In order to discuss the implications of this move by Delta, we first need to acknowledge the main drivers to the deal. If we exclude short-term shifts and look only at mid-term macro developments, we can observe the following:

a) Heating oil crack spreads, a proxy for jet fuel cracks, have tripled compared to 2009 and now stand at about $30 per barrel. Volatility from Q1 2007 to Q1 2012 has been very high, with spreads fluctuating 40-50% on average, from one quarter to the next. This has subsided over the last year and it seems that spreads will remain at current levels for the rest of 2012. The main driver for high spreads is the much greater overseas demand for distilled fuel, compared to domestic US.

b) Refinery capacity in the US has been shrinking, with some refineries becoming inactive and many being on sale since early 2011. Whereas in 2009-10, a similar mid-sized refinery with 185,000bpd capacity would be priced at $500-600M, refinery prices are now depressed. From Conoco’s perspective, which has been looking to sell its Pennsylvania facility since 2011 and was about to close it down, a $150M price tag is better than nothing. Delta acknowledged the opportunity and acted quickly.

c) Similarly, with greater overseas demand and shrinking domestic US supply, crack spreads should remain at historic highs for the foreseeable future.

Delta’s fuel managing team is experienced in similar situations, as this is not the first time the airline has been proactive in managing costs: Going into 2011 the crude oil WTI-Brent spread increased substantially. With WTI been the benchmark for US airlines in setting fuel hedging contracts, it was no longer considered reliable. Delta was among the first to shift its fuel hedging contracts to Brent, in March 2011.

We could be quick to judge Delta’s move as both proactive and positive, if this were an investment. But it is not an investment, as the airline mentioned it was driven to buy the refinery by the inability to hedge against jet fuel cracks.

Nonetheless, buying the Conoco refinery does not remove risk, unlike hedging. By acquiring this facility, Delta essentially goes long the jet fuel crack spread. They are betting that spreads will either remain at current levels or keep on rising. So, effectively, Delta is adding risk. Should spreads decline, while there is still refinery overcapacity in the US, Delta will incur much lower returns and possibly a write-down on its refinery assets. If the end objective is to manage risk, then Delta would have been better off going to the derivatives market (by selling an underlying heating oil / jet fuel futures contract and buying an underlying crude oil contract, so as to hedge against jet fuel cracks).

As with everything else in the airline industry, we should not expect this deal to be a first of many. Even if refinery valuations are at an all time low and jet fuel crack spreads at an all time high, airlines will not rush to buy similar assets. Delta’s competitors will adopt a “wait-and-see” approach. When Air France merged with KLM in 2003, industry experts were quick to predict a surge in airline mergers. But it was not until 2007 when the industry witnessed a second mega- merger; that between Delta and Northwest.

Today IAG announced its 2011 annual results, characterised by a doubling of operating profits from €225 Million to €485 Million. However, we expect the tough economic climate to negatively impact all European airlines in 2012.

This year European airline consolidation will intensify, with airline groups actively looking for opportunities to enhance their operations and bring economies of scale. The driver for consolidation is the worsening European economy, rising fuel prices, low cost carrier growth and the lack of financing for organic growth. In these situations, large network carriers tend to benefit. Among these, IAG is in a position, both financially and strategically, to take advantage of economic conditions and acquire niche players at bargain prices. If we look at the two companies in play, Aer Lingus and TAP, and exclude BMI which is an opportunistic acquisition, TAP seems to offer more network synergies with BA and Iberia. Aer Lingus is an airline in transition and apart from being part of the oneworld alliance, it is not an attractive target.

In late 2011 IAG released some early performance indicators on the success of the BA-Iberia merger and seems to be on target, even though it has chosen to set itself very low targets to begin with. Shareholder value cannot be realised at such a short period following a merger. In the case of the 2003 AF-KLM merger, it took the combined entity a number of years to produce any meaningful synergies. In cross-border M&A and more specifically in the airline industry, it is normal to have unexpected delays in synergy realisation, due to labour disputes, Government intervention and change resistance. Nonetheless, we have to put everything into perspective. It is far easier for IAG to realise benefits from an acquisition of a much smaller player, like TAP, than achieve full synergies from a merger of equals.

When discussing airlines, we have to mention the effect of rising jet fuel prices, which are indeed a systemic risk in the airline market. Since the year 2000, jet fuel prices have tripled, while fuel costs have grown from 15% to 30% of total operating costs. A steep increase in any given year will, with near certainty, have a major impact on airline profitability, whatever the hedge coverage. Particularly for IAG, fuel hedging is expected to be around 50% this year, compared to 70% last year.

Few airlines get it right when it comes to fuel hedging and IAG is not an exception. Fuel hedging is a practice that adds some level of certainty in an unknown and highly volatile variable, but overall it has proven an unreliable risk hedging tool in itself. This is why airlines rely more on fuel surcharges, as opposed to hedging policies, in an attempt to pass on the costs to their customers.

To conclude, larger airlines like IAG have more firepower to withstand sharp periodic fuel price increases, like the one in the first half of 2008. Prolonged increases however, such as the one witnessed throughout the last decade, require more fundamental changes in airline business models.

Today IAG announced its 2011 annual results, characterised by a doubling of operating profits from €225 Million to €485 Million. However, we expect the tough economic climate to negatively impact all European airlines in 2012.

This year European airline consolidation will intensify, with airline groups actively looking for opportunities to enhance their operations and bring economies of scale. The driver for consolidation is the worsening European economy, rising fuel prices, low cost carrier growth and the lack of financing for organic growth. In these situations, large network carriers tend to benefit. Among these, IAG is in a position, both financially and strategically, to take advantage of economic conditions and acquire niche players at bargain prices. If we look at the two companies in play, Aer Lingus and TAP, and exclude BMI which is an opportunistic acquisition, TAP seems to offer more network synergies with BA and Iberia. Aer Lingus is an airline in transition and apart from being part of the oneworld alliance, it is not an attractive target.

In late 2011 IAG released some early performance indicators on the success of the BA-Iberia merger and seems to be on target, even though it has chosen to set itself very low targets to begin with. Shareholder value cannot be realised at such a short period following a merger. In the case of the 2003 AF-KLM merger, it took the combined entity a number of years to produce any meaningful synergies. In cross-border M&A and more specifically in the airline industry, it is normal to have unexpected delays in synergy realisation, due to labour disputes, Government intervention and change resistance. Nonetheless, we have to put everything into perspective. It is far easier for IAG to realise benefits from an acquisition of a much smaller player, like TAP, than achieve full synergies from a merger of equals.

When discussing airlines, we have to mention the effect of rising jet fuel prices, which are indeed a systemic risk in the airline market. Since the year 2000, jet fuel prices have tripled, while fuel costs have grown from 15% to 30% of total operating costs. A steep increase in any given year will, with near certainty, have a major impact on airline profitability, whatever the hedge coverage. Particularly for IAG, fuel hedging is expected to be around 50% this year, compared to 70% last year.

Few airlines get it right when it comes to fuel hedging and IAG is not an exception. Fuel hedging is a practice that adds some level of certainty in an unknown and highly volatile variable, but overall it has proven an unreliable risk hedging tool in itself. This is why airlines rely more on fuel surcharges, as opposed to hedging policies, in an attempt to pass on the costs to their customers.

To conclude, larger airlines like IAG have more firepower to withstand sharp periodic fuel price increases, like the one in the first half of 2008. Prolonged increases however, such as the one witnessed throughout the last decade, require more fundamental changes in airline business models.

Last week Air France-KLM announced one of the bigger aircraft orders this year, with options for up to 110 long-haul aircraft split evenly between the Airbus A350XWB and the Boeing 787. Apart from the apparent Boeing success in securing orders for the 787 from a French carrier, this deal is clearly not an indication of European traffic growth. Combined with American Airlines’ July order for 460 single aisle aircraft, also evenly split between Airbus and Boeing, it is rather an indication of fleet modernisation efforts in both, Western Europe and North America. Simply put, most Western airlines are in need of modernisation, even though their respective markets will see little growth over the next few years. Comparing that to Air Asia’s Paris Air Show order for 200 A320s; an airline clearly geared for growth.

This fact leads to the next big announcement from Airbus, on Monday this week, of their new 20 year forecast for 2011-2030. The forecast is slightly less optimistic than Boeing, in terms of global aircraft deliveries, which according to Airbus will be 28,000 instead of 31,500 expected by its rival. Another, unsurprising, point of difference between the two: Airbus expects double the number of deliveries in the “Very Large” aircraft segment, backing its A380 programme. Nonetheless, the most important take from this forecast is the constrained optimism over economic growth figures. Airbus expects a 3-4 per cent world GDP growth in 2012, with a corresponding air traffic growth of 7 per cent. Once again, so called “mature economies” are the ones which keep the global airline industry from double digit growth. Emerging economies will see a GDP growth of 6 per cent and air traffic growth of 10 per cent in 2012, according to the manufacturer.

In turn, the above announcement made way to yesterday’s forecast from the International Air Transport Association (IATA), which once again revised its full year global airline net profit estimates, from $4.0 to $6.9 billion, on the back of better results from European carriers.

This is not the first time IATA makes such generous revisions to its forecasts. In fact, these forecasts are good indicators of market sentiment, but rather irrelevant from a macro-perspective. In reality the $4 - $7 billion profit range can be translated into a 50-100 basis point difference in net margins for the industry. The industry will, most certainly, enjoy margins of between 0.5-1.5 per cent this year.

Let’s ignore the actual numbers and rather concentrate on the trends. In 2010 airlines saw a rebound from a depressed 2009 air traffic level, while 2011 was a year of positive yet modest results, as European and US airlines witnessed the positive effects of restructuring and negative effects of stagnant GDP, rising fuel prices and political turmoil in the Middle East. Next year airlines will struggle to break-even, on the back of ever increasing jet fuel prices and fears of a contagious European economic crisis.

That is true for European airlines but not for their Asian counterparts. In fact European airlines may see a sovereign default giving way to a new recession of European economies, where the only positive outcome will be a devalued Euro currency driving inbound tourism.

Perhaps it is not surprising then that Lufthansa issued pessimistic earnings guidance yesterday, even though IATA sees better results from Europe. Lufthansa is one of the few European carriers with aggressive expansion plans; indeed plans that were initiated a bit too early. They are in the position where they need to rid of subsidiaries that provide little benefit (see BMI) and further integrate others (see Austrian, Swiss).

To summarise, announcements over the past week seem contradictory, in terms of the state of the industry today. Particularly IATA’s upward revised forecast creates a positive market sentiment. But their forecast is irrelevant from a macro-perspective. Everything is pointing towards a difficult 2012 for airlines.

There were two related announcements made yesterday by American Airlines. The first one was the biggest order for narrowbody aircraft ever made by a single carrier, with 460 orders split equally between the A320 and B737. This announcement cheered up the investor community, with both Airbus and Boeing share prices registering marginal increases. The second was AMR’s results for Q2 2011, which were disappointing to say the least. Clearly the two news stories are the two sides of the same coin; American Airlines is in need of restructuring, as it holds some of the industry’s worst first places:

• The only US major that posted losses last year ($470M)
• The only US major expected to post a loss this year, after a disappointing Q2 with losses of $286M
• The airline with one of the oldest fleets globally, with an average age of 15 years
• One of the two US airlines that have not (yet) gone through a consolidation process

In my view this order has been long overdue, as the airline is facing ever increasing fuel and maintenance costs, partly as a result of the upward trend in fuel prices and partly because of its older and more inefficient aircraft. Looking at AA’s fleet profile, it is also evident that the new orders will not be used to expand operations, but rather to replace its older narrowbody fleet. In fact, AA’s fleet size will remain roughly at the same levels over the 10-year modernisation period, as seen in the graph below.

It can be argued that neither the decision to modernise, nor the decision to split the order in four (130 A320, 130 A320neo, 100 B737-8, 100 re-engined B737), were options to AA. These were decisions forced upon them, by the prospect of missing out on vital aircraft delivery slots available at capacity constrained manufacturers.

However, the decision did have a positive externality, as it also forced the hand of Boeing to choose between a new engine and a completely new airframe to replace the B737. Ever since Airbus announced its intent to bring to market the re-engined A320neo (December 2010), Boeing has been sitting in the sidelines procrastinating about the best strategy going forward. In the same period, EADS has registered a 43% growth in its share price, while Boeing’s shares rose only by 9%. Obviously, the investor community is not as patient as Boeing’s board of directors, when it comes to the roll out of game changing strategies; particularly in a (soon to end) duopoly market.

The decision to offer AA a re-engined option, nonetheless, is a short-term measure to avoid disaster, by partially stopping Airbus from winning the ultimate prize in the aircraft manufacturing world; that is stealing someone else’s customer and convincing them to replace their existing fleet with yours. More than anything, Boeing has to act fast and decide in favour of a completely new airframe now. The alternative is to drop prices and follow Airbus in every sales pitch they are doing with old Boeing customers.

The following are my thoughts regarding the upcoming Paris Air Show at Le Bourget. Apart from my opinion regarding the success of the Neo programme, I am going against all consulting "rules" in trying to predict orders so close to an event. Indeed consultants and analysts typically create forecasts well in advance and rightly so in some cases (see here http://reut.rs/dSOZ3R).

So here it goes...

B737 replacement

Following yesterday’s announcement (16th June) of the two major orders from Cebu Pacific and GoAir, the heat is on in the Airbus-Boeing order feud at the Paris Air Show. The latest orders for the new A320neo take the number of firm orders for the type to 434 and the number of operators, with plans to introduce it, to 7. This is an important announcement for Airbus, leading up to the Paris Air Show, but definitely not a surprise nor a major breakthrough for the re-engined A320.

Four of the seven operators are low cost airlines with aggressive growth plans and with an existing all-Airbus fleet; their decision is driven by their business models, where economies of scale through fleet commonality would have excluded them from ordering any new B737 variant.

In addition, ILFC that has ordered 100 A320neo, is a major lessor with a clear objective to stock any aircraft required by their customers. Their decision to order the Neo is not the result of a major fleet assessment; they will also order the new B737 variant as soon as it is announced.

The only airlines with Neo orders and a relatively diversified fleet are legacy carriers Lufthansa and Brazilian TAM. Nonetheless, both of them have showed preference for Airbus short-haul aircraft in the past. Lufthansa operates mainly A320s and some B737 Classics, while TAM operates only A320s short-haul.

As a conclusion I do not view these latest orders as either surprising or a major win for Airbus. As the Neo enters operations, older A320 variants will be discontinued, thereby offering no alternatives to airlines that operate Airbus fleets short-haul and have ambitious growth plans. However, if airlines that have yet to make announcements, like Scandinavian Airlines, China Southern or BA-Iberia were to make firm orders for the type, it would be a major blow to Boeing.

Should Boeing continue to delay its announcement for either a re-engined B737 or a completely new aircraft, only then will we see the first airlines shifting to Airbus, to satisfy medium-term growth plans. However the timeline for a Boeing announcement is not as tight as it may seem; I expect a decision by end of the year and one that confirms reports about a complete replacement to the B737, rather than a re-engined model. Getting it right to begin with is far more important than making rushed decisions and changing aircraft specifications later; as witnessed by the U-turn on the A350-1000 (http://bit.ly/llRaUU).

Expected order numbers and airlines that may make headlines

Based on market sentiment, the Paris Air Show is due to follow the early recovery signs of Farnborough 2010 (237 Airbus/Boeing orders), though the number of orders will most likely trail behind Farnborough 2008 (480). I expect Airbus to win this battle, as they’ve done in recent years, with approximately 200 orders, for a total between the two manufacturers of 300-350. Airbus should dominate narrowbody orders, while Boeing aims to further establish itself in the widebody market.

Airlines that could have an impact this year are the Chinese carriers, particularly China Southern, Air France-KLM, BA-Iberia (widebodies), Scandinavian Airlines, Monarch, Qatar Airways and Air Canada. Unlike past events, I expect more active role from the European carriers that have been going through phases of consolidation and network restructuring. Their orders will both serve the purpose of replacing older fleets and allowing further expansion.

I will be here to discuss the accuracy of my predictions next week...

On financial results...

The Emirates press release today (May 10th), with details on their financial results, is in line with my expectations, following outstanding performance during the first half of their financial year and current operational challenges, with higher oil prices and the Middle East political crisis. Their results are also in line with a return to profitability for most major carriers globally, following poor performance in the period 2008-2010. Last year, Emirates was in a position to benefit from low oil prices, higher yields, increase in consumer confidence and record growth in cargo traffic. Additionally it is in a very strong cash position to further grow capacity, by an average of 10-12 long-haul aircraft annually, allowing it to increase frequencies on existing routes and implement ambitious growth plans in the Americas and South Asia.

There is no doubt that the current financial year will be challenging for the airline industry as a whole, including Emirates. But let's put everything into perspective. Last year’s record results were, more than anything, a return to normality after two years of heavy losses during the global economic recession. Airlines are still susceptible to global economic and political events and operate in a heavily regulated market characterised by overcapacity. Airlines with primarily international route networks, like Emirates, are more affected by global events. In addition, further capacity growth and the introduction of new untested routes will impact their profitability.

As such I do not expect them to repeat last year’s performance during the current financial year. Their market share and dominance in routes connecting Asia with North America and Europe go undisputed, but I expect their operating margins to struggle to remain at the same level.

On fuel surcharges...

Just a day before their financial results press release, Emirates also announced its intention to eliminate fuel surcharges. This is, perhaps, nothing more than a PR stunt. The steep drop in oil prices, following developments in Pakistan, is by no means an indication of a long-term trend. In fact, I believe that in the medium- to long-term, oil prices will keep rising, forcing many airlines to reintroduce or increase fuel surcharges. In this case Emirates stepped in first to make an announcement, without concrete data on what the average oil price will be for the foreseeable future. The announcement also comes just 3 weeks after Emirates introduced a fuel surcharge across its network.  I do not believe that the global economic outlook changed so dramatically over the last 3 weeks to warrant two contradictory moves by Emirates.

Nonetheless, this move will bring additional traffic over the summer period, boosting their load factors further and can also be interpreted as a response to a prolonged political crisis in the wider region. Even if oil prices return to higher levels though, Emirates has a strong cash position to absorb costs, rather than pass these on to their customers.

On fuel hedging...

The Emirates fuel hedging strategy has served them well over the last decade, with the single exception of 2009 when they bet that oil prices were going to continue growing and signed large contracts. As opposed to other airlines, they do not have a strict hedging policy, instead adopting a “wait-and-see” approach. This is, perhaps, the best approach at this point in time.

On airline industry woes and Emirates positioning...

One of the hindrances to the airline’s growth this year is volatility in oil prices. But that's not the end of it. The airline industry is also characterized by chronic illnesses, such as overcapacity and strict regulations, forbidding foreign investments and uncontrolled growth in international markets. As an example, a restrictive bilateral agreement between the UAE and Canada is an obstacle for Emirates’ growth plans in that country. Additional hindrances are the political unrest in the Middle East, which everyone predicted as a short-term issue just three months ago, uncertainty over the future of Western economies and overall industry consolidation. Emirates is now having to compete against large airline groups, such as the Lufthansa Group, Air France-KLM, BA-Iberia, United-Continental and Delta-Northwest that have completed big mergers adding economies of scale in their operations. The codesharing agreements Emirates signed with JetBlue in New York and Virgin America in San Francisco are a sign of things to come, as Emirates partners with more airlines to counter competitor actions. A future merger or acquisition is not out of the cards for the airline either.

On the possibility of an IPO...

With regards to Emirates launching an IPO, I do not see it as an ideal move in the next couple of years, at least until investors feel more confident over the future outlook of the airline industry. Political instability in the Middle East, doubts over economic growth in Europe/North America and fluctuating oil prices are all causes of concern. Their strong financial results and cash pile to fund medium-term growth are not adding pressure for an IPO soon.

Just two days ago (April 13), the Aviation Industry Corporation of China (AVIC) announced its plans to invest over $1.5 Billion in R&D for a new engine to power the Chinese C919 narrowbody.

This is surely a threat, but not a surprise, for both CFM and Pratt & Whitney, that were aiming to be the main engine suppliers for the aircraft. A Chinese built engine could, in theory, enter the market by 2020 and be a real contender both domestically and in international markets.

But is that a step taken too far for the, already, overly ambitious Chinese? Clearly China has an abundance of labour and capital to throw on any development project, no matter how big or small. But what it is lacking, is technology; a vital element missing in the otherwise bounderless ambitions of domestic manufacturers. The recent flurry of JVs between Western and Chinese suppliers suggest otherwise: it is only a matter of time until the Chinese gain the technological know-how.

In a recent survey of US businesses with operations in China, most highlighted unclear laws, bureaucracy and IPR infringment as major concerns. Yet an overwhelming 78% of businesses were either "profitable" or "very profitable", in their Chinese ventures in 2010. This essentially means that China has the upper hand, particularly as Western economies are susceptible to negative or very low growth rates. For many Western businesses China is the only source of revenue growth and profitability and they are willing to forego some of their IPR, in return for signing lucrative contracts, tapping into a largely virgin market. It is easy to see why: by 2029, China will account for almost half of all narrowbody aircraft deliveries in Asia and 12% of all deliveries worldwide. By any standards, that is a lot of potential business for Western suppliers.

Now, is the inevitable transfer of technological know-how going to bring immediate international success for Chinese aircraft and engine manufacturers? I doubt it. So long as Western suppliers maintain their own investment in R&D, Chinese success will be limited to China. After all, technology and innovation are the only remaining comparative advantages of Western suppliers in international markets.

Two weeks ago I was invited to speak at the 2011 Avionics & Defence Electronics Europe conference in Munich. I was particularly impressed with the number of different workshops and presentations running throughout the two event days, but not so much with the weather in Munich.

My presentation focused on forecasts and key trends across commercial avionics markets (air transport, business and general aviation). Here is a summary of the top 5 trends in the industry right now:

1. Stable growth in spending, with market picking up post-2014. At that point we will see the impact of new commercial platforms, with production (hopefully) at full capacity. Nonetheless it is the retrofit market that will grow faster than both forward fit and parts&services.

2. Surveillance and Communications are the two most promising segments for newcomers and incumbents alike. With revenue potential in 2010-2020 of $47.8Bn and $13.9Bn respectively, low-to-medium market concentration and high growth rates, they offer most opportunities to suppliers.

3. Rockwell Collins and Garmin are the two companies to look out for. They have both made their mark in the business (RC) and GA (Garmin) markets and have agressive expansion plans for the future. Surely a situation that keeps Honeywell alert...

4. Smaller avionics related markets, such as Flight data management and Automatic Test Equipment (ATE), are in the radar of avionics OEMs. We expect more consolidation.

5. Outsourcing and Offshoring are now viable alternatives for OEMs. With Asian engineering firms enhancing their capabilities and technological know how, while keeping their labour costs down, outsourcing core functions such as product design and prototyping will be an option for Western OEMs.

A press release from the conference, with some additional details, is available here. For a full presentation just contact me on diogenis.papiomytis@frost.com.

A beautiful day in London today; it seems the spring is here, following months of rain and cold weather. Also the day I decided to post my first ever blog entry on frost.com, so all the better!

Let me introduce myself. My name is Dio Papiomytis and I'm a Principal Consultant in Frost & Sullivan's Aerospace & Defence department, heading our commercial aviation consulting projects in Europe. I have worked for Frost & Sullivan for the last 6 years, with a one year break whilst I tried my luck in academia as a lecturer in aviation studies.

I will use this blog as an opportunity to talk about our research in commercial aviation markets and in particular my areas of expertise, which include Avionics, Cabin Interiors and MRO. Will also comment on the most important market trends and newstories across a diverse range of commercial aviation topics.

Here's to a good start!