Airline industry faces turbulence ahead

If you wanted proof that these are tough times in the aviation sector, two pieces of news today have provided ample evidence.

Lufthansa, Germany's largest airline and the third-biggest in Europe by stock market value, reported an operating loss of €336m (£290m) for the first three months of the year.

That compared with a profit of €52m in the same period last year and was sharply higher than the €186m loss that had been pencilled-in by analysts.

The news came hours after shares of Jet Airways, India's oldest private airline and once its biggest, collapsed on reports that the stricken carrier's management is discussing a complete suspension of operations.

There is a common thread between the two.

Both the European and Indian aviation markets are struggling with over-capacity, with too many carriers chasing too few passengers, putting all of them under pressure to bring down their costs - just as jet fuel prices are starting to rise.

In Europe, this overcapacity contributed to the collapse of Swiss carrier SkyWork in August last year and the failures of Primera Air, the Danish budget airline and Cobalt Air, the Cypriot airline, in October last year.

Those collapses were followed by the demise of Lithuania-based Small Planet Airlines last November and Flybmi and Germania in February this year.

The latest failure, at the end of March, was the Icelandic budget carrier WOW air.

In India, the attrition rate has been somewhat lower, with no major casualties since the failure of entrepreneur Vijay Mallya's Kingfisher Airlines in 2012.

But state-owned Air India is heavily loss-making and is only being kept afloat by taxpayer bailouts while the three largest budget airlines, IndiGo (the market leader), Go Air and SpiceJet, have all been loss-making at various points during the last 12 months.

The latter came close to going under two years ago. At the end of last year, there were 14% more seats available in India than at the end of 2017.

Those woes now seem to be afflicting the aviation sector in the wider Asia-Pacific region, with carriers in Indonesia, Malaysia and Thailand all said to be at risk due to overcapacity.

There are now 60 budget airlines operating in Asia and only a handful, such as Indonesian carrier Lion Air, Philippines-based Cebu Pacific and AirAsia - the Malaysian-based carrier founded by Queens Park Rangers owner Tony Fernandes - are thought to be making any real money.

More failures seem likely.

Adding to the commercial pressures in both Europe and Asia has been the unexpected snap back in jet fuel prices.

Since hitting an intra-day low of $49.93 on Boxing Day last year, the price of a barrel of Brent crude has since rallied sharply, hitting a high for the year of $71.87 last Friday.

When your pricing is under pressure and the only way of bolstering profits is to try and contain costs, a rise of 40% in the price of one of your main overheads is going to hurt, particularly as the recovery in crude prices has been of such a magnitude that the airlines have been unable to fully hedge against it.

Ryanair, Europe's biggest airline by stock market value, said in May last year that it was 90% hedged for the year ahead at a price of $58 per barrel but warned that, even under those circumstances, its fuel bill would be at least €430m higher for the year.

More recently, it has said that, for the year ending March 2020, it is 90% hedged at $71 per barrel, so it still faces being caught out if crude prices rise much further above their current level.

Ryanair is one of the best-run carriers in Europe, if not the most efficient.

If it is finding life hard - and it has issued two profit warnings during the last eight months - it is a fair bet that others will be finding things tougher still.

Michael O'Leary, Ryanair's chief executive, said in February this year he feared some of his competitors were still too optimistic about current operating conditions.

He pointed out that, for the seats sold in advance so far for April to September this year, Ryanair's average fare was down 1% on the same period last year.

The cost factor was the main contributor to the loss reported today by Lufthansa.

The German carrier admitted today that it paid €202m more for jet fuel during the first three months of the year than in the same period in 2018.

Its fuel bill for the year as a whole is likely to be around €650m more than it was in 2018.

And, even though it managed to raise its sales by 3% to nearly €8bn during the quarter, the downward pressure on airfares caused by overcapacity meant this was not nearly enough to make up for higher fuel costs.

How will this play out?

In both Asia and Europe, the answer will have to be consolidation.

This has already happened in the United States, where just four airlines - Southwest Airlines, American Airlines, Delta Air Lines and United Airlines - account for 67.5% of the domestic market.

By comparison, in Europe, the five biggest airlines - Lufthansa, Ryanair, IAG (the owner of British Airways, Iberian and Aer Lingus), Air France-KLM and EasyJet - account for barely 45% of the total seats available.

The Asian market is similarly fragmented.

The question is whether that consolidation comes as a result of weaker players going to the wall, with other operators seeing a natural rise in their market share as a result, or via takeovers.

Yet the latter are notoriously difficult to complete, as shown by the on-off talks between IAG and Norwegian, which eventually collapsed when IAG walked away from making an offer for the low-cost long-haul operator in January this year.

Ironically, one of the biggest companies to have emerged from a previous bout of consolidation is Air France-KLM, which promises to be one of the more interesting European carriers to watch in coming months.

It was warned last July by French president Emmanuel Macron's government - at the time its biggest shareholder - to reform its working practices in the way that British Airways and Lufthansa have in the past.

Shortly afterwards, Air France-KLM took the previously unthinkable step of appointing a non-French chief executive, poaching Ben Smith from Air Canada.

More recently, though, the Dutch government has accumulated a 14% stake equivalent to that of Paris.

The move took both Air France-KLM and Paris by surprise and has generated ill-will within the business at a time when relations between the two carriers comprising it were already under strain.

KLM has outperformed Air France, ostensibly the senior partner, in nine out of the last 10 years and, last year, its operating profits were four times as much.

It remains to be seen whether Air France, with its notoriously poor labour relations, is capable of modernising its working practices.

In the meantime, airlines are likely to resort to more cost-cutting measures, such as walking away from bases - a tactic deployed in recent times by Ryanair, EasyJet and Wizzair.

As Mr O'Leary said in February: "Can we rule out further cuts [to capacity]?

"No, we can't.

"If oil prices keep rising, or if airfares keep falling, we would have to keep trimming capacity or keep switching capacity away from those [airports] that are unprofitable and reallocating more capacity to those that are profitable."