Rising oil price threatens aviation sector growth

11 July 2008
With demand for flights soaring, Middle Eastern airlines have so far avoided the worst effects of rising fuel costs, but fears are growing that the sector’s rapid expansion is not sustainable.

The concern was tangible among delegates at the annual general meeting of the International Air Transport Association (IATA) in Istanbul from 1-3 June. With crude oil prices hitting $135 a barrel in the days before the event, the mounting cost of jet fuel dominated proceedings.

Among the industry’s senior executives there was no doubt: global aviation is in a full-blown crisis. IATA reports that 24 airlines have gone into liquidation since late 2007, and more are sure to follow.

On the conference platform and the fringes of the event, airline executives openly discussed how many of them would still be in business in 2009. Most agreed that the fuel crisis was an even more difficult test for the industry than the worldwide slump in aviation that followed the attacks on the US on 11 September 2001.

It is a measure of the speed with which the crisis has crept up on the industry that in the days after the conference, crude oil prices surged by $11 in a single day to hit a new high of $139. Prices of $150 a barrel, or even $200, have been predicted.

Growing demand

So far, the Middle East has avoided the worst of the impact. Building from a much smaller base, growth in passenger traffic across the region was 18.1 per cent in 2007, more than twice the global average of 7.4 per cent, and three times that of the worst-hit European and North American markets, which recorded 6 per cent and 5.5 per cent growth respectively.

Being based in the world’s principal oil-producing region does have its advantages. Middle Eastern airlines may be lamenting the high price of fuel, but the boost to the region’s petro-economies provided by the record oil price is increasing the disposable income of the general population and encouraging demand for air travel. Middle East aviation is also unrivalled by cheaper alternatives such as rail, which are hitting the profits of European operators.

“Of course we are not happy about rising oil prices, but at the same time the economies are booming and more people are travelling,” says Marwan Boodai, chief executive officer (CEO) of Kuwaiti low-cost carrier Jazeera Airways.

“There were 140 million passengers in the Arab world last year, which is 10 times the Indian market. The impact on the low-cost market is huge but we have to make the most of the economic upturn, fly more people and spread the cost where we can. We will not see airlines going bust any time soon.”

Despite the perception of some industry figures, the Middle East market is not immune from the global trend. As in Europe and the US, the low-cost and business-only markets, where margins are tightest, are under greatest pressure. Fuel as a percentage of total cost has doubled in some cases to almost 50 per cent of total overheads and most short-haul carriers in the region confess it is at least 40 per cent. Surcharges have been added to ticket prices as the oil price has continued to climb.

“We try to pass on as little as possible to the customer but if costs continue to rise, we will have no choice,” says Adel Ali, CEO of Air Arabia, the region’s first low-cost carrier, based in Sharjah. “Our surcharge is about $30-35, and has probably increased by about 50 per cent over the past year. We are still comfortable with our business but we will have to focus constantly on cost. It is going to be a difficult year.”

Ali fears that the Middle East low-cost sector is in danger of following developments in India, where a glut of small carriers appeared in the market a few years ago and they are now struggling to cover their costs. “The Middle East is showing signs of the same scenario but in the airline industry few people learn from past mistakes,” he says.

National regulators will have to control the number of new entrants to the market. But it is not just the low-cost sector that is under financial pressure. Even Emirates, the undisputed giant of Gulf aviation, has admitted that despite recording net profits of AED5.3bn ($1.44bn) for the past financial year, its fuel expenses were $500m more than anticipated.

“If the rise continues, some airlines in the region will go out of business if they are not supported by their governments,” says Ali.

“This is not a low-cost issue but an airline industry issue. We all use the same fuel. It will impact everybody, low-cost or legacy carrier.”

Airlines that do not enjoy subsidised or discounted fuel from their governments will have their commercial viability severely threatened, even if state ownership means national carriers are not going to be allowed to go under. Kuwait Airways, for example, has made a loss in 15 of the past 16 years. Its financial difficulties are nothing new, even with the government covering its losses and supplying cheap fuel.

Imposing surcharges

Despite receiving heavily discounted fuel from Riyadh, Saudi Arabian Airlines recently announced it was imposing a $100 surcharge on return flights to Europe and a $90 increase in regional fares.

Ali says the soaring fuel price has also dampened enthusiasm for airline privatisations. With their flag carriers beginning to struggle, some governments are once again erring towards protectionism.

“Several airlines have been looking at privatisation but high oil prices encourage governments to increase subsidies,” he says.

“Things are changing slowly but it is unfair competition. Protectionism is a fact of life, though. We just have to focus on our own business.”

So far, the steady rise in prices has not dampened demand but consumer patience is not inexhaustible. This is of particular concern for airlines in the region with large orders placed for new planes.

Emirates alone has 243 aircraft on order, worth $60bn at list prices. Qatar Airways, Dubai Aerospace Enterprise and others also made multi-billion dollar orders in 2007. Even the low-cost market made orders, with Jazeera Airways ordering 30 Airbus A320 aircraft worth $2.1bn.

Acquisitions on that scale have slowed dramatically in 2008 as fuel costs have hit home. Eti-had has indicated it will unveil an order for 50-100 planes at the Farnborough Air Show in the UK, which opens on 14 July. However, similar orders are unlikely.

Carriers are consolidating while they wait to see how the crisis unfolds. Many in Istanbul said they feared the full impact of the fuel price rise would not be felt until the autumn. With people having already booked summer holidays, it will not be until September that customers review their finances and decide that an autumn or winter break is not affordable.

Given the scale of new capacity scheduled to arrive in the Gulf in coming years, concern is mounting that the phenomenal recent growth in the Middle East’s aviation market will not be sustained.

“There is a clear danger that airlines’ assumed passenger levels will remain at the same level as the boom years when we know this is a cyclical industry,” says Andrew Cowen, CEO of Saudi low-cost carrier Sama, which launched early in 2007. “Rising prices will choke off passenger demand but we have seen airlines ordering huge numbers of aircraft.

“So many airlines paid top dollar for new planes at the top of the boom. I am sure they did their sums but we looked at new aircraft and could not see how it made sense to buy at the top of the cycle. I am glad we are not tied into that kind of commitment for billions of dollars with oil at $135 [a barrel]. We want to grow to 35-50 aircraft over the next 10 years but we simply may not be able to under these economic conditions.”

Single sky

Others are more optimistic and urge development and progress rather than caution. The Arab Air Carriers Association (AACO) is pushing ahead with discussions on introducing a Middle Eastern single sky, with a fully integrated air space and air-traffic control system. This could then be linked with the united European airspace.

Speaking to MEED in Istanbul, Abdul Teffaha, AACO’s secretary general, says this should be achievable within five years and he anticipates the region’s strong growth in aviation will continue, with the ‘single sky’ policy giving a massive boost to passenger traffic.

However, this would expose fragile national carriers to full competition. Emirates, Etihad, Qatar Airways and even Air Arabia or Jazeera might urge greater deregulation. But less successful airlines such as Syrian Air or Sudan Airways are unlikely to be so keen to relinquish state protection.

The Middle East aviation market has inherent advantages over other regions, but many airlines are being tested for the first time, and newcomers such as Bahrain Air or the forthcoming premium airline Wataniya Airways in Kuwait look particularly exposed.

It is a difficult time to be launching into the market. It is not yet clear how customer demand will be sustained or how much flexibility the airlines’ business models possess. If demand starts to decrease, airlines will have to absorb more of their fuel costs themselves.

“We know the market,” says Bjorn Naf, CEO of Bahrain’s national carrier, Gulf Air. “We are in a downturn now but the growth is there. Maybe in 12 months or two years the world will look different. We are always saying there are too many players in the arena so maybe in a few months there will be fewer players, making it easier for the others.”

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