ISTAT News | 04 February 2020
An Industry in Transition
Life today is all about change and managing — or at least coping with — change. And while change is ever-present at some level in the world we live in, the aviation sector has been in a positive, expansive and profitable state for almost 10 years. This is a much longer bull run than in almost every previous industry cycle. Passenger traffic growth has been averaging more than 6% per annum and running above trend in eight out of the past 10 years.
Does this represent a new normal? It’s probably too early to say for sure. IATA is forecasting a return to the 5% levels of the past. My strong feeling at the moment is that medium-term growth rates will remain closer to what we have been experiencing recently, even as the wider economy slows.
While passenger demand has been running well above trend, the same can’t be said of air freight, which has been struggling to maintain long-term growth and is running well below historical levels, despite being exposed to the same macroeconomic global forces.
I think the performance of air freight over the past decade more closely reflects the uncertainties and global economic challenges of the real world we are living in, but clearly the changes taking place in global trade patterns have had a radically different impact on the cargo market over the past decade compared to the changes in passenger market forces.
So, different sectors face different challenges. Unlike the air cargo sector, passenger load factors have been steadily rising. They now consistently exceed 80% on an annual basis and edge close to 100% in peak periods and busy routes. With airlines now clearly able to figure out how to fill seats, airline profitability has also been hitting record levels. So, that’s all good. Except that, even during the good times, there has been a spate of airline failures, the latest example of course being Thomas Cook, with still more in intensive care.
And although the overall industry has been enjoying unprecedented profitability, much of this is highly concentrated. With 45% of industry’s profits generated by North American carriers, many airlines around the world continue to exist on slim margins or are losing money, including some with big names and franchises. This leads inevitably to the conclusion that, although supply and demand is nominally in balance, there are simply too many cheap seats being sold in the market and too few expensive ones.
As I think is now well understood, much of the global traffic growth is being fueled by rapidly expanding middle class populations in emerging markets. Access to and use of air services within a population increases exponentially as disposable income rises. This clearly separates the mature economies of North America and Western Europe from all of the emerging markets — in Asia, Latin America and Africa. Since many of these emerging markets are home to the largest populations, the potential for further growth in passenger demand is very significant.
Worldwide passenger numbers are set to pass 4.5 billion this year and are increasing by 200 million every year, resulting in huge pressure on existing airports and infrastructure and driving the dramatic facility expansion that is taking place in markets like China and India. Almost all of the growth is coming at the low end of the market, with little increase in premium traffic.
Airlines have the tools and technology to fill seats, but, of course, the first casualty of over-capacity is yield. And in an overheated market where several competitors all have overexuberant growth plans, price wars will and do break out. Who is to blame for this race to the bottom and for putting airlines into intensive care? The fault doesn’t lie just with the airlines — although they surely play their part.
The OEMs are also complicit, as they sell their dream of greater efficiency, longer range and lower seat costs, with pricing that gets ever more attractive as the order size increases. Treating airlines like foie gras by tempting them into committing to large, long-term fleet orders can only work when airlines are willing and able to compete rationally and resist the temptation to chase market share and load factor through irrational pricing.
Another significant causal factor is the plethora of cheap finance, from banks and lessors, that has given airlines access to funding for new assets that should, for many, remain out of reach.
So, what can we expect in the way of change as we look ahead over the coming months and years? Although we have enjoyed an unprecedented period of growth and profitability, it seems to me that there are clear signs that the best is already behind us. Global economic activity is slowing, traffic growth has been trending back toward the long-term norm and airline profitability is slowing up.
We can categorize the potential catalysts of change in various ways. We can separate them into events that are external to the industry and those that are internal to the industry. We can identify potentially existential threats and those that may be temporarily disruptive or disadvantageous. We can also sort them into threats that we can control and influence, and those that we can’t.
Starting in the world at large, what should we be concerned about in respect of having the potential to impact our business? There is no shortage of media coverage and commentary regarding what may or may not come next in the Middle East, U.S.-China trade relations, what the North Koreans are up to, Iran sanctions, etc. Any or all of these has the potential to impact demand for air transportation, for regional and global economic activity, for conflict and, as we are once again experiencing, for oil prices.
There seems to be no clear way forward in the diplomatic impasse that has developed between Iran and the White House, now spilling over into the proxy war being waged in the region and threatening to escalate into wider military activity, presenting a heightened threat to oil supplies, which is directly reflected in oil prices. If, as well as a return to $100-plus oil, there was to be a serious restriction of supply, the impact on the global economy, to say nothing of the aviation sector, could be profound.
At the next threat level, we have a mix of potentially existential threats and more inconvenient truths. The disruptive impact of Brexit, the destruction of the Amazon rainforest, breakdown of the rule of law in Hong Kong, and concerns over climate change will all impact the lives and livelihoods of billions, with high potential to disrupt our own aviation sector. With one obvious exception, we as individuals or as an industry can’t influence or change any of these issues either, but we do need to anticipate how our markets and businesses could be affected and devise strategies to insulate from or minimize the impact.
The exception here of course is climate change, which has huge potential to score a direct hit on our industry. We have only recently seen the “flight shame” movement develop, with an immediate effect on demand for shorthaul travel, according to SAS and others on the front line. Inevitably, aviation’s share of harmful emissions will rise, and the weight of public opinion will increasingly encourage governments to ban, limit or tax our airline operations. These concerns loop back to my thesis that there are too many cheap seats in the market and not enough expensive ones.
Here in Europe, we can routinely find flight bargains that offer absurdly low-priced opportunities to spend short breaks in cities or at resorts. If we are increasingly traveling almost for the sake of it, there is a price that is being paid by our environment.
I have no argument with enabling new generations of travelers to fly in emerging markets; this is clearly lifestyle changing and a positive trend that also helps to develop economies. But, in the developed world, we all need to be thinking more carefully about what we should be prepared to pay for our leisure trips, rather than how little we could pay. We as an industry must keep control of the narrative and speak up for what we have been doing and are continuing to do to improve our impact on the planet. And we must continue to explore and invest in new technologies to ensure that our industry is sustainable over the long term and is not beaten up and ground down by governments and public opinion.
The recent issues with Boeing and the FAA around the 737 MAX have highlighted a worrying level of complacency in our industry around the core value of safety that is central to the routine operation of airlines and the continued health of the industry. Air travel remains by far the safest means of mass transportation, yet for the first time in perhaps 40 years there is a widespread narrative around the inherent safety of aircraft.
Passengers must have absolute confidence in the aircraft that they will fly in and implicitly must also trust the manufacturers and the regulators to keep safety paramount. It will be important that the readmission of the MAX to airline operations is achieved in a coordinated manner across all of the regulators.
2019 has seen both of the major OEMs experience a major slowing of new orders, which, when combined with an elevated level of cancellations, has taken them into an unprecedented negative net order situation, with a combined total of minus 36 commercial airliner orders booked up to the end of August.
I hope, though, that the recent trend of orders and cancellations combined with less bullish economic indicators and multiple sources of market uncertainty will persuade the OEMs not to push ahead with plans for any further rate increases.
In summary, we as an industry are transitioning from a prolonged period of stability, growth and profitability into a more uncertain future, where multiple external threats make planning and decision making more challenging than ever. The impending economic downturn and any surges in fuel price may result in bad news in the shorter term but are issues that we have experienced and survived before and will surely do so again. This industry is no stranger to threats and challenges, and I am confident that we will continue to embrace the changes that we can see coming, as well as those that remain hidden, and to deal responsibly with the future.