Aviation: Climbing Through the Clouds

LAST month 230 international airlines gathered in Singapore for the annual meeting of the International Air Transport Association (IATA), their trade body. The price of oil, at more than $110 a barrel, cast a pall over proceedings: a rise of $1 a barrel adds $1.6 billion to airlines' costs, and IATA expects a barrel to cost an average of $30 more this year than last. The industry's net profits of $18 billion in 2010, a rare good year, were forecast to plunge to $4 billion in 2011 (see chart 1). Yet only a fortnight later at the Paris Air Show airlines went on a $90 billion shopping spree, ordering 730 planes from Airbus and 142 from Boeing, enough to keep production lines humming for seven years.

Two things explain this paradox. The first is that because oil accounts for a third of operating costs, airlines are desperate for more fuel-efficient planes. Late last year Airbus brought out a re-engined version of its A320 single-aisle family, offering fuel savings of up to 15%. It has become the fastest-selling new aircraft in history. More than 1,000 have been ordered, many of them by fast-growing budget airlines. The biggest demand is in the Asia-Pacific region: India's IndiGo and Malaysia's AirAsia ordered 380 between them in Paris. This illustrates the second explanation, the tilt of aviation, like that of so many other industries, to the east. Profits in Asia were double those in the rest of the world last year (see chart 2) and growth rates there are stronger than in Europe and North America.

But civil aviation is undergoing a more wrenching change than just a drift eastward. A history of regulation and government involvement has left it burdened by trade protection, inefficiency and excess capacity. Airlines helped to bring about globalisation, but their own industry is far from globalised. Instead of globe-spanning giants, the world has 230 flag-carriers and several dozen budget airlines. Even last year the industry's profit margins were not fat. Only those innovative low-cost carriers make decent money.

Yet this old model is coming under pressure: consolidation of a sort is taking place at a regional or continental level. The rapid growth of Asian traffic is one reason for this. The rise of low-cost carriers born in liberalised markets is another. And over the past decade airlines have been buffeted by one external shock after another, from the terrorist attacks of September 11th 2001 and the SARS health scare to recession in Western economies, volcanic eruptions (last year in Iceland, this year in Chile), the Japanese earthquake and tsunami, and the rise in oil prices.

The effect of this succession of troubles can be seen in airlines' profits. Airlines took six years to recover from losses of $13 billion in the annus horribilis of 2001 and made a profit of $14.7 billion in 2007. But then the cost of a barrel of jet fuel more than doubled, to $170, just as the recession sent load factors down. Some airlines, such as Ryanair, the biggest European budget carrier, have taken to parking many of their planes in the winter rather than burning fuel in half-empty aircraft.

The sharp recovery that began last year as fuel costs eased and demand picked up was soon snuffed out when oil prices rose again. Giovanni Bisignani, a former boss of Alitalia and the head of IATA from 2002 until this year, reminded colleagues in his leaving speech in Singapore that even in 2010, "the best year of the decade", they had "a pathetic [net profit] margin of 3.2%". For most of the past 40 years, he notes, margins were merely 0.1-0.2% on average. At the best of times airlines are fragile. Even low-cost successes such as easyJet and Ryanair make losses some of the year.

IATA claims that its members have made great strides in cutting costs, carving out $55 billion a year. For example, persuading countries to open air space to allow more direct routes has saved $16 billion on fuel. Squaring up to monopoly suppliers such as airports and air-traffic-control services has yielded a further $19 billion. A broad programme to simplify the business by, for example, phasing out paper tickets for online bookings, introducing bar-code boarding passes and streamlining baggage and freight handling is worth about $18 billion. Although this sounds impressive, it amounts to a saving of only 10%--and it took seven years.

Consolidation--of a kind

Some efforts have gone further. For years airlines in America staggered in and out of Chapter 11 bankruptcy, which was supposed to give them protection from creditors until they became fit to fly profitably again. Their reliance on this device was criticised by foreign carriers as a disguised subsidy that maintained excess capacity and postponed overdue consolidation. Yet it did eventually lead to reductions in cost, for example by allowing airlines to renegotiate labour agreements with unions.

The industry's plight also led to an easing of the antitrust scrutiny that had attended airline mergers. Delta was cleared to take over Northwest Airlines in October 2008. Struggling United Airlines and Continental were allowed to merge in September 2010, after several spells in Chapter 11. The mergers helped airlines trim their capacity and restore profits (although rising oil prices pushed them back into loss this year). The only network carrier in America not to go through Chapter 11, American Airlines, has fallen on hard times, slipping from the number-one slot to number three. Its share price has fallen by about 80% in the past five years as it has slid into loss. Without the pain of bankruptcy to force change, it is left with the highest labour costs and pension obligations.

European airlines have been consolidating too. Air France and KLM led the way, merging in 2004. They created a holding company so that each airline could keep nation-specific traffic rights under bilateral deals with countries outside Europe and America. The liberalising "open skies" deal between these two blocks, signed in 2007, made European mergers much easier by allowing European and American airlines to fly from anywhere on one side of the Atlantic to anywhere on the other.

After much dithering British Airways and Iberia got together in 2010. BA plans to use Madrid as a second base to get around capacity limits at Heathrow, where plans for a third runway have been blocked. Paris-Charles de Gaulle and Frankfurt now serve more destinations directly than London's main airport does. Lufthansa has swallowed Swissair and Sabena, and has taken full control of bmi British Midland. However, the European Commission has blocked purely national mergers between Ryanair and Aer Lingus, in Ireland, and Olympic and Aegean, in Greece.

The big limitation of the open-skies arrangement was that it left in place the 25% limit on foreigners' stakes in American carriers. In the European Union non-EU investors are restricted to 49%. Limits on foreign ownership have spurred international airline alliances, which for years have pooled marketing and sold seats on each other's flights, to press for the antitrust immunity needed for deeper integration, or "virtual" merger. The pursuit of this is justified by a (contested) theory that virtually merged airlines offer lower fares on flights through their hubs. Separate carriers, seeking to maximise profit on each leg of a journey, would charge more.

As a result of all this consolidation on both sides of the Atlantic, Aviation Economics, a consultancy, says that this summer three virtually merged groupings will carry 73% of traffic across the ocean. These are: International Airlines Group (BA and Iberia) plus American Airlines; United, including Continental, and Lufthansa and Air Canada; and Air France-KLM with Delta, incorporating Northwest. Some routes from continental airports, such as Frankfurt or Amsterdam, are monopolised.

The failure to scrap barriers to foreign ownership has meant there are no intercontinental mergers. Aviation has thus missed out on the sort of global rationalisation that occurs in most other industries. Apart from the transatlantic joint ventures, attempts at linking up between continents have tended to be disappointing. Singapore Airlines makes no secret of its desire to ditch its 49% stake in Virgin Atlantic, which is in turn up for sale by Virgin Group because it can no longer compete across the Atlantic with merged and virtually merged rivals.

Newcomers in new places

Perhaps the most surprising bout of consolidation and revival, however, has been in Latin America. Governments in the region have followed Chile's lead and decided to get out of the way of private airlines. The failure of Brazil's state-owned airline, Varig, was a turning-point. It helped the rise of Gol, a Brazilian low-cost carrier, and TAM, which has a more traditional network. Now TAM is planning to merge with LAN, a privatised Chilean airline which has long set the regional standard for efficiency in its open, liberalised home market. LAN has built partnerships with airlines in Colombia, Costa Rica and Panama. Most of these are family-owned and are therefore able to act quickly and boldly without the hindrance of nervous capital markets or restrictive state shareholders. The merged company, LATAM Airlines Group, will be one of the largest quoted airlines in the world.

The rise of another region, the Gulf, is causing acute pain to American and European airline executives. Led by Dubai's Emirates, Gulf airlines are redefining long-haul travel. Emirates is often accused by envious Europeans of growing thanks to state subsidies. It is owned by the government, but had only a tiny capital injection to get going 25 years ago.

Since then it has expanded profitably, helped by its government's pro-aviation policies such as the rapid expansion of its home airport and the provision of efficient air-traffic control. Above all, Emirates, led by two British veterans, Maurice Flanagan and Tim Clark, twigged that in the age of aircraft capable of flying 18 hours non-stop, Dubai was the ideal spot for a new kind of hub. Planes such as Boeing 777s (of which it is the biggest buyer) and Airbus A380s (ditto: 15 are already flying and 90 are on order) can fly anywhere in the world from Dubai. It is free of air-traffic congestion, has no ban on night flights and has plenty of runway space. Emirates' remarkable success is one reason why air-travel growth is fastest in the Middle East.

Dubai is handily placed to connect nearby emerging markets, such as India and Pakistan, with the rest of the world: as people there become better off, they want to travel more. But it has built links to Europe too. While Europe's flag carriers concentrated on their hubs, Emirates sought secondary markets such as Manchester, Glasgow, Hamburg and Dusseldorf. Messrs Flanagan and Clark saw that passengers would happily fly from such cities to Cape Town, say, via Dubai, stopping briefly or even overnight, if transit was pleasant and the fare was cheap.

When Emirates was setting up these routes, European governments saw no threat from this upstart Arabian airline and were happy to grant it traffic rights in liberal bilateral treaties. Now they are stuck with them and can do nothing to fight the competition, since Dubai is, in essence, a tax-free zone with access to cheap labour from the Indian subcontinent. Emirates reported a 52% rise in profits this May; the year before they increased fivefold. Because its routes are exclusively long-haul, Emirates has planes flying 18 hours a day, making them remarkably productive.

Dubai already has the world's third-busiest international airport, with traffic growing at 20% a year. On July 6th it said it would spend $7.8 billion on expanding it. Yet a huge new one, costing $35 billion, is being built and is already open for cargo. In about ten years, with its five runways and capacity to handle 160m passengers a year, it will be the largest airport in the world.

Emirates will also have the biggest fleet of the biggest airliners. Some observers believe that Emirates is a pioneer of low-cost long-haul travel, capable of keeping economy fares below competitors' if it has to. By deploying so many large, economical aircraft from a vast base, open around the clock and halfway between Europe and Asia, Emirates could in effect run a global hub, reducing European airports to a feeder role and impoverishing their associated flag carriers. No wonder airlines such as Lufthansa keep sniping at Dubai and its alleged "subsidies". And no wonder aviation accounts for 28% of Dubai's GDP.

China leads the way to freedom

For the first half-century of its emergence after the second world war, civil aviation was dominated by the huge American market, where distance favoured air travel for domestic journeys. Internationally, other countries were afraid of the dominance of the two biggest American carriers, TWA and Pan American. For their part, Americans were afraid of hostile European planes flying over their homeland, perhaps to drop bombs rather than passengers. That mutual lack of trust gave rise to the Chicago Convention on air travel in 1944 and then to restrictive bilateral air-traffic deals, exemplified by the so-called Bermuda agreement covering transatlantic flights. IATA was formed to run this regulated aviation commerce, acting as a clearing house for payments between airlines and drawing up rules for everything from the size of sandwiches to the price of headphones for in-flight films.

Those days are on the way out. Mr Bisignani, the retiring boss of IATA, reckons that China will lead the way now. The Asia-Pacific region already accounts for 40% of the air-cargo market and 26% of passenger travel, making it bigger than America. By 2014 the region is forecast to have 30% of the world air-travel market, adding 210m passengers from China alone. China has built 45 new airports in the past five years and plans another 52 by 2020. India is waking up to aviation after a long sleep. It has fast-growing low-cost airlines and plans to make Delhi a regional hub.

The capital markets seem to have spotted this reshaping of world aviation. Emirates is still locked away in the ownership of the Al Maktoum family, which runs Dubai (although Dubai's financial troubles in 2008 at one point seemed likely to force a flotation to repay debts). But three of the world's leading airlines by market capitalisation are from East or South-East Asia: Air China, Singapore Airlines and China Southern Airlines. With LATAM on the way, the top five will contain only one European airline, Lufthansa, and not a single American carrier, even though American airlines still fly most passengers (see chart 3).

Asia is also proving an unlikely champion of free trade, with little enthusiasm for clinging to outdated, traffic-limiting bilateral deals. ASEAN, the Association of South-East Asian Nations, is working on establishing a single aviation market with no traffic restrictions by 2015. "China will break Bermuda and the old IATA system," says Mr Bisignani. Thus a new economic power that joined the World Trade Organisation only in 2001, whose trade policies are frequently criticised by members of longer standing, is likely to play a leading role in tearing down the restrictions of the most regulated of global industries.

When the dust clears from the sensational order boom (at least for Airbus) in Paris, perhaps reality will crowd in. Past experience suggests that, to paraphrase St Matthew, many are ordered but fewer are delivered. But that seems unlikely this time, given the need for more fuel-efficient planes and the fact that the orders are coming largely from the undersupplied and booming Asia-Pacific region. And there are other sources of demand.

Emirates is already muttering about more orders at the next big air show, in November on its home turf in Dubai. Whereas in Paris carriers splurged on single-aisle planes, the rise of long-haul budget carriers could boost sales of wide-bodied craft in the next few years. Tony Fernandes, boss of AirAsia, wants Airbus to put new engines and improvements on the A330, which is used by his company's long-haul budget airline, AirAsia X. And European carriers such as Air France-KLM and Americans such as American Airlines urgently need to replace ageing wide-bodied planes with more efficient modern ones.

The shifts in global aviation may affect builders of aircraft as well as buyers. Boeing and Airbus could lose their tight grip. Embraer in Brazil and Bombardier in Canada are moving up from smaller regional jets to big ones; and Russia's Irkut and China's Comac are entering the international market for single-aisle airliners. Ryanair has signed a co-operation deal with the Chinese company, with a view to using it as an alternative to Boeing, its sole supplier. As aviation goes properly global, so might the aircraft industry. Wherever you look, newcomers are muscling in on what was once a Western domain.

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