Airline capacity war is risky business
Get set for some significant sales on domestic flying over the coming months if the current capacity splurge continues.
In fact, passengers are likely to have seen some fantastic deals in February through to April already.
Recently, Virgin Australia released its February operating statistics, which shows growth over the year in a measure of capacity called available seat kilometres of over 16 per cent. Over the same period of time Qantas Group domestic capacity rose by almost 8 per cent.
With Qantas intent on holding onto its 65 per cent domestic market share target, it's going to have raise its capacity growth to keep pace with Virgin.
The move by Virgin to raise its capacity by over three times its long run average growth rate is a bold one in the current domestic economic environment.
Domestic leisure demand is in a weak period in the cycle as more Australians switch into short haul outbound leisure destinations from Australian leisure destinations as a result of the strength of the Australian dollar.
Domestic leisure demand has also been hurt by the higher prices of non-discretionary goods, such as energy prices, the impact on confidence generated by the continued uncertainty in the global and local jobs markets, and the significant drop in the population growth rate.
And business demand, which closely follows what happens in equity markets, is likely to be growing below trend.
This would suggest that the CEO of Virgin Australia, John Borghetti’s capacity strategy is banking on continued steal from the Qantas business rather than stimulation of market demand. And this steal will put pressure on Qantas fares.
Most of the downward fare pressure will come about because the additional capacity will not stimulate business-purpose traffic, because this traffic is driven more by the performance of the economy then by cheap airfares.
And it will find it difficult to stimulate leisure traffic because that traffic is headed overseas.
The only reprieve for fares will come if a large proportion of the additional Virgin capacity is headed for the regional market.
Growth in underlying demand for regional travel, generally, is much stronger than in interstate travel as a result of the strong performance of the mining sector and in particular Fly-In-Fly-Out traffic.
According to Bureau of Infrastructure, Transport and Regional economics, market level capacity grew at almost 20 per cent for the regional sector in January and that growth is set to continue in February.
While the regional aviation market as a whole is likely to be strong, pockets of that market are expected to be weak.
Regional leisure city pairs such as Sydney to Port Macquarie, Coffs Harbour and Ballina are likely to be experiencing underlying demand growth that is much weaker than city pairs that are mining related, such as Perth to Karratha and Port Hedland, or Brisbane to Gladstone.
The rapid growth in Virgin capacity is not only bold from the perspective of the weak economic environment but also from the perspective of the highly unfavourable cost environment.
Jet fuel prices averaged $US134 per barrel in February, up almost $US13 from a year earlier and over $US50 from two years earlier.
Jet fuel consumption is highly linked to capacity so that growth in capacity of 16 per cent will invariably result in the growth in jet fuel consumption, as it relate to domestic services, in the order of 16 per cent.
This growth in consumption will put an enormous strain on Virgin’s bottom line if Virgin can’t steal additional revenue from Qantas.
From the perspective of higher jet fuel prices, growth in domestic capacity of 3 times the long run average growth rate is simply irrational.
While Virgin will have some fuel price protection from the hedging that it has in place, in an environment in which the jet fuel price continues to trend northward use of financial instruments such as options and swaps only delay the onset of higher fuel prices.
It’s difficult to believe that capacity growth rates of around 16 per cent are sustainable, even for a relatively short period of time.
Because of the Qantas Group’s strategy of preserving a 65 per cent share in the domestic market, this seemingly irrational capacity strategy of Virgin will also result in a seemingly irrational capacity plan of Qantas.
Capacity in domestic aviation has a very clear two or three-year cycle - capacity growth is very strong for two or three years and then is very weak for two or three years.
These cycles are brought about because of airline irrationality and the preoccupation with market share, which is good for passengers but bad for airlines.
The cycle usually starts with an airline pouring more capacity into the market. Competing airlines must follow to preserve market share.
The double capacity whammy places downward pressure on yields. Yields fall below unit variable cost, airline profitability suffers and then they withdraw capacity.
Yields then come up again and more capacity is poured back into the market.
A cycle of this type is typical of immature competition. If Qantas and Virgin are to get their profitability and share prices back on track, it’s time for them to grow up.
Tony Webber was Qantas Group chief economist between 2004 and 2011. He is now managing director of Webber Quantitative Consulting and associate professor at the University of Sydney Business School.