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In brief:
With the easing of travel restrictions and a post-pandemic bounce in our step, consumers have taken to the skies again and enjoyed a holiday, or two, far away from home. Similarly, business travellers have taken the opportunity to physically reconnect with colleagues and customers after nearly two years of video calls. For the airlines this pent-up demand has generated much-needed cash and given the sector a lifeline after a devastating pandemic.
However, it’s never easy trying to start a car that has been sat idle for a few years and in the case of the airlines the challenges have been numerous and visible for all to see. Staff shortages coupled with a general unpreparedness by airports have led to flight cancellations, lost luggage, strikes and in a lot of instances a customer experience so poor that alternative means of travel are being considered where feasible.
Airlines are moving to resolve these operational issues and do so quickly, but time may not be on their side. Macroeconomic events have sent costs spiralling both for the airlines and the customer. Suddenly there are question marks around what next summer’s holiday will cost and whether the average customer will be able to fly at all in the middle of a cost-of-living crisis. Flash seat sales and other marketing initiatives to try and sustain demand may help in the short term; however, if the dark skies on the horizon are to clear, costs across all parts of the global economy will need to stabilise and do so quickly.
1. Fuel Costs
Jet fuel prices and airline profitability are intrinsically linked. When one goes up the other usually goes down! The recent pent-up demand has bucked this trend as customers have been desperate to fly at any cost evidenced by the fact that airfares in the U.S. have increased 33% in the last 12 months¹.
Since the start of 2022 jet fuel prices have increased by 51.23%² and at the time of writing the price per barrel is hovering around $144.5 / bbl or 47.3% more than a year ago ³. Effective hedging strategies and customers armed with more spending power post the pandemic have shielded the sector so far from any negative impact on profitability. However, the $64,000 question is whether passengers will be willing to keep paying more for airfares in the middle of a global cost-of-living crisis and rampant inflation.
Airlines will argue that higher fuel prices will be an opportunity to improve operational efficiency by cutting capacity and deriving more value from every ticket sold. Due to the low marginal cost of a flight, airlines are incentivised to add capacity as a means of increasing market share. With higher fuel prices and a higher marginal cost of flying airlines can row back on capacity and look to improve profitability. While such a strategy may have long term benefits it will not address the short-term issue that airlines are selling cheap tickets in the current booking window on routes that will cost far more to fly.
An obvious remedy to this will be to pass the cost on to the customer by introducing fuel surcharges but this has not happened in the most part yet, and the costs are already stacking up. The impact of jet fuel price increases on the 2022 total fuel bill for airlines, at the time of writing, already stands at $131.8 billion ⁴. Effective hedging could also mitigate against the increase in cost but hedging levels vary across the industry with some of the largest airlines in the world not employing a fuel hedging strategy at all.
2. Passenger Spend
If airlines are to pass on fuel surcharges to customers, how much can the average customer afford to pay? To try and answer this question we have examined what the average customer in the U.S., the world’s largest single market for air travel, was willing to pay in the pre-pandemic market and compared this to current market conditions.
If we go back to 2019, the top ten U.S. based airlines flew 846 million passengers and generated passenger revenues of $171 billion ⁵. This equates to an average passenger expenditure of $202 in what would have been considered normal conditions and contributed to an average passenger operating margin of 10.9% ⁶.
Fast forward to today and what are the current market conditions?
Let’s assume the following:
Under these market conditions the required average passenger expenditure to achieve half the operating margin of 2019 would be $230 per passenger. This is an increase of 14% on pre-pandemic spend and comes at a time when inflation in most developed countries is running at over 8%. To put this into context if the U.S. airlines can only achieve the average passenger expenditure of $202, as in 2019, and the larger airlines continue to adopt a no hedging policy then losses in respect of passenger operations could exceed $8.5 billion.
3. Cancellations
All aspects of the aviation industry were decimated by COVID-19 and had to essentially start from scratch when air travel took off again - in a hurry. Airlines and airports have had to comply and enforce ever-changing rules on testing, vaccines and quarantine requirements, find staff to replace those let go during the pandemic, train new staff and manage unprecedented levels of demand. Unfortunately for travellers this has resulted in long lines at airports, lost baggage and cancelled flights.
In the second quarter of 2022 alone, around 64,000 flights have been cancelled across Europe. Under European law, airlines whose flights have been cancelled must give passengers a refund of their fare within seven days ⁹. Should demand plateau, the congestion issues will ease but the processing of refunds will continue to impact cash due to delays in payments caused by the same staffing shortages that contributed to the flight cancellation in the first place!
Across the water, nearly 122,000 flights within, into or out of the U.S. have been cancelled in the first half of 2022 which is around 20% more than the same period in 2019¹⁰ While most U.S. airlines do not offer refunds for cancelled flights, they do rebook at their own cost.
And if things are not difficult enough, the staff that airlines and airports have retained are now feeling overworked, underpaid and unhappy. This has led to pilot strikes at SAS and Lufthansa, cabin crew strikes at Ryanair and the familiar strikes by French air traffic controllers. Ryanair alone had to cancel 420 flights in one day recently due to the French ATC strikes¹¹.
If one or more of the factors outlined above create a demand and supply squeeze, airlines and their lenders may be forced to consider operational or financial restructuring strategies to ensure viability. In this section we explore some of the restructuring options available under the Irish framework.
Examinership is a restructuring process overseen by the Irish Court for companies that are insolvent but have a reasonable chance of survival as a going concern. The objective of the process is similar to a Chapter 11 in the U.S. and the recently introduced Restructuring Plan in the UK. The principal benefits of examinership are that it is more cost effective than a Chapter 11 process or a UK plan process and the bar to obtain creditor approval is quite low. It is also a recognised process throughout the EU and generally recognised in the U.S. through Chapter 15.
Any company that can demonstrate to the Court that’s it centre of main interests (COMI) is in Ireland can apply for an examiner to be appointed. In some cases, as shown in the recent examinership of Norwegian Air, a non-Irish debtor company that does not have its COMI in Ireland can also have an Examiner appointed if it is related to another company that has its COMI in Ireland, is also in examinership and where the debtor has a “sufficient connection” to Ireland.
Another aspect to consider when it comes to COMI is branch registrations, several well-known U.S., European and Non-EEA airlines hold branch registrations in Ireland and this may well support a case for COMI in Ireland, however this has not yet been tested before the Irish Courts.
A Scheme of Arrangement process is a procedure which provides a structure for a distressed company to agree with its creditors a rearrangement, including compromise, of its debts and obligations. The scheme, if approved by the members and creditors of the company, is sanctioned by the Irish High Court and facilitates the company to continue as a going concern. Recently, Nordic Aviation Capital, with the assistance of the EY Ireland Restructuring team, successfully implemented a Scheme of Arrangement to restructure its $6 billion of debt.
The most effective and often only course of action for a debt provider, in a situation where a borrower is facing financial distress, is to appoint a receiver pursuant to the underlying security. Debt providers may baulk at this option as the prospect of a bank taking control of an aircraft might seem ludicrous, but the receiver will step into the shoes of the lessor and take immediate steps to take control and safeguard the assets. The overall objective of the receiver will be to sell or redeploy the aircraft and return the proceeds to the charge holder.
Appointing a receiver can be very beneficial particularly when the lender has lost faith in the lessor’s ability to properly care for the aircraft or if the lessor is not prioritising the redeployment of the aircraft should it come off lease due to an airline insolvency. Furthermore, if the borrowing entity is a Japanese Operating Lease with Call Option (JOLCO) the lender usually must step in and negotiate directly with the airline in an insolvency situation, this role can instead be passed to a Receiver freeing up the lender’s time and resources.
The EY Ireland Restructuring team has recently acted as receiver over two Boeing 787-9’s as well as JOLCO structures and in all cases has achieved a more than satisfactory outcome for the charge holder.
If circumstances create a demand and supply squeeze in the aviation industry, airlines and their lenders may be forced to consider restructuring strategies to ensure viability.
