Turbulence ahead for aviation sector

The price of fuel has dropped faster than anyone dared hope. The chart below demonstrates the oil shock this year – prices doubled and now have halved again. This data comes from the US Air Transport Association (ATA).

While the data applies to the US, the trends are global. Oil is priced in US dollars and while a weaker dollar hurt US airlines, the recent swing to a stronger dollar is now hurting non-US airlines. The commercial aviation system is just that – a system of interlocking factors and challenges.

According to the ATA (the US airline club), in 2007, US passenger and cargo airline operations required 19.6 billion gallons of jet fuel, or about 465 million barrels. In 2008, that amount is projected to fall to about 445 million barrels. This trend started a few years ago as the US airline industry started to move towards greater fuel efficiency.

At a consumption rate of about 18.7 billion gallons per year, every penny increase in the price of a gallon of jet fuel creates an additional $187 million (Dh686m) in annual fuel costs for US airlines. So if the price were a dollar higher over the course of one year that comes to about $18.7bn higher operating expenses. Quarterly airline cost index, fuel has overtaken labour as the industry's top cost, ATA said.

But clearly the recent sharp drop in fuel prices is going to save the industry just as much, right? Well yes, you would think so. But the industry is complex and open to numerous exogenous shocks. Just as airlines are getting relief from the oil shock another cost issue is appearing. We are talking about labour.

Air France recently went through a four-day pilot walkout. This is just the beginning. Labour unions among the world's airlines want to claw back the concessions they gave up over the past few years. This year has seen 30 airlines go out of business, and British Airways' CEO said on on record that he expects to see another 30 airlines shut down.

This is where our counter intuitive argument starts. Given the shocks the industry has absorbed over the past few years, really continuously since 9/11, airlines are in no position to cut fares as fuel prices plummet. For the airline industry to remain a viable business, airfares cannot come down.

What are the primary factors that remain a threat? We have already mentioned labour costs. But clearly the biggest threat looming over the industry is the recession. In the United States, consumer sentiment has plummeted. A report from the US Commerce Department showed October retail sales tumbling 2.8 per cent, compared to economists' forecasts of a 2.4 per cent decline. Leading retailers such as JC Penney and Nordstrom both forecast fiscal fourth-quarter earnings below analysts' projections while posting fiscal third-quarter net income declines of more than 50 per cent. Clearly, we can expect to see airline travel slump. Airlines have cut capacity and may have to cut even more. On top of this, airlines are upside down on their fuel hedges.

So what about the one place where airlines seem to be doing reasonably well? Of course, we mean the GCC region. Well, matters there also are starting to stack against the industry. Travel is divided into two types, business and leisure. The current recession is clearly going to crimp both types.

Moreover, the Middle East's wealthy nations are being tapped by the developed economies for capital. British Prime Minister Gordon Brown travelled to the Gulf in an appeal to oil-rich states to pour money into stabilising the world financial system. It will be interesting to see where this leads.

The region has been impacted already by the Wall Street meltdown. On top of this the declining oil price is clearly adding to pressure on regional economic plans. Property prices have begun to fall, according to brokers and banks.

We should also expect negative growth in the region's airlines as the capacity may be outstripping demand. The airline industry suffers the same problems; some sooner and others later. But every airline is now under threat.

The author is a Partner at Innovation Analysis Group, a US-based firm providing information and consulting services in travel and aviation industries