Airlines face another big plunge

The latest International Air Transport Association outlook for the airline industry simple confirms what was already obvious. The industry will be barely profitable this year, if indeed it is profitable.

Given IATA's propensity to be over-optimistic, its forecast of a $4 billion profit for an industry that generates nearly $US600 billion of revenue probably underestimates the downside. Even so, having forecast a halving of earnings this year compared to last year in its previous outlook statement in March (which was based on 2010 earnings of $US16 billion that have now been restated to $US18 billion) it has more than halved them again to levels 76 per cent below those experienced last year.

That's despite a reasonable global economic recovery that has led the association to forecast a 4.7 per cent increase in demand.

There are two major reasons why the industry is sliding back towards break-even or worse. The obvious one is the cost of fuel, with the oil price expected to be about 15 per cent higher in 2011 (averaging $US110 a barrel) than it was last year. While about half the industry's fuel costs are hedged, that still equates to a $US11 billion increase in costs.

Most of the big airlines, like Qantas, have added fuel surcharges but not only don't those fully recover the higher jet fuel costs but they also impact demand, particularly for the more price-sensitive leisure travel that helps drive load factors.

The other big reason for the decline in profitability is that the industry itself, and the individual carriers within it, are also usually overly optimistic and almost always add capacity at a rate ahead of the growth in demand (and the actual demand that eventuates). IATA expects capacity growth of 5.8 per cent – well above the 4.7 per cent estimate of growth in demand.

Falls in load factors and the average hours flown by aircraft have a leveraged impact on bottom lines.

The industry hasn't, of course, been helped by the wave of natural disasters in Japan, the US and New Zealand, or by the political unrest in the Middle East and North Africa, or the economic woes of southern Europe.

Even in Asia-Pacific, which in recent times has been the most resilient and profitable of the major regional markets, profits are expected to be only a fifth of the $US10 billion generated last year. That's partly due to the problems with the Japanese market but there is now a lot of capacity slushing around the region and its carriers tend to be more exposed to the oil price than others.

The amount of long haul capacity that has been added to the region explains Qantas' fascination with growing its inter-region network both with its Jetstar brand and, potentially, with a new premium product.

In this market, Virgin Australia's recent wins in obtaining regulatory clearances for its trans-Tasman and trans-Pacific alliances with Air New Zealand and Delta might help ease the pressure on the economics of those routes, although the "other” long haul alliance, with Etihad, is potentially quite threatening, and Virgin's attempt to push into Qantas' domestic business market will create some competitive pressures that didn't previously exist. Plus, of course, Qantas faces some potentially significant and damaging industrial unrest.

It was, of course, ever thus. This is an industry that has never been sustainably profitable and where only a handful of carriers have ever covered their cost of capital. Murphy's Law has been a constant in the industry, with the latest series of assaults on its profitability just another illustration of it.