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Making money out of thin air has never been easy, argues Christian Wolmar. He sees more turbulence ahead for the airline business.

The aviation industry is a paradox. In one way it is a fantastic success. What other industry has achieved steady average annual growth since the end of the Second World War? Yet it has rarely, as a global business, been profitable. Recent years have been littered with the corpses of major companies such as PanAm, TWA, Swissair, Sabena and British Caledonian, to name just a few.

To explain this contradiction, let us first look at the positives. It is now four years since 9/11 and on the face of it recovery is almost complete. Traffic is surging ahead to record levels in many parts of the world. According to the International Civil Aviation Organisation (ICAO), passenger numbers jumped 14 per cent overall in 2004, with international traffic up a staggering 16 per cent. Freight, too, had a good year, rising just over 10 per cent.

The desert of Arizona is no longer a parking lot for unused aircraft as it was in the wake of the Twin Towers attack, and this growth appears to have continued, with a nine per cent rise in the early months of 2005.

However, the industry faces a number of challenges which threaten to disrupt its long term growth – terrorism, high oil prices and over supply as many new players, often low cost, enter the market.

The most buoyant market is Asia-Pacific where increases in passenger numbers are above average and many airlines are very profitable. The Far East and China are the highest growth areas but hot on their heels is the Gulf, where the arrival of Etihad Airways two years ago has boosted the number of routes and flights. Based in Abu Dhabi , Etihad was launched to rival the two existing airlines in the area, Gulf Air and Emirates.

During its brief existence, the newcomer has placed $8 billion of orders for 29 aircraft (24 Airbuses, five Boeings) and opened up routes at the rate of one a month during 2004, with the hope of having 70 by 2010.

The existing major players in the Gulf, Saudia, Emirates and Gulf Air are all flourishing, boosted by wealth created by increased oil revenues and the rapid development of the region. Saudia, the most long established of the region’s airlines, has one of the world’s most extensive networks and was boosted in the late 1990s and early 2000s by a large order of new aircraft – 61 planes, a mix of various types and makes from both Boeing and Airbus which brought its fleet up to the 139 mark.

The airline, which is still state owned although studies on its privatisation are being undertaken, achieved profitability in 2002 and in 2004 the airline carried over 15 million passengers, recording a 14 per cent rise in profits in 2004 to SR440 million ($117m). To boost its fleet for regional flights, the airline ordered 15 Embraer 170 aircraft from Brazil in a deal worth $400 million in April 2005.

Emirates, based in Dubai , which has become a heavily used hub with 120 carriers, already has 77 routes and has been profitable since its creation in 1985. It is planning to more than double its fleet in seven years, and serve more than 25 million customers within a decade. Dubai itself is seen as the key, as it offers year-round potential for tourism and commerce alike.

Meanwhile Gulf Air, the national airline of Bahrain , Oman and the UAE, carried a record 7.5 million passengers last year. Qatar Airways too has made a major impact and in June this year announced plans for 60 new Airbus A350 jets, 20 Boeing 777s and at least two A380 superjumbos.

So the Gulf is a boom area, but Etihad is entering a crowded market at a time when there are wider concerns about the future of the aviation business.

The traditional problem is that, while the industry has managed to attract demand, making money from flying planes has always proved much more difficult.

The profits of the successful airlines have been overshadowed by the situation in the US , where domestic operators which have not recovered from 9/11 are still being propped up by government payments and occasional Chapter 11 protection.

Overall figures for the US remain appalling: despite profits from low-cost carriers such as Southwest Airlines and JetBlue Airways, the industry as a whole sustained a staggering net loss of $9.2 billion last year.

The poor situation of American carriers has meant they have traditionally received protection in their markets from foreign competition, a source of great rancour among several European carriers who would like to fly freely within the US .

Indeed, such rigidities still characterise much of the business. They are the vestiges of a system that, for the first four decades after the Second World War, saw the industry characterised by heavy regulation and dominated by national carriers receiving large and often disguised subsidies from governments.

Manufacturing, too, was supported by state funding: in Europe, through direct financial backing for Airbus and in the US through more disguised yet nonetheless important support for research and development funded by military programmes.

In the past two decades, governments and intergovernmental organisations such as the European Commission have tried belatedly to end this drip feed of subsidy and open up the aviation market. The cosy bilateral arrangements protecting national carriers have gradually been undone amid pressure from the low-cost airlines and there is currently a fierce row brewing between the US and Europe over the extent and nature of the subsidies to their respective aircraft manufacturers.

The combined effect of all these different pressures is, says ICAO, that the world’s airlines last year had a net loss of 1.1 per cent of operating revenues, a total of $4.12 billion. Such losses, combined with the reluctance of many countries to see their airlines go broke (even now that there are few national carriers which have not been consolidated into bigger groupings), mean it has proved difficult to wean the industry off state support.

Although aviation managers are perennially optimistic, there are three great threats which could keep the industry in the red. The most obvious is terrorism. While increased security measures at airports in the wake of 9/11 make hijacking far less likely, other types of attack – such as the London bombings in July – inevitably have an impact on tourism, especially from the US, reducing passenger numbers in the crucial summer period when business travel dries up.

Secondly, there is the increased pressure to tackle global warming and, in particular, the environmental effects of greenhouse gases from aircraft. Environmentalists argue that it is hidden subsidies, such as non-taxation of aviation fuel and support for manufacturers, which have stimulated such rapid growth in a loss-making industry.

That view is gaining support in Brussels where the European Commission is looking at ways to ensure the sector pays fully for the environmental damage it causes. Member states are to be allowed to impose taxes on aviation fuel. Clearly this would be impractical unless there was a multilateral agreement, since aircraft would simply refuel in the cheapest place.

Emission trading schemes are in the offing, which would involve buying the right to create CO2 from other companies. However these are very complex and are seen by the environmental lobby as insufficient.

Lord Berkeley, president of the Aviation Environment Federation, calls them, “cheap get-out-of-jail tax avoidance gambits devised and promoted by the industry’s corporate affairs specialists [which] can be dismissed right now for the non-policy options they are”.

Instead, environmentalists want airlines to pay for the full environmental damage, which has been estimated at $63 per 1,000 passenger kilometres, which would put about $175 on a return flight between London and Rome . Such a tax, would face stern opposition from the airline industry, and would reduce the rise in demand but, arguably, still not entirely stop growth.

While such new tax regimes are unlikely to materialise for several years, there is a much more immediate threat, the soaring oil price. The annual reports of airlines are littered with expressions of concern about what will happen should the price remain high for long.

The total fuel bill rose from $44 billion in 2003 to $63 billion last year, and even at the low estimate of an average $43 per barrel in 2005,

it would be $76 billion, eating heavily into potential profits for all but the best-run carriers.

Predicting the cost of oil is, of course, the ultimate mugs’ game, but the high prices have meant fuel surcharges at a time when airlines would like to have profited from healthy load factors, making more money for their own bottom line.

Added to these threats is the impact on many established airlines of competition from the low-cost carriers which have revolutionised the business. In Europe and America , where they are best established, they have forced the major players to respond.

You only have to go to the British Airways website to see that it is sometimes possible to get a BA flight cheaper than the equivalent easyJet or Ryanair trip, especially if you take into account the fact that you are likely to land at a bigger and more convenient airport better served by public transport.

And the model is spreading. Look at Air Deccan in India, which less than two years after launch is carrying 1.4 million passengers a year, and operating 123 flights a day from 37 airports, many of which are rural hubs poorly connected by other carriers.

Several airlines have, however, found to their cost that the no-frills model does not on the whole work for long haul. Simon Calder, travel editor of The Independent newspaper in London explains: “There is much less scope for savings since the low-cost airlines reduce expenses by having very quick turnarounds and using cheaper airports out of town. Such savings are not really open for long-haul trips.”

Moreover, full price airlines have a kind of internal subsidy system. For three quarters of the year, business flyers at the front paying high fares subsidise the economy passengers at the back who pay very little. In the summer, this is reversed, with holidaymakers paying relatively high prices while the front of the plane is empty.

However, Calder reckons there may be a new type of low-cost airline once second-hand A380s start coming onto the market in a decade or so: “Given that the A380 will already be a third cheaper to run in its 555 passenger configuration, a low-cost airline may cram even more people in – and given the savings, the opportunities for much cheaper flights will be available.” He expects the cost of travel to plummet to and from rapidly growing, large countries like China and India .

It is mainly the low-cost model which is driving predictions of growth for the industry. In the British government’s Aviation White Paper, published in 2004, the mid-prediction is that by 2030 there will be around 500 million people travelling through UK airports annually, two and a half time today’s total – that is two return trips for each UK resident compared with just under one today.

The industry’s financial health is predicated on the achievement of such growth. Aircraft sales are booming and the A380 will greatly improve the economics of long haul.

So it seems as if the one certainty in an uncertain industry is that aviation will remain a paradox. If the predictions are met even in part, there will be more and more passengers taking to the air and a steady demand for aircraft.

Yet there will still be precious little money to be made from this most global of all businesses – and those who do make steady profits will be the carriers who adapt to the deregulated and more competitive environment of the new century.

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