In late September, Saudi low-cost airline Sama announced it was cutting a host of domestic services.

Unable to pass its soaring fuel bill on to customers because of a state-imposed fare cap on domestic flights, Sama’s chief executive officer (CEO) Andrew Cowen said the airline could no longer sustain the massive losses it was incurring.

The carrier, which launched in May 2007, halted flights from Riyadh and Dammam to Medina, and halved its service between Dammam and the capital.

Cowen indicated that further routes could be slashed from the network if the situation did not improve.

The same month, the kingdom’s national carrier, Saudi Arabian Airlines (Saudia), sold off a 30 per cent stake in its cargo business to a consortium led by two local firms: Al-Muhaidib & Sons and Acwa Power.

he cargo division was the second unit at Saudia to be partially privatised, following the catering arm last year.

Although this was welcome progress, the privatisation of the airline is falling far behind schedule and the hardest task - the partial sell-off of the carrier itself - is still to come.

Saudi Arabia has the largest economy in the region. It is the most populous country in the GCC and, with its holy sites, is the focus of a vast market for pilgrimage and tourism that stretches across the entire Arab world.

It should be the perfect market for a competitive, deregulated aviation sector. Instead, it is going backwards.

Struggling sector

The events at Saudia and Sama expose the systemic faults within the kingdom’s aviation sector and illustrate why, rather than fulfilling its potential and leading the Gulf’s airline boom, the Saudi market is struggling.

For all the good intentions, bureaucratic lethargy within government and the aviation regulator, the General Authority for Civil Aviation (Gaca), is holding the industry back.

“We applaud the moves towards liberalisation that Gaca has made,” says Cowen. “Saudi Arabia has liberalised its market far more than most in the region, but there is unfinished business.

We have been flying for 18 months and the playing field is still not level. We had no choice but to cut our domestic routes, because we cannot sustain these losses. We are appealing to Gaca to sort this situation out.”

Two years ago, things were very different. The Saudia privatisation was about to get under way and the kingdom was poised for the launch of two low-cost carriers: Sama and Nas Air, owned by aviation group National Air Services.

By the time the first Nas Air flight took off in January 2007, officials at the two budget operators had been in talks with Gaca for two years about the precise terms of their licence. Enshrined in the final agreement was a guarantee of equal treatment for the new carriers and Saudia.

The national airline enjoys a huge fuel subsidy from the government, equivalent to four-fifths of the market rate.

This softens the impact of the fare cap, which was brought in for domestic economy class tickets in 2001. The move was designed to make air travel around the country affordable for all Saudis.

With Saudia’s monopoly about to be broken, the two low-cost airlines were anxious that these anomalies were removed, so that all three airlines could compete on a commercial basis.

Negotiations in 2006 made slow progress, however, and with the airlines ready to launch, they were persuaded to go ahead with both the fare cap and Saudia’s subsidy still in place, but with reassurances that the issues would be resolved quickly.

“It did not seem too problematic at the time,” says Taher Agueel, CEO of National Air Services. “We were promised everything would be resolved soon.”

While talks continued, the new airline shook up the market. Stirred into action by the new arrivals, by the summer of 2007, Saudia had suggested launching its own low-cost operation, as well as a dedicated Hajj and Umrah service.

With fuel prices rocketing since their launch, the situation has become critical for the new airlines.

The fare cap means that Nas Air and Sama cannot levy a fuel surcharge on their customers to mitigate their higher costs.

Large sections of the domestic network are loss-making, compounded by Riyadh’s insistence that the airlines maintain services on little-used routes, known as public service obligation (PSO) routes.

Like the fare cap, they are meant kindly, ensuring that far-flung regions of the kingdom retain regular air connections.

However, for the airlines, the PSOs are disastrous. Planes are frequently almost empty, with the fuel costs on flights far outweighing the paltry revenue from ticket sales.

In desperation, Sama and Nas Air have increasingly moved into the international market, where the fare cap does not apply. Here, they have found high passenger volumes and profitability to compensate for their losses at home.

According to Cowen, 75 per cent of Sama’s operations are now on international routes, and the company is considering cutting its domestic flights back to just the PSOs until the fare cap and fuel issues are resolved.

The company has lost SR40m ($10.7m) on flights to Medina alone over the past year, despite passenger loads of 80 per cent.

Shareholder bailout

The airline has already been bailed out by its shareholders once this year after the com-pany’s $80m start-up capital rapidly disappeared, and another hand-out is likely to be needed soon if nothing changes.

“Liberalisation was supposed to bring choice for the Saudi traveller,” says Cowen. “Increased competition was meant to lead to reduced fares.

“It has done that on international routes but because of the losses from the fare cap and the rates we are paying for fuel, we are increasingly reducing domestic routes. This cuts across the liberalisation principle.”

Gaca has responded by cutting the number of PSO routes that the low-cost operators are obliged to fly and forcing Saudia to shoulder a larger share of the compulsory routes.

While appreciated, this piecemeal approach does nothing to address the fundamental inequality in the market.

“We understand the political difficulty of lifting the fare cap, but then give us the same fuel subsidy enjoyed by Saudia,” says Cowen.

“We have been flying for 18 months and the playing field is still not level. As a small carrier, we cannot continue to sustain these losses.”

Hamstrung by conservative elements within the Saudi government, Gaca appears unsure which way to turn.

Committed to liberalisation in principle, the regulator has failed to offer any guarantees as to when the situation might be resolved.

“We do not want liberalisation to start going backwards because this will mean less choice for the consumer, but the situation about the fare cap and allowing the airlines to apply a surcharge is still being reviewed,” says one Gaca official close to the negotiations.

Asked about the possible alternative of giving Nas Air and Sama the same fuel subsidy as Saudia, the official would only say that “part of Gaca’s strategy is equal treatment between all national carriers”.

While equal treatment still seems a remote prospect for the budget airlines, Saudia has its own share of problems.

The national carrier told potential investors in December 2006 that privatisation was about to begin.

After the catering arm was sold off, the cargo division would be ready for privatisation in February 2007, followed by ground support by March 2007, and maintenance and training in May that year. The airline itself was to be privatised in the first quarter of 2008.

It did not take long for the schedule to unravel. A Saudi-French joint venture won the bidding for the catering division in March 2007, but did not take control of the business until September.

In August 2007, the Saudi cabinet resolved to accelerate the privatisation by registering each unit within the company as a private business, but bids for the cargo unit still went in a year late.

In February 2008, a consortium led by Al-Muhaidib & Sons won the contract, but it took a further seven months to complete the sale.

Overstaffing

Riyadh still seems unsure of how to progress. Saudia is known to have large debts and is severely overstaffed, but the government is sensitive about talk of lay-offs. Saudia and Gaca officials shy away from any suggestion of cutting staff.

As with the low-cost sector, the long-term benefits of competition are being hindered by the fear of adverse publicity in the short term.

Yet in other areas, Gaca has proven it can act decisively. Foreign operators have been successfully brought in to manage the kingdom’s three international airports and prepare them for flotation on the Saudi stock exchange by 2011.

The fundamental obstacle seems to lie in government. While modernising Saudi Arabia’s aviation sector is not easy, the glacial pace of bureaucracy in Riyadh is hampering progress.

The travails of the low-cost airlines will deter other potential investors from entering the sector, but whatever happens, the consumer will ultimately pay.

“In the short term, lifting the fare cap would inevitably lead to increased prices,” says Cowen. “We understand that concern, but we will take the surcharge off as oil prices fall.

“If we are forced to cut our domestic routes back to just the PSOs, which is one of our options, it will reduce choice for the Saudi consumer. We don’t want that.

“We are not trying to make threats, but we need to stimulate debate. What does the public want? “If they want a diverse, competitive aviation sector, then there need to be changes.”