ANALYSIS: The challenge of matching capacity to demand

For any business, a key relationship is ensuring there is relative excess demand for what the business offers at the prices it needs against its prevailing cost base, which reflects the outcome between underlying demand and the amount of product or capacity in the market.

For airlines, economic activity remains the key driver of underlying demand - at all fare levels - with supply determined by net new deliveries and deployment decisions.

Recent economic data and comments from the IMF chief that there may be a three-speed global economy do not reveal ­anything new. Depending on the degree of disaggregation you might want to adopt, you can define many more speeds. For some time it has been clear there will continue to be a wide range of experiences and, for some economies, recovery will result from painful structural change instead of any form of a cyclical bounce.

Economic change is asymmetric in effect - it is not like a rising or falling tide said to affect all boats equally. For a large part of the world, changes in forecast rates of economic growth - or decline - are still in the realm of forecasting errors and spurious accuracy.

Economic cycle

As we have argued in the past, the traditional economic cycle has been broken, at least for what we have described as the "northern and western economies". We wait to see whether the outturn for the US GDP growth will match the IMF's latest forecast of 1.7% or its earlier forecast of 2%, and if the headlines on the latest Markit eurozone Purchasing Managers' Index - which proclaimed on 4 April that the "eurozone downturn intensifies as German economy shows near-stagnation" - become reality.

By the same token, any regular readers of the IPSOS Mori economic snapshot should not be surprised by these outcomes. The main issues are still more about direction and recognition that what we face now is not only the "new norm" but that the previous forecasting relationships are unlikely to hold from a causal perspective.

A key feature of traditional economic theory is that rational behaviour prevails and market adjustment is costless and instant. As we all know and have debated, the real world is quite different; not only in terms of behaviour where it is not obvious that it is or has always been rational but that there are time lags and significant costs related with adjustment.

The restructuring programmes under way at a number of European airlines bear witness to this latter point. For airlines in the northern and western economies, the majority of their activity is in markets where there is no economic cycle to ride to recovery and improvement in performance will come through structural change internally and externally.

Externally, the focus is on matching capacity with demand. Internally, for the so-called legacy airlines, it is about trying to move production systems closer to that of the newer market entrants.

In the medium term this changes the market dynamics and places pressure on some LCCs - particularly those where the underlying assumption of management appears to be that their legacy competitors were incapable of change and decline was their only option. Notwithstanding the interruption to Boeing 787 deliveries, production rates remain at all-time highs for jets with over 80 seats. But while deliveries remain high, the latest schedules data for capacity deployment suggest less of a potential imbalance between supply and demand. Comparing data for the third quarter of 2013 with that of 2012, against the background of actions being taken at a company level, there is some encouragement that a turning point may be close at hand for those operating in the more challenging economic environments - although recovery to previous performance levels is some way off.

Intra-europe unchanged

Third-quarter capacity - according to DIIO schedules - in the intra-European market is expected to be unchanged in terms of the number of flights (+0.2%) with the number of seats offered only 1.4% higher. Similarly, in the Europe to North America market, flights are expected to be up by only 1% and seats by 1.8%. In North America, the constrained and rational approach to capacity at an industry level continues with flights down by 0.7% and seats up by 0.6%.

In regions where the outlook for economic growth remains better, although not without challenges, intra-Asian capacity is forecast to grow by 7% and 7.5% in terms of flights and seats respectively. But direct capacity between Europe and Asia is flat in terms of flights (-0.1%) and up 2.4% in terms of seats.

Conversely, capacity between the United Arab Emirates and Europe is 10.7% higher in terms of flights and 14.1% higher in terms of seats, and between the UAE and Asia there are 15.6% more flights and 14.6% more seats - more evidence of another structural change in the market.

The key issue is if this approach to capacity continues. And while we may be at the cusp of a changed environment, the benefits will not be evident for some time. The hope is that financial markets do not get bored with the wait.

Source: Airline Business