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Latin America: Global Industry Capacity

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Latin America has only 5% of global industry capacity. Aviation has been playing a key part in supporting long-term economic growth in the region through its facilitation on trade, travel and tourism. However, the near-term economic factors have not been favourable. This is causing discouragement among carriers (especially European) to grow capacity in the region. A big opportunity is offered by the degree of liberalization of air service agreements. While Chile and Brazil have recently adopted Open Skies agreements, Venezuela and Argentina have really strict restrictions on air travel, with both government making protectionist laws by limiting access to airports and issuing high passenger-related taxes. In case of some relaxation of such policies (as the new Argentinian government is starting) there will be important upsides to the regional industry, since network will be expanded, traffic stimulated and customers will benefit through lower fares and improved service. Finally, we have the African region. It represents the smallest region globally and it is the only region where the load factor does not exceed the region’s breakeven load factor. However, given the low urbanization rate (40% – the lowest in the world) is expected to sharply grow in the next 30 years together with the general regional macroeconomic environment, demand for air travel to, from and within the egion should be stimulated.

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INDUSTRY CYCLE BREAKDOWN

The aviation industry is cyclical. As the “RPK Cycle” chart used on a global basis by IATA shows, past cycles have rarely lasted longer than 10 years (Exhibit 3.1). Most cycles have ended after 8 years, or shortly after, which is where we find ourselves today. However, it’s worth mentioning that the end past cycles coincided with important macroeconomic events. To better assess the shape of a cycle, and to help us understanding at which point we might be in that cycle, we can simply look at the combined EBITDA margin for a set of listed airlines in Europe. As Exhibit 3.2 shows, previous cycles bottomed at around 2.5% and 3% EBITDA margin, but they have not extended beyond 12%. We have now reached peak margins, moving far beyond the 12% EBITDA margin limit on a sector wide basis. However, the current sector is fundamentally different prom the past, and we cannot be fully certain on whether the current picture clearly presents a simple conclusion.

One thing is common from recent past cycles: they all ended with a bang. In 2002 (the beginning of the first cycle analysed in the Exhibit above) the industry was dealing with a recessionary environment. Additionally, the aftermath of the 9/11 attacks were strong in people’s mindset and airlines capacity and passenger demand were at their lowest. That cycle ended with the Global Financial Crisis (GFC). Just before the start of the GFC, fuel peaked at levels were crude oil was way above the $100/barrel mark. From the 9/11 to the GFC airlines had been adding more than 60% of capacity in just 6 years. As a direct consequence, as airlines capacity keeps increasing, yields starts to decline. The second cycle in the analysis offers a different way of reasoning. After the GFC, airlines were way more cautious and added only 3% capacity in three years, which gives a positive development for yields. However, towards the middle of the cycle, the macroeconomic conditions started to deteriorate: European GDP growth slowed down and turned negative, and fuel prices rose again to $100+/ barrel. This combination put pressure on companies across the sector, ending the cycle in late 2012.

The third and current cycle is fundamentally different. Capacity has been increasing, despite a flattish demand at first (between 2013 and 2015) and rising consequently the following years. But fuel price has been declining, which supports a yield declining without deteriorating further the bottom line. Moreover, economic growth has recovered to a stable base between 2% and 3% (in real terms). Further exogenous events have regularly depressed sector earnings, like terroristic attack in Paris, or the attempted coup in Turkey in 2017. After all, EBITDA margins are at record high, which makes us to infer that the sector is much more resilient this time around. Having said that, there are some sources of headwind that might deteriorate such margins, driving the current European (and global) cycle to its natural end. More specifically, these are (I) rising in oil price, (II) macro-economic slowdown and (III) Brexit. I. RISING IN OIL PRICE. The biggest source of concern nowadays is represented by the rising fuel prices. The cost of jet fuel has increased by over 50% since June 2017, and now stands at $711/MT (as of 08/06/2018). While this situation doesn’t represent a doomsday scenario yet, these rising costs are worrying airlines executives, as days with lower fuel price might be over for some time, especially after recent tensions between USA and Iran, or among OPEC countries.

As the current forward curve implies, we won’t probably reach oil price level at $100+/bbl peak, which translates in fuel price of $1000+/MT, but the current level of fuel price is set to increase the operating expenses in the European industry by c.€2.5B in FY2018. This increase in fuel price will likely not be recovered in the top-line, due to a highly competitive European environment with capacity growth outpacing demand growth. Moreover, companies’ ability to pass on increasing fuel prices to customers through higher ticket fares is limited in the short run, since customers are extremely price sensitive (especially for leisure short-haul flights), and depends on conditions linked to demand and supply equilibrium in the long run. In order to limit the top-line deterioration and reducing earnings volatility caused by short term variations (increase) in oil price, airlines undertake rather aggressive hedging strategies. European airlines also need to consider the foreign exchange impact of their fuel exposure; thus, they usually engage in some degrees of currency hedging to reduce further the volatility of their economic cost of fuel . Some steps are required to calculate the economic cost of fuel (Exhibit 3.4): by starting from the Brent Crude and (1) adding the Crack Spread (the cost of refining and treat Brent in order to be used as jet fuel) we end up with the jet fuel. Then we need (2) add the so called “into-plane costs”, which are those costs related to transport the fuel from refinery to the actual plane, and tax expenses. We end up with the “purchased cost of fuel”; and (3) with the addition of net hedging result (the benefit or cost of hedging over the period), the result is the economic cost of fuel.

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