North Atlantic: Virtual airlines protest too much? Jul/Aug 2015

A side-effect of the US carriers’ political attack on the Gulf super-connectors has been a new focus on the profitability of the North Atlantic market, which might just provoke a regulatory response.

At first sight, it is not obvious why the US carriers have chosen to attack the Gulf carriers so vehemently. There are, remarkably, only two routes where the US carriers compete directly with the Gulf carriers: Dubai to Washington (Emirates and United) and Milan — New York (Emirates, Delta, American), using fifth freedom rights.

Moreover, according to a study by Oxford Economics commissioned by Emirates, the true O&D markets of the two groups of carriers are markedly different. For the Gulf carriers, the passenger profile is dominated by Asian, Middle Eastern and African originating or destined passengers — 95% in total. By contrast these regions only account for about 18% of passengers on US airlines, their traffic being dominated by the Americas (60%) and Europe (22%).

Nevertheless, the Gulf carriers have been increasing their presence on the North Atlantic market (defined as all flights from West and East Europe, the Middle East and Africa across to North America) — their capacity share is now about 8% of seat capacity, up from just 0.6% ten years ago. It is perhaps not the relatively small current share that is important, rather it is the potential threat to the concentrated market structure on the Atlantic — about 72% of capacity is shared among three JV carriers, with each virtual airline (Star, SkyTeam and oneworld) having varying but generally very high degree of control in their own sub-markets (see table, page 2).

Over the past five years the North Atlantic market has been turned into the major profit generator for both US and European network carriers. European airlines’ investor presentations frequently allude to positive trends in Atlantic unit revenues, though they have all stopped providing regional profitability analyses. The US DoT does compile this data for US airlines (Form 41 data), and this illustrates how important the Atlantic has become for the profitability of the US carriers (and for their European partners which in effect act as one airline on the North Atlantic, coordinating prices and capacity, and ultimately sharing profits)..

For the US Big 3, Atlantic margins in 2014 averaged 15.9%; the consolidated US domestic market, 10.2%; the Pacific, where ATI alliances with JAL/AA and ANA/UA are currently being implemented, 7.4%; the financially stressed Latin American market, -5.9%; and the total system, 9.4%. Over half the $2bn improvement in the Big 3’s operating profit between 2013 and 2014 was generated by the North Atlantic sector.

The US carriers’ economic rationale then becomes clearer. Their aim is to protect their major profit-generator — the North Atlantic — by maintaining “disciplined” capacity growth which the Gulf carriers are beginning to threaten, and to stem the traffic loss to the Gulf carriers from their European partners on Asian, Middle East and African routes to North America, which directly impacts their joint services across the Atlantic. Over the past five years the three JVs have grown in total by 1% pa, the Gulf carriers have expanded by 20% pa but from a low base, and the overall market capacity has increased by 2% pa.

The risk for the US carriers, and some of their European partners, is that by using aeropolitical action (in which they are supported by the labour unions) to combat the Gulf carriers they may provoke a regulatory backlash. The US DoJ is showing signs of unease with the degree of consolidation within the US, launching an investigation into possible price and capacity collusion. It seems unlikely at present that they will find any damning evidence for this, but next the US DoJ could turn to the Atlantic where it has always been unhappy about the antitrust immunity afforded to former competitors.

One issue might be that the academic economic analysis which was used by the US DoT to justify the virtual mergers — “horizontal double-marginalisation” (don’t ask). Essentially though, the assumption was that virtual mergers would result in lower fares, net of fuel and other external cost changes. Intuition and evidence suggest otherwise; to take one example, a July 2015 survey by CWL Solutions (a travel consultancy, owned by Carlson Wagon Lit) observed that bookings on North Atlantic JVs had jumped from 16% of the total in 2009 to 94% in 2014 and that the average fare recorded for the Atlantic had risen by 17%, compared to 11% on average for all intercontinental routes.

Rising fares by themselves do not necessarily point to anti-competitive behaviour; the industry has to rationalise to earn its cost of capital over the long term. But the degree of concentration in sub markets can only be justified if there is clear effective inter-network competition.

This table summarises the current situation as regards transatlantic hub to hub traffic flows, showing capacity shares on routes between each alliance’s Euro-hubs and those of the partner airline in North America.

Star has been able to build up total dominance. All the traffic between Star’s Euro-hubs and its US hubs belongs to the JV. Connecting traffic at both ends is guaranteed to be funnelled into the JV, ie onto one single virtual airline.

SkyTeam has achieved near dominance on its hub-to-hubs, with the exception of the well contested JFK market.

oneworld cannot achieve the same degree of dominance simply because its hubs at London and New York are also top global destinations, served from numerous other alliance hubs, and the volume of Atlantic traffic at LHR, Europe’s prime O&D point, is over twice that at CDG or FRA . There is also of course the presence of a local rival, Virgin Atlantic: allied with Delta, this virtual airline commands 39% of the LHR-JFK market and 23% of the total LHR-US market against oneworld’s 59% on LHR-JFK and 56% on the total market.