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The sun is shining, but the dominos are falling as airlines begin to collapse

As we hit mid-November, a crisp wintery air is sweeping across Europe, bringing with it a feeling of freshness and clearing the hustle and bustle of summer. But as the fresh, clean and crisp air of winter rolls into Europe, another reality also sets in - not every airline will make it through a cold winter. We say farewell to Estonian Air and Intersky this month and we expect another handful wont make it to next summer.

Airlines finally begin to enjoy the benefits of lower fuel prices. Those which weren't hedged heavily have had an advantage over others for about a year. But many airlines tended to have the majority of their fuel hedged meaning that they did not benefit from these fuel prices much, until their hedges progressively ran out.

As we've previously forecast, we believe there is a general overcapacity in certain markets in the world, and a general structural inefficiency in the markets due to the existence of too many airlines. This is exacerbated by poor business models, a lack of focus and a general disconnect between what some airlines offer and what the market wants.

Troubles for the big carriers

The overcapacity - including by some of the biggest airlines in the world - leads to constant sales promotions to fill seats. These seats are sold under cost for even the largest airlines which have lower unit costs because of their capacity. It adds undue pressure on smaller airlines. Passengers which could happily fly non-stop with a small or mid-sized airline within Europe, for example, are incentivized through deep discounting to fly through one of the major airline's hubs. The larger airlines also do this to each other, so often a flight Frankfurt-Zurich is cheaper via Paris, for example, or a flight London to Athens might be cheaper through Munich. Even though the cost of delivering that service is likely to be higher when accounting for the extra take-off and landing, baggage handling, fuel, crew costs, etc.

And so, it comes to this, something has to break, and it is breaking. Focusing on Europe (our home market), the business models of some of the largest airlines are simply unsustainable. That is not to say they are in the wrong business as they (for example, Lufthansa and Air France) seem to suggest, not at all. The reality is many such airlines are overcapacity, they have aircraft which are too large on many markets, they are carrying excess costs as a result of those capacity decisions, and they have too much infrastructure linked to this capacity. The answer is to right size. Unfortunately, many of these businesses are following the mistakes which airlines in North America and Asia Pacific tried and abandoned because they fail.

The staff know this, and they are resisting these changes vigorously, as evidenced by unprecedented levels of strikes in 2015 at some airlines.

Unfortunately, large airlines have deep pockets and can continue to distort markets for a long time.

Troubles for smaller airlines

In the meantime, the distortions caused by larger airlines also contributes to the challenges smaller airlines have. Not many markets can sustain small airlines of say under 30 aircraft. But some can, as long as it is an established airline with a long history and some loyalty. Being a national icon helps.

But the reality is that is not enough in many cases. It takes a few new flights or expansions by larger airlines to put extensive stress on these small carriers. And these small airlines often don't attract the strongest management teams.

Structural industry challenges, distortions by larger airlines, a lack of scale and difficulty retaining human capital certainly makes it challenging, but not impossible, to manage smaller airlines profitably.

The reality, however, is there are still some airlines which are unsustainable, whether facing the competitiveness the larger airlines or being unable to sustain costs against Ryanair, Wizzair, easyJet, Vueling or Norwegian, for example.

And so, as we've forecast before, we expect a few airlines in Europe will not make it to next summer. We've got our thoughts which ones they are. For some it is time to retire into history, for others, there is a good potential for rehabilitation, but the right pieces haven't fallen into place for them... yet.

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