The links between the economy and the airline industry are well documented. It used to be that when the U.S. sneezed, Europe caught a cold. The interdependencies between the two economies are clear. The question today is which side of the Atlantic is most prone to a bad economic cold?
Today’s economic indicators and the relative performance of the airline industry are a bit perplexing. Real GDP remains below 2007 levels. Household incomes are at 1996 levels. Consumer confidence is an oxymoron as it recently hit the lowest non-recession reading in its history. While manufacturing activity showed strength in the early half of 2011, it is now close to levels suggesting contraction of the sector might be around the corner.
Despite the negative signals surrounding the economic indicators we tend to rely upon for direction of U.S. airline revenues, the industry is performing admirably - albeit still not covering its weighted average cost of capital. Maybe even incredibly given the economic headwinds it faces. At the heart of the industry’s performance are the positive results being realized from consolidation and a religious adherence to capacity discipline.
An example of the industry’s improved financial performance can be found by comparing financial results in 2008 and expected results in 2011. The U.S. airline industry yearns for its earnings to be relatively stable like those of corporate America; steady with minor ebbs and flows based on economic cycles.
Instead, the airline industry follows a boom and bust pattern – mostly bust. Look at 2008 and, as oil ran to $147 per barrel, the industry lost 17 cents on each dollar of revenue. In 2011, the industry is paying more for oil on average than in 2008, yet is expected to earn one penny for each dollar of revenue. This is a remarkable result particularly given the negative economic underpinnings, the price of crude oil and the price to refine a barrel of crude into jet fuel. Ancillary fees have helped most airlines, but are still secondary to consolidation and capacity discipline.
Truth is, without the high oil price trigger, it is unlikely the industry would have had the will or the necessary pressure to cut capacity. The U.S. airline industry has too often expanded too much during the up cycles and kept unprofitable capacity in place in the down cycles - all in the name of market share. The industry’s obsession with market share arguably created an airport system too big to be sustained as well. Today, 97 percent of domestic demand can be found at 40 percent of the commercial air service airports comprising the system.
That brings us to the airport side of the equation that, arguably, has more capacity than is necessary to satisfy profitable demand. Why should the infrastructure for a consolidating industry not consolidate itself around the strongest airport markets serving any number of regions within the U.S. air transportation grid? Are all of the airport markets enveloped by larger airport market catchment areas necessary?
Over the past three decades, aircraft technologies, airline marketing strategies, and one could even say, airport strategies (think Los Angeles with five airports serving one metropolitan area) have all been designed in some way to fragment markets. Some argue this creates “healthy” competition, but I think it actually is destructive. Look at it this way, current fuel prices caused airlines to cut capacity and, in some cases, retrench in certain markets. Those same fuel prices – which are probably never returning to previous levels – are why examining what airport capacity can be removed from the system without disenfranchising significant amounts of the population is necessary.
2012 begins a period in which the U.S. air service map begins to redraw itself. There is no way the government will do the right thing and study the nuances of airline service and determine whether one airport is more profitable, or more ”essential,” than another. Politics will not allow it. The market, though, is already at work determining the survivors. This is not a process that will happen in one year; I believe the 2012–2020 period will be a shakeout of profitable and unprofitable airport markets.
Some will say a smaller regional airline network and fewer markets served will have a negative impact on overall demand. I disagree. True demand will find its way into the air transportation system even if the highway serves as the first access point. Think back to the days when iconic airline names were lost and hubs were closed. Are those hubs like Atlanta and New York smaller today? No. Is St. Louis? Yes, because it does not have the same economic vitality as an Atlanta. In most markets new capacity quickly replaced capacity lost. Along the same lines, small market capacity will find its way to larger regional markets within a reasonable drive.
On the other hand, there are a significant number of markets that realized less traffic in 2010 than in 1990. There are a number of factors why, including the location within the catchment area of a competing low-cost carriers and the fact jet service was replaced with regional carrier service. This trend will continue as long as the price of jet fuel remains at the equivalent of $120 per barrel. Don’t forget, Delta announced it was looking to pull out of 24 markets mid-2010. They won’t be alone in 2012 – 2020 period.
Airport markets with relatively strong local economics and demographics will survive the war of attrition. Markets with three or more choices of a larger regional airport with a more diverse menu of services within a 2 hour drive may find it hard to keep service. A look at any airport map shows there is too much duplication of service in the Northeast, Upper Midwest and parts of the Southeast.
The regional airport of tomorrow will offer a mix of networks, low-cost carriers, as well as some “traditional” regional service. It will not be dependent on the 50 seat jet. It will also have competition from carriers representing each of the three global alliances. It may have service from a carrier like Allegiant, but if its traffic makeup is comprised of a majority of ultra-low cost service, it is unlikely to be the airport of choice within a region.
Most airlines are expected to report a profit in 2012 because they have consolidated and adhered to capacity constraints. But there is still more to do. Today’s industry only cares about profitable flying, not flying for the sake of pretending to be something for everyone. The regional airport of tomorrow, though, will need to be everything to everyone.
My outlook is not all doom and gloom. I see it as the next phase of restructuring being undertaken by an industry badly in need of a fix. The industry is inextricably tied to its infrastructure and what has become a necessity for airlines might soon become reality for airports. That is to regionalize, the airport vernacular for consolidate.