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Flying into the unknown

By Martin Rivers November 2011

Despite their bold expansion plans, Gulf carriers are watching closely as European debt problems cloud the global economic outlook

An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen," wrote the late US educator Laurence Peter. His words ring as true today as ever before, with the world's brightest economic minds showing little aptitude for diagnosing - let alone remedying - the perfect storm of a European debt crisis, a stagnating US economy, and political upheaval across the Arab world.

And yet while meaningful forecasts elude the experts, the simplest of litmus tests is available to anyone by looking up, towards the skies, at the air transport sector - the lifeblood of the global economy.

Trade body the International Air Transport Association (IATA) gave an unequivocally bleak assessment last month, saying simply: "The industry has shifted gears downward." Global passenger numbers may be up against 2010, but year-on-year growth slowed from six per cent in July to 4.5 per cent in August. Worryingly, freight markets - often seen as a bellwether for wider economic prospects - were already declining, and their contraction accelerated to 3.8 per cent in August.

The Middle East appears to be faring better than the rest of the world, with passenger growth holding firm at 6.7 per cent and IATA sharply raising the region's 2011 profit forecast to $800 million - an eightfold increase on the sum bandied around at the height of the Arab Spring.

However, there are several factors unique to the wider Middle East and North Africa (MENA) region which could yet undo this progress. Having doubled in size to 11 per cent of global traffic over the past decade, the MENA aviation market is now entering an uneasy period of reflection, while state-backed carriers weigh up the consequences of indefinite economic uncertainty.

Their concerns fall into two spheres. First, the rapid expansion plans pursued by Gulf carriers must be re-assessed in light of the potential for sustained lower demand. Second, shifting expectations about political freedom - plus all the vagaries that flow from it - must be factored into business models.

Looking at growth projections, few would deny that Middle Eastern carriers lead the way when it comes to aspiration. Their enviable operating environments - which combine generous tax regimes, geographical advantage for connecting traffic, and low cost bases for labour - already deliver consistent double-digit annual growth. Over the next two decades Boeing expects to sell $390 billion-worth of aircraft to the region, which is equivalent to 150 per cent fleet expansion.

Emirates and Qatar Airways have by far the most ambitious plans, with both carriers continuing to place multi-billion dollar aircraft deals on the back of their already bulging order-books.

Not content with the 74 Airbus A380s being delivered between now and 2017, Emirates president Tim Clark has voiced his desire to buy yet more of the mammoth double-decker jets. He blames limited capacity at Dubai International Airport for staying his hand, and seems unperturbed by the prospect of a 300-plane fleet in a country of just three million people. If all goes according to plan, Emirates will be the world's largest operator of wide-body jets by 2015.

Qatar Airways lags slightly behind, taking delivery of its 100th aircraft in September compared to the 160 currently operated by Emirates. However, even in the midst of a renewed economic crisis, chief executive Akbar al Baker is promising another major order at this month's Dubai Airshow.

Elsewhere in the region orders are more subdued, but it is hard to find a MENA country that will not profess to be expanding its air infrastructure. Iraq and Kuwait, for example, both want to double airport capacity over the coming years - despite neither operating a profitable flag carrier. EgyptAir is navigating political turmoil, but chief executive Hussein Massoud still told The Gulf he expects to launch a low-cost subsidiary next year.

With such an appetite for expansion, MENA airline bosses will be watching the European debt crisis unfold with bated breath. History shows that whenever worldwide gross domestic product (GDP) growth slips below two per cent, the airline industry typically starts losing money.

"We will be perilously close to that level at least through 2012," warned IATA director general Tony Tyler. "The industry is brittle. Any shock has the potential to put us in the red."

Worse still, the prospect of a finance-driven recession emanating from Europe is just one storm cloud on the horizon. Should that scenario be averted, fuel prices seem likely to resume their upward trend - at best eroding profitability, and at worse paving the way for a separate oil-driven recession.

The industry's 2011 fuel bill is already forecast to reach $176 billion, or 30 per cent of costs. With airlines balancing on a razor-thin profit margin of $4.9 billion (0.8 per cent of revenue), sustained Brent Crude prices above the April peak of $127 per barrel could trigger a wave of bankruptcies. Still more frustratingly, the recent short-term dip below $100 was of scant benefit to many airlines due to their fuel hedging contracts.

Though petro-economies like Saudi Arabia and Kuwait protect their flag carriers with fuel subsidies, that fortune is also a double-edged sword. In both cases, state support has been decried as the root cause of operational inefficiency. Both airlines are now undergoing privatisation.

Leveraged as highly as they are on the health of the global economy, MENA airlines may look to their home markets for comfort. But with ongoing civil unrest across the region, the outlook is decidedly uncertain.

The immediate effect of the Arab Spring has without doubt been to ward off foreign holidaymakers. MENA countries have so far lost $7 billion in tourism revenue, according to the Arab Tourism Organisation, with visitor numbers in the first half of 2011 falling 11 per cent in the Middle East and 13 per cent in North Africa.

Egypt alone is expecting to lose $2.5 billion, with archaeological resorts in the Nile Valley being worst hit. And yet it is foreign leisure carriers like Thomas Cook Airlines which seem to have lost the most passengers. EgyptAir, by contrast, increasingly relies on transit traffic through Cairo International Airport - emulating the success of neighbouring hubs in the UAE - and has duly made swift progress in restoring capacity.

Other regional hotspots have seen equally mixed fortunes. Passenger traffic at Dubai's main hub rose nine per cent in the first half of 2011 after Dubai Airport's boss Paul Griffiths rightly predicted that the emirate's reputation as a safe haven will attract visitors. But in Lebanon, another mere observer to the Arab Spring, international visitor numbers fell 24 per cent between January and August.

Bahraini flag carrier Gulf Air had to postpone its break-even projection until 2013 after traffic slumped more than 25 per cent in the first five months of the year. But in Libya, a nation hit by far deadlier violence, the impact appears to be positive. Libyan Airlines and Afriqiyah Airways were both quickly removed from the EU's blacklist after the fall of Tripoli, opening up dozens of lucrative new routes for the state carriers.

While the Arab Spring's impact seems cruelly unbalanced, the worst-affected MENA airlines can draw consolation from a widespread belief that the eventual long-term benefits will outweigh the short-term pain.

One tour guide in Luxor put it better than any economist could, when he told Bloomberg in February: "We'll probably starve for a while, since tips from tourists are my family's only source of income. This may even go on for a whole year, but we don't care. It's for the better, and for the future of my baby girl." As soon as she reaps the benefits of political transparency, so too will the region's airlines.

Burdensome regulatory frameworks stifling the low-cost sector may be the first wall to come crashing down. It seems fair to presume, after all, that closer ties between MENA democracies will gradually result in liberalised air treaties, paving the way for an EU-style single aviation market.

But such idealism works the other way too. In Europe, aviation headlines are dominated by stories about politicians raising travel taxes, local residents opposing airport expansion, and unionised workers staging strikes. We can only speculate about whether wholesale democratisation of the Arab world could lead to similar scenes, in turn undermining many of the factors that give Gulf airlines their competitive edge.

Ultimately, as Laurence Peter succinctly noted, the global economic forces at play are simply too complex to decipher. No-one knows if the next big threat will come from Europe, from the price of oil, or from an unforeseen variable like terrorism. Nor can we be certain how the Arab Spring will unfold, nor whether the region's transformation will even be good news for MENA carriers.

Just about the only thing we can predict is that airlines will take an ever-more pragmatic approach to the myriad challenges facing them. A preference for leasing new, fuel-efficient aircraft will be one prudent strategy. Boeing's 787 Dreamliner, as well as the under-development Airbus A320neo and Boeing 737MAX, look to be the safest bets.

MENA carriers which have the financial clout to issue bonds, notably Emirates, will continue to take deliveries on-balance-sheet. But for most airlines, eight to 12-year operating leases will start to look increasingly attractive, delivering immediate fuel savings while preserving cash-flow.

Should the macroeconomic landscape remain dire, carriers will also consider re-marketing their dated aircraft as they receive newer models, rotating rather than expanding their fleets. Order cancellations are another option, but with most delivery slots several years away this would require a truly catastrophic downturn.

Despite the worrisome outlook, Etihad, one of Gulf's youngest airlines, still expects to post its first profit in 2012. "I always take advantage of a good crisis by shaking up the company," veteran chief executive James Hogan said last month. One way or another, he will get his crisis.

© The Gulf 2011