Given historical experience, the airline industry can rarely enter a year fully confident of ending it with a strong collective profit, but there are relatively robust reasons for hope that carriers might stretch their profits run to a new peak in 2016.
Last year marked the airline sector's sixth consecutive and most significant year of profit yet. IATA now estimates that industry net profit will reach $33 billion – almost double the 2014 figure and a record for the sector. And in its first forecast for 2016, issued in December 2015, IATA sees this rising again this year, to $36.3 billion.
FUELLING GAINS
While it would be simplistic to say airlines' improved performance is solely driven by the fall in oil prices, lower fuel costs are a major contributing factor. IATA estimates that airlines' global spend on fuel was around a fifth lower in 2015, and sees it falling a further quarter this year. While fuel will remain airline's biggest expense item, it will comprise only 20% of operating costs in 2016, compared with 30% two years ago.
The barrel price of Brent Ccude oil fell below $40 in December, taking it into territory not seen in over a decade
"There are quite a range of expectations for [oil prices in] 2016, with some coming out saying it will fall further," says IATA chief economist Brian Pearce. "Certainly, there is a lot of surplus oil in inventories floating around. Others still expect it to rise."
IATA's 2016 forecast is based on an average price of crude oil slightly lower at $51 per barrel.
"Our forecast is based around the middle, but even if higher numbers come... we are still in an environment where oil costs are relatively low for airlines," says Pearce.
For many airlines, lower oil prices have not yet translated into a significantly lower fuel bill. Heavily hedged airlines have been unable to reap the benefits until these positions unwind, while those whose local currencies fell against the strong US dollar last year had their gains reduced.
US carriers, relatively unhedged and benefiting from being the right side of the strong dollar, saw a more immediate impact, and this is part of the reason why North American carriers last year outperformed other regions to such an extent – contributing over half of industry profits.
Assuming exchange rates prove less volatile in 2016, Pearce believes that unwinding hedges should enable carriers from the other regions to enjoy more of the gains from lower fuel prices.
And just as fuel hedges capped airline gains initially, Peter Morris – chief economist at Flightglobal consultancy Ascend – notes that the oil futures markets illustrate the potential for airlines to lock in lower fuel costs for the coming years. "There is a degree of stability in the fuel price you haven't seen for some time," says Morris.
Lower fuel costs have come at a time of stable – if unspectacular and mixed – economic growth. This provided a double upside for an industry more accustomed to an environment of "when it rains, it pours".
Airlines had been hunkering down for high fuel prices for the long term with little prospect of a significant fall in fuel costs. The result was that various operating efficiencies were already being targeted to combat the high fuel prices. So the combination of those efficiencies and a low fuel price is providing a double boost for airlines.
"There is a kind of wrong-footing, but in a good way," says Morris. "In the US, there was already a war of attrition being waged against the cost base, and they had settled in to accept a smaller, more profitable airline structure. Now, the forces of higher fuels costs have just fallen away and it is a very positive environment."
He adds: "The cost pressure from fuel, at least, has been postponed for several years it seems. So you are probably looking at a US airline industry which gains from high efficiency measures driven by the original high fuel price, market power from consolidation, and now a lower fuel price which might last up to five years if future prices are to be believed.
"It is a perfect sunshine day, but perhaps one that is so positive that it will start to encourage new competition to enter."
ECONOMIC CONCERNS
Pearce believes a deterioration in the economic backdrop is generally a bigger risk to airline profits than rising oil prices. "The industry has always been able to do reasonably well with a strong economy. With a weak economy, even with low fuel prices, that's always been a difficult environment," he says.
Most economic projections seem to suggest more of the same for 2016. IMF boss Christine Lagarde, writing in German business daily Handelsblatt at the end of the year, predicted that in 2016 global economic growth would be "disappointing and patchy", citing concerns including the impact of rising interest rates and the Chinese slowdown.
"'No worse than it was' seems to be the 2016 view on the economy," says Ascend's Morris. "There are ups and downs. In Latin America, there are problems which will probably take longer than a year to turn round. But in the US, there is overall growth of around two-and-a-bit percent, while Europe is on an upward trend – albeit from low levels. Asia has slowed, but still the average GDP growth is around 4%."
While fresh stock-market jitters in the first day's trading offered a reminder of China's economic challenges, Morris notes that the country shows 2016 GDP growth still well in advance of European or US levels.
"I think China is not as bad as people paint it," says Pearce. "I think what we are seeing is a shift from investment-led to consumer-led growth, which is good for aviation. We are seeing strong performance on travel, and airlines are doing okay."
But there is a disparity between emerging and mature economies – and while China is still in growth and India is thriving, it is a different story in the remaining much-vaunted BRIC markets of Brazil and Russia.
"The BRIC [countries] are no longer the poster child for growth. We've got Brazil and Russia in deep recession, and the airlines are struggling as a result," says Pearce.
"If you look at the developed economies, we have seen significant improvement over the last few years. and I think there are good reasons to expect that improvement to continue [in 2016] because of the continued boost to consumer income from low energy costs," he adds. "I think the more uncertain future is around the emerging economies."
BUSINESS RISKS
Air travel demand is also highly sensitive to external shocks including geopolitical events, evident again in second half of 2015 after the terrorist outrage in Tunisia, security concerns in Egypt around the crash of a Metrojet A321 flying over the Sinai, and the attacks in Paris.
"It's always difficult to know how these events will impact traffic. All we have to go on is how it has had an impact in the past," says Pearce. "What we find, certainly in the developed countries, traffic is surprisingly robust, probably because a lot of it is business travel. What we have found in the past is, six to nine month later, we have seen a rebound in traffic."
Morris notes that outside shocks can illustrate the benefits of a diversified business model – either from a balanced regional network, as with some European LCCs, or a portfolio of travel options, like the IAG stable. Diversification provides a flexibility to deal with the unexpected, he says, noting for example that when European demand to North Africa dropped off in 2015 after terrorist incidents, European tourism to more secure southern regions of Europe benefited. "While some travel may be deterred by risk, in many cases tourists look for substitutes and airline groups that can flex in this way will benefit," he says.
But, equally, airline actions could similarly impact their own profitability, if the recent discipline around capacity and costs is loosened too far.
"The key risks to airline profits in 2016 and beyond are continuing pressure on yield/unit revenues resulting from too much capacity entering the market against a weakening economic environment," says CTAIRA analyst Chris Tarry. He notes that while the fall in fuel price means airlines can absorb this increase, the longer-term result is a resetting of fares at a lower level and with increased capacity.
Fuel has been a key driver of airline capacity discipline. Spiralling oil costs forced airlines to accelerate the retirement of inefficient, fuel-hungry types. That purge helped drive airlines to a position where many could still make money even with fuel prices over $100 a barrel.
But without such stark consequences, there is a risk of adding capacity beyond demand – with an impact on yields.
IATA is forecasting that airlines will collectively lift ASK capacity 7.1% in 2016, an increase of more than a point on the rate of capacity growth of the previous two years. At the same time it sees airlines increasing traffic 6.9% – which would result in a slight fall in load factors over the projected record high of 80.6% in 2015.
"The other key risk is an increase in non-fuel costs, which for many airlines are already rising quite sharply – particularly, but not only, labour," adds Tarry.
Ascend's Morris says: "In real terms, airline salaries have generally suffered and, as airlines become more profitable, there are likely to be increased cost pressures from labour. But given the size of the fuel windfall that has occurred, there should be quite a lot of room for manoeuvre."
Pearce notes: "It's a very volatile industry, so airlines need to use this period of stronger profits to repair their balance sheets – and we've seen that in the US, where they are paying down debt – and invest in more robust business models able to survive in weaker periods and probably with higher fuel costs. So you don't want to give that all away in excessive pay."
There is a focus among airlines on returns, Pearce argues, echoing the sentiments of IAG chief Willie Walsh, who said at an IAG Capital Markets Day in November: "I think the main change has been a drive towards profitability, rather than on market share and scale."
Walsh added: "I think there have been some changes in the dynamics of the industry, and they have been there for seven or eight years now. We don't see any move away from that behaviour.”
Source: Cirium Dashboard
