American Shipper: A fuel-induced free fall?
By Eric Johnson
Middle East airlines expand as fuel prices soar, raising the specter of fuel subsidies. Either way, shippers seem set to suffer.
There's no beating around the bush anymore when it comes to the size and clout of the Middle East's air carriers. Not when Boeing openly admits that it allowed a 54-plane order from the chairman of the Emirates Group to skip past orders for 3,600 planes from other carriers. "A lot depends on who the customer is," Charlie Miller, a Boeing spokesman, told the New York Times in June. "Clearly, if you are Emirates, you deal with them differently."
The list of planes on order from the cadre of burgeoning Middle Eastern airlines is eye-popping, especially in the current climate of high fuel prices. Etihad, Saudi Arabian Airlines and Qatar Airways have all joined Emirates in ordering scores of planes over the next decade. All have ambitious cargo divisions.
But in these times of elevated fuel prices, the question that often goes wondered but unasked is whether Middle East carriers are getting any breaks when it comes to fuel.
The answer depends on which airline you're referring to, or to whom you ask.
Dubai-based Emirates, which includes cargo division Emirates SkyCargo, steadfastly maintains it receives no fuel subsidies.
In fact, the airline insists it operates in the most openly competitive market in the world, and that it is happy to take on all comers because it has a better operating model - using new and fuel-efficient planes, optimizing routes, and hubbing out of only one location.
While Emirates was seeded with start-up money from the Dubai government in the early 1980s, it has functioned as an independent commercial airline since.
But other airlines in the region - like Saudi, Qatar and Abu Dhabi-based Etihad - are more closely linked with their governments, and there are indications that some receive fuel subsidies from their governments.
The question then is whether there's anything wrong with Middle East airlines getting a leg up from fuel subsidies? And how is it affecting cargo airlines that are in direct competition with them, such as those in Asia?
The answers are few and far between. Airlines don't like talking about the internal workings of their competitors, and are generally loathe to discuss how any rival's advantage - perceived or real - might erode their competitiveness.
For instance, Hong Kong-based Cathay Pacific declined to comment to American Shipper on whether competitors receiving fuel subsidies affected its business, or even whether it perceived competitors to be receiving subsidies. Cathay did, however, explain in detail how it intended to combat the impact high fuel prices has on its own business.
Singapore Airlines declined an interview on the subject altogether, as did Etihad and Qatar.
John Strickland, a U.K.-based aviation consultant, said that while it's difficult to conclude once and for all whether airlines from oil-rich states receive fuel discounts, "they say their accounts are open for all to read," he said. "One thing is for sure. They benefit from a good geographic position and a strong network and brand proposition."
Emirates has been the most vocal among the Middle East airlines about the fact that it receives no subsidies, especially while most airlines are cursing their fuel bills.
"We operate in an environment in Dubai where it is survival of the fittest, with no government protection, subsidy, cheap fuel or restrictions on competitors," Tim Clark, president of Emirates, wrote in a July 16 editorial for the Financial Times.
The story may not be the same for Saudi Arabian Airlines, which is closely tied to the government, according to Andew Cowen, chief executive officer of privately owned Saudi Arabian domestic airline Sama.
"During June 2008 for example, Sama paid the equivalent of $178 per barrel for aviation fuel, yet the domestic economy fare cap has been unchanged for the last eight or nine years," Cowen said in a July report by the Middle East North Africa Financial Network, a news agency. "This situation is different to Saudi Airlines, who is benefiting from subsidized fuel rates that are one-seventh of what Sama fuel costs are on all their domestic routes."
The Middle East's other carriers have, in various reports, denied receiving subsidies. "We hedge fuel," Etihad CEO James Hogan told Gulf News in February. "We borrow money from financial markets. There are no free kicks."
A Different Scale. While outright fuel subsidies or giveaways may not exist, it's clear the Middle East airlines operate on a different scale. Think of it in terms of the September takeover of British soccer club Manchester City, which was bought by Abu Dhabi investors and promptly tried to spend astronomical sums for a handful of the world's best players - players who would have been out of the club's reach under its previous ownership.
The wealth in the region means fleet and service expansion is not necessarily bound by profits and revenue.
Both Etihad and Qatar have embarked on ambitious expansion plans in recent years, rivaling Emirates' growth in some ways, but without the steady foundation that Emirates laid in the 1980s. Both are expected to be profitable sometime after 2010, but that of course means they aren't profitable now. As a report on the Web site Middle East Aviation put it, they are "rewriting the textbook on profitless airline growth."
"Middle East governments are recycling profits derived from sovereign oil funds," Ned Laird, managing director of the Air Cargo Management Group, told American Shipper. "Now whether that means they're subsidizing their air carriers is in how you interpret it."
He said costs for facility use and ancillary charges are lower at Middle East airports, meaning that airlines based out of Dubai, Abu Dhabi or Qatar reap these benefits to a greater extent than European or Asian carriers. Likewise, a handful of huge new airports are being built in the Middle East but at lower costs to hometown airlines. Some oil rich nations are building airport projects without collecting all the underlying user fees from hometown carriers.
"That's a different scenario than what you see in Charles de Gaulle," Laird said. "If you want to build a new terminal at Charles de Gaulle, which Air France is doing, then Air France has to pay for it."
While such benefits may not amount to outright subsidies of Middle East airlines, it is "difficult to keep clear books that are fully transparent to determine the cost charged to hometown airlines versus European and Asian air carriers," Laird added.
"There's no evidence that Emirates receives a subsidy, and they've been clear about that in their public audits," Laird said. "At the same time specific arrangements between the Middle East airports and hometown airlines are confidential. But it's the same for American Airlines at Dallas Fort-Worth as it is for Etihad at Abu Dhabi."
What is certain is that Middle East airlines enjoy the advantage of having their hubs closer to where the majority of the global oil supply is located. However, refining capacity for aviation fuel in the Middle East does not fully meet current demand, with jet fuel and other finished oil products imported from Turkey, Iran, Saudi Arabia and India.
"In fact, the price of jet fuel is higher in the Middle East than the global posted price," Laird said. "In some cases, though, taxes and 'into plane' fees are significantly lower for hometown airlines."
Economic Development Tools. Strickland said, subsidies or not, the aggressive expansion of Middle East fleets is "very much linked to the development of their respective states. They are seen as tools of economic development and that happens to fit very nicely with the geography, which facilitates numerous traffic flows."
Forget subsidies, even the issue of whether Emirates, as well as most other airlines in the Middle East, benefit from relatively low costs on fuel is a point of contention. Some analysts, such as Laird, say airlines operating in the region enjoy low taxation on fuel, while others say fuel costs are inherently lower because the regional economies derive so much revenue from oil.
Emirates said that's simply not the case. "We certainly don't get a break on fuel," said Hiran Perera, senior vice president of freighters for Emirates SkyCargo. "Not even on my birthday."
In fact, Perera said that aviation fuel costs are higher in the Middle East than in other regions Emirates flies to, like Singapore or Amsterdam, because refining capacity isn't as high.
"I think our customers understand that certain quarters would like to make these allegations," he said. "But we've always had a transparent policy. People can see what we're paying for fuel."
Emirates' fuel surcharge is publicized on its Web site.
"But the fuel surcharge only contributes to increased costs, it doesn't fully cover the increased costs we incur," Perera said. "This is not just hurting us, but the whole industry. It's a tough environment. And there doesn't seem to be a let-up in the near term."
Perera also said that given the price of oil worldwide, Emirates' customers probably understand the airline's plight.
"Our customers understand," he said. "Everyone is facing high oil prices. Some don't want to accept it as much because the whole supply chain is under pressure. Costs have gone up all along the way. Things have moved to another dimension in terms of cost."
Pricing Out Shippers. Aside from whether certain airlines are getting breaks or not, there's the simple fundamental issue of whether the cost of crude is pricing shippers out of the air freight market.
"The way it's been mostly manifesting itself is in fuel surcharges," said Christopher Snelling, head of global supply chain policy for the U.K. Freight Transportation Association. "It's an emotional issue at the moment."
He said, "People are understanding because we've all seen our business impacted by the high costs of fuel."
However, Snelling said he sees no excessive rush to move to other transportation modes, at least not yet.
"Everyone's always looking at what they can migrate to a different mode," Snelling said. "It's always been expensive to move by air, but now that trend (of looking to other modes) has been exacerbated. Fuel costs are causing quite a pinch."
That's especially true for perishables and time-sensitive pharmaceuticals where going to other modes isn't an option. Producers of goods where ocean is an option, like high-end electronics, are likely to examine closely what absolutely needs to move by air, he said.
"People have long been looking at how they can make better use of sea," he said. "Now there's an impetus. It's not just air versus sea either. People are talking about short-sea shipping, rail versus road, using modes that are less expensive."
Meanwhile, 3PLs and forwarders will feel the squeeze, too.
"Shippers are looking at what their 3PLs are doing and putting pressure on rates," he said. "They're also looking at what operations they can bring back in-house, and that's a bit surprising."
And maybe a bit telling as to how deep the concern is over transportation fuel costs.
"If it becomes apparent (that high oil prices are here to stay), then that's the new paradigm," he said. "Long-term it could have a major impact, but we shouldn't overestimate things. It's important to remember that oil is still a small amount of the cost of transporting a small piece of fruit a great distance."
Air To Sea. Some shippers are looking to move items once thought of as clearly air freight to sea.
"Technology and medical products are increasingly migrating from air to ocean," said George Lebron, director of supply chain services for Illinois-based Fidelitone Logistics. "Most are looking to see if they can move perishables by container. But not all perishables can do that. The size of the shipment and the risk shippers are willing to take all come in to play. Reefer shipments are not fool-proof on the sea."
Lebron said that in the interim, shippers are "still moving by air when they have to and by sea when they can."
Perishables are particularly hard hit by rising air cargo rates.
"Perishables already pay a premium, anywhere from 150 to 300 percent of the base rate to get priority when moving their goods," he said. "Add in extra cost with fuel surcharges and it's hard to make it all work."
Lebron said the oil prices are, quite simply, "creating havoc" with supply chains.
"Our inflation is at a 17-year high, which shows that companies are passing along the cost," he said. "We're all going to have to look at alternatives and every company will have to look internally at what we can do."
Peter Lam, corporate director of air freight for Trans Global Logistics and a former cargo executive with Virgin Atlantic, agreed.
"It used to be that most electronics went by air," Lam said. "Now, however, more and more electronics are shipping via sea because of the high costs of air freight. Sea freight will be the standard that each factory will plan for. But, ultimately, this will always depend on the product and urgency. Sea-air is an option."
Lam said that in a cost pressurized environment such as the current one, a niche that will continue to provide air cargo carriers with revenue and yield are high-end items.
"High-end products of any kind because they don't need to ship in great bulk but more on a regular basis and (provide) better yield," he said.
Stability Over Price. On an optimistic note, Perera said he expects oil prices to stabilize, but that the key is to avoid volatility in prices.
"My personal view is that $140 to $150 is difficult to sustain long term," Perera said. "But $30 is also unrealistic. If oil settles at a price and changes 5 to 10 percent, we can manage that. It's the 30 to 40 percent volatility that's hard to manage.
"In the last two to three months, fuel costs have gone up 30 to 40 percent from an already high base. It's 70 to 80 percent higher than a year ago. High fuel prices is a problem in and of itself, but the volatility of the prices is even harder to manage. If a large part of your operating costs swings up and down by 20 to 30 percent, it's hard to manage."
Laird said it will take a year or two for shippers to be able to absorb the added costs of fuel into their supply chains, just as it did when fuel prices doubled in 1974, 1983, 1994 and 2002.
"The future of the industry is sustainable as increased jet fuel prices are passed along through the supply chain by shippers to consignees," Laird said.
Air shippers will have to shunt the extra cost down the supply chain all the way to consumers. Lam added that forwarders are already passing their costs along to shippers.
An even bigger problem for airlines truly dedicated to cargo is that, as fuel prices rise, freighters become a costlier endeavor compared to combo carriers. About 30 percent to 35 percent of Emirates' volume moves by freighter, the rest in the belly of passenger planes.
"Freighters are more burdensome because you have directionality of cargo, and also because freight is the only source of revenue on that flight," he said. "In combo, you have two streams. Of course, fuel impacts the passenger side as well, so you have the same problems. But fuel is a large proportion of our costs, and more so on freighters."
Somewhat presciently, given the way crude oil prices have come down since their extreme peaks in the height of summer, Perera cautioned that the summer isn't necessarily the best time to examine the air cargo industry and apply generalities.
"The overall global economic situation has resulted in a slowing down of trade and volume. But traditionally, this is the low season for freight, so we have to factor that in," he said. "In the long term, there has to be a correction and things will perk back up. One needs to take a longer view in these matters. But in the short term, you have to rationalize weaker, lower revenue routes. You have to take a different posture during these times, but still take advantage of future opportunities."
Profitable Routes. Perera gave an example of how Emirates recently pulled freighter service out of Johannesburg.
"We have three passenger flights a day to Johannesburg using 777s," he said. "That's 60 to 70 tons of belly capacity, and we also go to Capetown. So there is capacity to that market, but we took freighters out because we had to adjust to the market situation."
Emirates made similar moves to match capacity to demand by suspending freighter service to Nairobi and Khartoum.
Perera said the high cost of air fuel would ultimately sharpen the market.
"We are more exposed to fuel costs than sea freight," he said. "There will be some switch to sea freight and inefficient (air) capacity will leave the market. Some airlines will go out of business. That said, you can have the world's most efficient airplanes, but if fuel keeps going up, you cannot be profitable. Income streams will have to change. It's going to be painful, but we're better prepared to get through this than most."
Perera said the arrival later this year of more fuel-efficient freighters, like the Boeing 777 and 747-8, are timely. It would have been interesting to see them released a couple years back, as Emirates told the plane manufacturer it would have liked.
"These planes were designed when fuel was 80 cents a gallon," he said. "Now it's more than $4. We told Boeing the 777 freighter should come out at the end of 2006, but unfortunately they couldn't do it. We wish these 777s were here right now."
Cathay Pacific, as mentioned before, declined to comment on fuel issues related to other airlines. But the Hong Kong airline did say it is pressing ahead with initiatives aimed specifically at reducing fuel costs, such as substantial fleet modernization and investment in fuel-efficient aircraft such as the 777-300ER, of which it has ordered 30.
"The 777-300ER is expected to deliver 22 percent higher fuel efficiency per payload ton than a 747-400," the airline told American Shipper.
It has also ordered 10 747-8 freighters, which are 22 percent more fuel efficient than the 747-200F and 12 percent more than a 747-400F.
By 2012, Cathay will have also gradually retired the less fuel efficient 11 classic freighters in its fleet (four of which are operated by sister airline Dragonair). It's already retired two.
Cathay said it is also working with aviation organizations to straighten air paths to save fuel - for example, the Y1 route from Hong Kong to Europe over the Chinese Mainland helps save three to 10 minutes flying time per flight.
The use of lighter cargo containers, providing a savings of 250 kilograms per aircraft, is also being promoted. And Cathay also intends to wash its planes more, preventing dirt buildup and improving fuel efficiency.
Fuel Takes Toll. That said, Cathay reported a first half loss of $85 million in 2008, saying fuel costs were undermining the airline business.
The "relentless rise" of fuel costs in 2008, as the airline put it, contributed to profits dropping 125 percent compared to the $330 million it earned in the first half of 2007.
Cathay's group turnover from January through June rose 22.6 percent, to $5.4 billion, with modest increases in cargo revenue and volume. But that hasn't been enough to stave off the pain of higher fuel costs.
"Ever-increasing fuel prices completely undermined the airline's business, with the average into-plane fuel price increasing by 60 percent to $132 per barrel," Cathay said in a statement in August. "As a result the fuel bill rose from ($1.35 billion) to ($2.47 billion), a climb of 83 percent."
The airline said fuel as a percentage of total operating cost rose to 45.3 percent for the first half of 2008, compared to 33.6 percent during the same period last year. Cathay Chairman Christopher Pratt said from Hong Kong in August that customers will have to recognize rates and fares will rise.
"Global aviation is making a painful adjustment to the new reality of $100-plus oil," Pratt said. "Cathay Pacific is reducing other costs where it can but there is a limit to how much cost can be saved before quality and brand are compromised. It is thus inevitable that fares for passengers and shippers will have to rise to reflect the new cost of operation."
Lam, of Trans Global Logistics, said the options are limited for airlines in a high fuel price world.
"There is not much that the airlines can do except minimize their losses by reducing the number of scheduled cargo flights, holding back their expansion plans, cut or reduce service for routes that are not profitable and cut operating costs - like lay off workers," he said.
The International Air Transport Association is taking the threat of high fuel prices seriously. IATA warned that the industry will be forced deep into the red by the fuel crisis, predicting worldwide losses of more than $6 billion this year if oil remains at its current price. India's airlines alone are predicted to lose $2 billion this year, while Chinese long-haul and domestic markets both are experiencing downturns.
"Airlines are struggling for survival and massive changes are needed," Giovanni Bisignani, IATA's director-general, told its annual meeting in Istanbul in June.
"Governments must stop crazy taxation, change the rules of the game and fix the infrastructure."
As Nol van Fenema, publisher of Payload Asia magazine, said at the Air Cargo China conference in Shanghai in June: "If the price goes up further, we will see a bloodbath."
But does the portent of consistently high fuel prices mean a period of consolidation in the industry? Laird doesn't think so.
"Cargolux and operators like Air Hong Kong are relatively small companies compared to major European flag carriers or major passenger carriers like Etihad or Air France," he said. "There will be some outright failures. The idea of merging in the airline business, however, is fast losing its attractiveness, mostly due to labor issues."
And currency issues could further cloud the future.
"Oil is traded in dollars and the dollar has been clobbered, so the carriers in Asia and Europe are in a better situation with their stronger currencies," Laird said.
He said European and Asian airlines have seen fuel costs rise as much as 40 percent less than U.S. airlines because of the hard hit American currency.
"The picture would be very different if jet fuel was traded in yuan or euros and not just in dollars, which would take pressure off the decline in the dollar.