Up in the air

15 December 2009

October 2008

Airlines face a difficult choice: do they raise fares to combat spiralling costs or lower them to avoid losing passengers?

If a far-sighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville [Wright] down," wrote legendary investor Warren Buffett earlier this year. The so-called Sage of Omaha is harsh but right. Airlines have always been awful at making money and right now they are facing one of their severest predicaments with several having gone under this year.

It is a quandary which makes forecasting how they will adjust their pricing in the year ahead particularly difficult. Do carriers raise fares to combat spiralling costs or do they lower them to avoid losing passengers in a softening global economy?

The arithmetic of their cost problem is simple. In 1998, oil cost $10 (£5.60) a barrel. Last year it hit $70 (£39) and this year it more than doubled again, although it has since fallen below $100 (£56) at press time. There is also a hidden cost not always appreciated by outsiders. "Airlines are paying $20-$25 (£11-£14) for refining," says Rose Stratford, senior vice-president for industry relations with BCD Travel. "Three years ago, they were paying $5-$7 (£2.80- £3.90) per barrel."

What is happening to demand is harder to determine. Most reports indicate passenger growth has slowed considerably since the beginning of the year but there is growth nonetheless. British Airways did experience a fall in revenue passenger kilometres in the summer, but most of that was accounted for by a drop in leisure, not business, passengers.

"We are still seeing flat or modest growth," says Mike Hare, commercial director of Portman Travel and air working party chairman of the Guild of Travel Management Companies. "The market is holding but we are aware of employee reductions among our client base. September to November is the busiest quarter of the year. After that, we'll know what's going on."

Meanwhile, airlines are working on numerous strategies to deal with the challenges they face. One is to reduce supply. Airline schedule publisher OAG calculates there will be 59.7 million fewer seats available globally in October-December 2008 compared to the same quarter in 2007. That represents a 7 per cent drop in capacity. The US domestic market has been hit hardest with a one-third capacity cut, but even Asian airlines are cutting back and in Europe easyJet has announced a 4-6 per cent reduction.

Supply will also be affected by merger and collaboration mania. Delta Air Lines and Northwest Airlines are merging, while BA has announced a "joint business agreement" with American Airlines, and Continental Airlines and United Airlines are entering into "cooperation". Meanwhile, Lufthansa has started a takeover of SN Brussels Airlines.

There has also been involuntary contraction of supply through numerous airline failures. More can be expected. Credit rating agency Fitch predicts "multiple bankruptcies and liquidations" in 2009, as does the International Air Transport Association.

Whether emboldened by reduced supply or not, many traditional airlines filed higher published fares over the summer, the increases averaging around 5 per cent. Those were in addition to more fuel surcharges: BA now surcharges £218 per return flight over nine hours.

Fuel surcharges are never included in corporate deals, but they put more onus than ever on travel buyers to negotiate good corporate discounts on the base fare. It also means buyers are having to run faster than ever just to stand still. "We have improved our discounts because we have shown airlines we can meet commitments and move demand," says BT travel manager Jan Tucker-Jones. "However, because of the higher fares and surcharges I'm avoiding costs that would be even higher but I am not saving money off the bottom line."

Richard Tams, BA general manager for UK & global corporate sales, is well aware of the problem. "Inflationary pressures mean we need to maintain pricing to maintain profitability, but we understand that at some point price increases could start to choke demand," he says. Yet Tams believes businesses are failing to maximise their discounts by following the same sound principles which have helped BT. "Many companies still do not have as tight a travel policy as we would like," he says. "They would benefit from better travel management."

The good news is that this is an excellent time to start a more disciplined approach, with cost-conscious senior management anxious to control travel as never before. "All overseas travel at BT now requires management approval," says Tucker-Jones. "We have never done that before. The economy is working in favour of travel managers. I am getting told to do what I was suggesting 12 months ago."

Where policy is being applied harder is in ensuring trips only receive approval if a strong business case is made for them, and in stronger insistence on using preferred suppliers. Downgrading to economy is not usually an option, mainly because most companies have already taken this step, other than for long-haul trips, where TMCs are reporting little appetite to increase the discomfort of employees. Instead, says Hare, the compromise with price is being made by flying business class indirectly with a third-country airline, such as London-Delhi via Dubai. "You can halve the fare by adding two to three hours to the journey time," says Hare. Tucker-Jones confirms she is investigating this option, as well as looking at alternative carriers.

Yet the most important way to cut costs, Tucker-Jones believes, is simply for companies to spend more time analysing their own demand patterns and changes in their supplier base.

BCD Travel says there are several aspects of supplier programmes which companies need to re-examine in the light of fast-moving developments. The first is the impact of schedule changes. If a scheduled airline has pulled off a route or reduced frequency — for instance to a secondary city in the US — then that carrier may no longer be meeting travellers' needs adequately. If the airline withdraws from a key route, this could also jeopardise its corporate clients' volume or market share targets, making renegotiation a priority.

Another priority is to analyse the total price charged. Fuel surcharges vary from carrier to carrier and so too do charges for what are now considered "extras", such as checking in baggage. "You may find a 10 per cent discount works out closer to 7 per cent once all the extra charges are taken into account," says Stratford.

Finally, alliance agreements could be worth another look, especially if BA obtains the anti-trust immunity it has applied for to operate its proposed agreement with American (see box). BCD says carriers are becoming more serious about doing business through alliances, and Tams agrees they are likely to figure much more prominently in negotiations over the next year or two.

When this is taken into consideration, Hare is hopeful that air pricing won't accelerate too much more for corporate clients which buy their travel in a professional manner. He believes further capacity cuts will mainly remove the seats on scheduled carriers that end up as distressed inventory in the leisure market.

In other words, the cost of a non-refundable ticket for a break in New York might go up, but the fare paid by a business traveller on the same flight could remain relatively unscathed, especially as airlines stay keen to cement relations with reliable corporate clients.

"High-quality negotiations for high-yield business can be successful right now," says Hare.



OPEN SKIES - SUCCESS OR FAILURE?

A new era of transatlantic flying was promised by regulators when Open Skies came into force on 30 March. This liberalisation package allowed any US or EU-based airline to launch scheduled services between the US and the EU, subject to usual fitness constraints and the ability to secure airport slots.

Whether it has succeeded or failed is a moot point. Steve Ridgway, chief executive of Virgin Atlantic, told The Daily Telegraph it has failed. "Open Skies has not delivered the competitive market which was promised," he says.

"It hasn't led to reduced prices nor has it brought the flurry of extra services passengers had hoped for."

Virgin is not a disinterested commentator. Open Skies has given the airline added competition at Heathrow, and the reality is more complex than Ridgway suggests. On the question of extra services, five airlines have launched transatlantic routes at Heathrow for the first time. As a result, the number of departures from Heathrow to the US has risen from 76 per day to 94 per day.

However, departures from other UK airports have fallen. Many of the new Heathrow schedules have been transferred from Gatwick, while American Airlines has pulled off Stansted-New York and Continental Airlines has dropped Liverpool-New York. In addition, all three business class-only carriers - Eos, Silverjet and Maxjet - have folded.

Now transatlantic flying is starting to lose popularity at Heathrow too. United Airlines has already scrapped its post-Open Skies Denver route and Air France is reducing its Heathrow-Los Angeles service. Virgin and BA are also trimming New York frequencies. Across the UK as a whole, transatlantic departures are down 3.3 per cent so far this year, according to air traffic control service NATS.

On the question of fare increases, the loss of the business class-only carriers will not have helped, but Mike Hare, chairman of the Guild of Travel Management Companies' air working party, believes the new entrants at Heathrow have had a positive effect.

He says: "They have brought traditional competition to the transatlantic market, which is always good."

According to Richard Tams, BA general manager for UK & global corporate sales, it will take two years before the impact of Open Skies can be judged properly.



RIP

There have been well over two dozen airline failures so far this year, according to the International Air Transport Association. Among them are:

• Eos, Maxjet,
• Silverjet, ATA,
• Skybus, Aloha
• Frontier
• Zoom and Oasis Hong Kong Airlines

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