax costs that the industry was forced to bear as a result of new government security mandates in the wake of September 11. What is more, the $10bn in loans and loan guarantees provided by the US government merely fed the significant increase in airline indebtedness that has developed over the last two years. Debt levels among US carriers have nearly doubled since 1999 (from $54bn to nearly $100bn), bringing the US industry’s debt-to-equity ratio to 93% in 2003 (up from 69% in 1999). In contrast to such increasing levels of industry debt, the entire outstanding stock of the US industry in February 2003 was worth only $3.2bn. Meanwhile, nearly every single major US carrier has experienced credit rating downgrades (and, in the case of US Airways and United, these downgrades have been dramatic) since the day before September 11, 2001.
Hopes of economic recovery in 2002 produced a brief respite for the airlines industry. By December 2002 the traffic scenario had improved, but underlying conditions continued to weaken. In 2002, most large carriers engaged in a strategy to defend margins by reducing capacity, engaging in other cost-cutting measures (including staff layoffs), and hedging fuel costs, which had begun to rise significantly. The six leading US carriers alone cut costs during 2001 and 2002 by over $10bn. Aircraft orders by US carriers has also plummeted, from over 2,600 (firm orders and options) in 2000, the highest level since 1990, to a mere 1,750 in 2002. Nevertheless, while the large airlines were cutting back on supply in order to adjust to weaker demand, a slew of low-cost carriers (LCCs, like Ryanair, Easyjet and Go in Europe, or JetBlue in the US) were successfully capturing market share with lower prices, placing even further pressure on the large carriers.
By the end of 2002, the much-vaunted recovery had not taken place, and the economic panorama was once again clouded by the brewing crisis over Iraq. By the end of that year, according to the IATA (the international industry association), the world’s airline industry had lost $30bn in two years, as the international industry experienced its first back-to-back yearly declines in traffic (around 5% in both 2001 and 2002) in history. According to William Gaillard of IATA, in 2001 alone, airlines lost “as much as they had ever made since the Wright Brothers started flying in 1903.” A number of large carriers, including SwissAir, Sabena, US Airways and United, were forced into bankruptcy. Upwards of half a million jobs have been lost. Even before the eruption of the SARS epidemic onto the scene, the ATA described the cumulative effects of the recession, September 11 and the Iraq war as the airline industry’s “perfect economic storm.”
However, the worst was fortunately avoided with the Iraq war. The pre-war rise in oil prices did not affect the industry as much as had been feared, for a significant portion of the industry’s fuel costs was hedged by that time. European carriers have been particularly fortunate in the face of stiff fuel price increases over the last year (in dollar terms, unit fuel prices on the spot market rose over 100% from February 2002 to February 2003) as the euro’s strong appreciation has shielded them from the most immediate effects. US airlines, however, remain particularly vulnerable given that most hedging contracts are now terminating. Should prices for jet fuel remain a current levels for just two more quarters, the additional impact, according to the ATA, could come to another $3.6bn.
Traffic, nevertheless, suffered during the period of the Iraq crisis. Furthermore, many large carriers, after losing market share to the LCCs in 2002, changed their strategy in early 2003, increasing capacity and allowing prices to drop in an effort to stem their loss of market share. This has meant a significant trade-off in terms of profitability, and, given the significance of the SARS shock, it will probably lead to another very bad year.
The SARS shock has certainly had a greater negative impact than the Iraq war. Nearly half of this year’s losses of $10bn expected by IATA is likely to be due to the SARS impact, itself twice as significant as losses related to the war. The additional shock to demand is likely to be especially damaging, particularly for Asian airlines. In April, international airline traffic fell 18.5%, but among Asian carriers it plunged 44.8% and among US carriers it slid by 23.5%. This has meant that airlines have been recently operating at less than 50% capacity, despite another recent capacity reduction of nearly 13%. In May and June traffic has continued to fall sharply, and now a number of investment banks have estimated that booking demand for even European carriers in the second quarter could actually decline more than the 6% originally expected.
Whereas all the major regions have suffered during the string of shocks over the past three years, it has been the Asian carriers –which had originally withstood the effects of the world recession and the terrorist attacks more resiliently than their US or European counterparts– that have been hit the hardest by the spread of SARS. On the other hand, most Asian airlines still remain on relatively sound financial footing, while the European carriers are the most heavily indebted (typically with debt-to-equity ratios between 100% and 300%), and the US industry has experienced the most rapid increases in its leverage over the last three years.
The airlines’ “perfect storm” of shocks –what some have called an “unnatural” market evolution in an attempt to generate a sense of urgency for policy change– has prompted a series of debates on what is to be done to secure airline profitability and stability in the provision of airline services. This debate includes the role of government subsidies, state guarantees on risk insurance, airport and air traffic controller behaviour, industry consolidation and the European Union decision to take over the negotiations of “open skies” agreements with US and other third countries. All of these controversies, however, are unfolding against a backdrop of economic weakness in the US, Europe and Japan and a general decline in the tourism industry.
In the US, one of the biggest issues is the perception that airports and air traffic controllers have avoided sharing the burden of losses with the airlines during the last years of crisis in the industry. “It is unacceptable,” says Giovanni Bisignani, Director General and CEO of IATA, “that in a year (2002) in which airlines without exception have suffered losses amounting to billions of dollars, some industry partners including airports and ATC providers have posted strong profits.” While in the US airports and ATCs remain under the control of the state, there is at least a reasonable doubt that they –even with state support– can adequately handle the burden of sufficient security. One possible alternative would be to privatise the airports –as has been done in the UK and other European countries– and make them legally responsible for security lapses. Private interests might be better equipped to efficiently deal with the security issue, thereby allowing airlines –which now must shoulder more expensive insurance– to return more easily to profitability in the security-enhanced, post-September 11 environment.
In Europe, the regulatory debate has focused on rationalising the single market. This is about to take place in one important sense through the EU’s decision to take over the negotiation of “open skies” agreements with non-EU countries. This move is perceived to be a potentially key catalyst for the future consolidation of an excessively large airline industry on the continent. The current 11 “open skies” agreements between the US and individual EU member states do not allow for any European airlines to fly to the US from other EU countries. This has created an informal barrier to European airline consolidation as carriers remain reluctant to purchase competitors if it is not clear that they would be able to inherit the target carrier’s flight rights to the US. A comprehensive EU-US agreement (which would cover some 40% of all international traffic) would open up the possibility of any European airline flying from any European location to the US. This would simultaneous open the door for more consolidation and eliminate the logic for maintaining costly national flag carriers in Europe –and with it much of the pressures and incentives to continue subsidizing national airlines. Nearly 38% of the current total European airline capacity is provided for by state-subsidised European airlines.
“The aviation industry is over-protected and over-regulated,” claims Rod Eddington, chairman of the AEA and chief executive of British Airways. “This is an historic decision that paves the way for a truly liberalised European air transport industry and the creation of a common aviation area covering Europe and the US. … (It) is good for airlines, because it will create a level playing field for fair and equal competition and help to deal with differing policies on competition, security, state aids and insurance. It will be good for consumers because it will foster competition and innovative new air services and it is good for Europe because the EU will be able to negotiate on equal terms with the United States. It could also pave the way for a framework agreement leading to cross border mergers, acquisitions and joint ventures.”
Conclusion: A strong economic upturn, the dissipation of the SARS epidemic and reduced geopolitical tensions would obviously relieve the airlines industry of much of the stress it has been forced to endure during the last three years. Nevertheless, none of these changes can be taken for granted, at least not in the short run.
In Europe, industry consolidation should provide more stability in the face of continued cyclical swings in demand while at the same time undermining the old European habit of subsidizing national carriers. The door to such a possibility has at least been opened by the recent decision –“an historic date” in the words of European Transport Commissioner, Loyola de Palacio– to shift authority for international aviation negotiations from the member states to the European Commission. The Commission should make sure that the new continental weight of Europe in such future negotiations with the US secures the optimal competitive conditions for European carriers in the US market. Furthermore, more thought should be given by European carriers -particularly those that may be well placed in the coming consolidation scenario (Iberia might be one of these)- to improve their financial position to successfully compete with US carriers in any new US-European aviation space.
On the other hand, the need for enhanced security and more expensive insurance that has emerged over the past few years is a structural change that is likely to last indefinitely. This may require a more rational burden sharing arrangement between the all-various actors in the aviation transport industry.
Senior Analyst for International Economy and Trade at the Elcano Royal Institute