Cargo's Steady Ascent
There's guarded optimism that 2006 will give the
air freight industry something to grow on in 2007
Marty Graham
Manager, Consulting Services
BACK Aviation Solutions
 lthough not out of the woods entirely, the air cargo industry had a far better year in 2006 than it did the year before, and 2007 is expected to continue that upward trend. Revenue and traffic growth is expected to be moderate overall but potentially industry-crippling fuel prices have stabilized, giving the aircraft operators a bit of breathing room, and the larger world economy more room to grow.
Orders for new widebody freighters are giving rise to expansion plans in international service, particularly in Asia-Pacific corridors, giving shippers and carriers hope for new capacity in some markets. The remaining unknown is how new air cargo security rules in the United States will affect business.
Entering 2006, the air freight industry was cautiously optimistic for a strong year.
After experiencing tepid growth of only 3.2 percent in total traffic in 2005 and weathering a multitude of events, from natural disasters to rising energy prices, that were outside the industry's control but dampened demand, many in the air freight industry held a guarded outlook for 2006.
Yet, entering what looked to be a strong peak season, the larger airline industry generally is showing improved financial health and the performance of the air freight industry this year has calmed concerns of further growth slowdowns and buoyed optimism for the industry heading into 2007.
International air freight traffic grow 5.2 percent in the first three quarters of the year compared to last year, according to the International Air Transport Association. That's stronger than in most years since 2001 but still behind most long-term growth projections for better-than 6 percent average annual growth. A separate measure by Boeing of overall air freight traffic showed just 3.3 percent expansion in the business over 2005 in the first seven months of the year.
However, the relatively small shifts in overall numbers mask undercurrents of greater change in the market and ongoing obstacles that confront operators in the air cargo industry.
First, because fuel accounts for over 20 percent of all airline operating costs, the spike in oil prices that escalated through the first half of 2006 cut deeply into airline profits. And the rapid march upward in energy prices threatened to dampen global spending while forcing airlines to further rationalize capacity to achieve profits.
Amazingly, since 2000, jet fuel prices have averaged 15.5 percent compounded annual growth. Fortunately for the industry, the price of jet fuel has stabilized since the summer, declining from record highs across the globe, easing pressures on airlines and consumers.
ATA Chief Economist John Heimlich believes the price of oil will stay in the $55-$65 per-barrel range for another 12 to 18 months. Fuel has become the airline industry's No. 1 cost, he said, remaining around triple the historical price norm.
Despite the drop in prices toward the end of the year, high fuel costs have resulted in slowing capacity additions, and putting pressure on airlines to hike shipping rates.
There also was a significant concern among economists on how the U.S. economy would handle the slowdown in the housing boom, which has fueled consumer spending over the past several years. Many analysts worried the housing slowdown would drag the U.S. economy into a recession as U.S. consumers struggled with mounting debt loads. However, the housing "bust" has yet to manifest itself, easing concerns of a recession for the U.S. economy. The continued U.S. economic growth was also supported by strong corporate profits and the related growth in corporate technology spending; the rate is expected to grow 4.9 percent through 2009. These two factors combined with the low inventory levels carried into 2006 by U.S. businesses drove strong growth in the high-value products shipped by air.
A few key trade lanes drove air freight traffic growth in 2006.
Air freight traffic benefited from continued Chinese strength as well as a recovering Japanese economy. The 5.3 percent growth in Asia Pacific air freight was buoyed by a strong domestic Chinese economy, which experienced a robust 10.6 percent year-over-year GDP growth as well as a steady Japanese economic recovery (2.6 percent GDP growth).
Next, North American air freight posted a 5.9 percent year-over-year growth driven mainly by the U.S. economy. The U.S. continued to be a major importer of air freight products, shaking off rising interest rates, a cooling housing market and inflationary pressures that dampened disposable incomes.
Emerging markets, such as the Middle East and Africa, posted impressive air freight growth in 2006, as traffic increased 16.8 percent and 7.6 percent, respectively. However, not all trade regions saw growth return to historical growth rates. Latin America (3 percent) and Europe (2.1 percent) experienced sluggish air freight growth in 2006, which was more a reflection of market maturation rather than any alarming market fundamentals.
Economic Outlook
Although BACK expects the strength of 2006 to continue in 2007, with air freight growth again approaching 6 percent, there are several drivers on industry traffic demand and capacity that must be closely observed. These factors will have an important impact on market pricing, availability of capacity, and overall industry profits in 2007.
In market regions, BACK expects the air freight industry to continue to benefit from the continued strength of emerging markets, such as the Middle East and Africa. But the United States as the world's largest economy and largest air freight market will continue to drive expansion even if much of that comes in the form of demand for imports from China.
Although 2006 proved to be quite strong as the U.S. economy shrugged off several fiscal concerns, there remains lingering anxiety that a U.S. recession is possible in 2007.
The U.S. economy slowed in the third quarter, expanding at a weak 1.6 percent annual rate. That followed growth of 2.6 percent in the second quarter and a robust 5.6 percent in the first quarter.
The lackluster growth late in the year largely reflects the weak housing sector, with residential investment plunging 17.4 percent at an annualized rate during the quarter.
Looking ahead, we expect the economy to grow at around a 3 percent annual rate in the first half of 2007, and to almost 3.25 percent in the second half. That would result in real GDP growth of around 2.7 percent for the full year of 2007, down from a forecasted 3.3 percent in 2006.
Apart from the tailwind of lower energy prices, the mild acceleration in economic activity will be supported by the notable easing of financial-market conditions, especially lower long-term interest rates and stronger equity valuations, that have occurred as the Federal Reserve Board kept its policy rate unchanged for the past three quarterly meetings.
Our forecast expects growth in consumer spending to remain reasonably firm, although slowing on the back of lower energy prices as well as continued firm growth in household incomes as labor markets remain sturdy.
Business investment spending is expected to pick up as corporate profits remain strong and balance sheets are in good shape. Although housing will likely continue to be a drag on the economy, we think that the drag will fade, and then dissipate completely by the end of the first half of next year.
Finally, export growth should be boosted by the continued robust performance of the global economy in addition to the ongoing lagged competitiveness benefits from the dollar's prior depreciation. Imports should slow along with domestic demand, with the combination adding modestly to real GDP growth.
In other regions, the Euro area growth has surprised on the upside all year.
Following average quarterly real GDP growth of around 3.5 percent in the first half of the year, the second half of 2006 should see average growth of 3.25 percent or a bit better. That would bring full-year economic growth this year to about 2.75 percent after just 1.5 percent in 2005.
Following years of retrenchment, the corporate sector, benefiting from strong profits and cleaned-up balance sheets, is again in an expansive mode. Initially, this was reflected in a strengthening of investment spending by business, which is continuing. But, more recently, corporations have begun hiring. Further, the rise in employment and reduction in joblessness seems to support an increase in household incomes, which, in terms of purchasing power, is also being augmented by the sharp fall in energy prices in recent months. Domestic demand is driving the economy forward, with the expansion broadening.
Tighter fiscal policy can be seen, particularly in Germany in the form of an increase in the VAT tax at the beginning of 2007. For all of 2007, real GDP is forecast to rise some 2.5 percent.
Asia will remain fixated on the growth in Chinese exports, as well as China's burgeoning domestic market as the country's economy grows.
Tentative early signs have appeared that earlier various tightening moves by the Chinese authorities have succeeded in moderating the growth of investment spending and, with it, overall GDP. That said, China's economy continues to boom on the back of strong consumer spending and robust investment, which in turn is backstopped by solid profit growth and seemingly ever-expanding exports.
After growing 10.4 percent year-over-year during the third quarter and by around 10.5 percent for 2006 as a whole, growth is seen moderating but reaching a still impressive 9.5 percent in 2007.
The more positive development for air freight development for the air freight industry is the continued focus by the Chinese government to increase domestic consumption and the investment in airport and transportation infrastructure.
The big problem of a ballooning Chinese trade surplus, particularly with the U.S., will continue to focus attention on the rate of appreciation of the Chinese Yuan, especially against the dollar. With the Democrats taking over both the U.S. House and Senate, the risk is for greater calls for protectionism and greater pressure on China to let the Yuan appreciate further and faster. This bears close watching, as risks of a trade war are likely to increase.
One of the big stories over the past year or so has been that the Japanese economy has finally pulled out of its deflationary slump and embarked on a sustainable recovery as corporate investment and a pickup in household spending augmented a solid performance in exports.
Although the economy lost momentum in the middle two quarters of the year, the economic fundamentals for both the consumer and business point to stronger growth in the coming quarters extending into 2007. For this year, real GDP is forecast to grow around 2.5 percent following 2.6 percent last year. Next year, economic growth should come in around 2.25 percent.
The continued improvement of the Japanese economy bodes well for air freight, particularly for westbound trans-Pacific shipments from the United States.
Industry Outlook
The industry and consumers alike found relief in lower pump prices for fuel and energy. Yet, we only have to look back less than a year to understand the severe impact the spike in energy prices had on the air freight industry.
If fuel prices spike again, the air freight industry can not only expect dampened air freight demand, but also upward pressures on profitability that would lead to increased fuel surcharges. The fear of rising fuel costs will also impact the decisions of airlines as they continue to evolve their fleet strategies to maximize efficiency and reduce unit costs.
We will continue to see air carriers shift in capacity over the next year to reap the largest benefit. Meaning, the airlines may add more international capacity while shifting short-haul or domestic capacity to smaller jets or regional flying partners. This may affect capacity on short-haul routes while boosting it in international markets, leading possibly to downward pressure on yields.
Several prominent airlines have announced orders for new or reconfigured freighter equipment.
Consider FedEx's plan to acquire and convert 90 757-200 and Atlas Air's $3.4 billion order for 12 747-8s. Look to the operators of older 747-200 freighters as the next customers of the 747-8F.
With the narrowbody average fleet age approaching 30 years of age, and a widebody market that is constantly seeking reduced unit costs, BACK expects fleet renewal in the freighter market to continue at a rapid pace. Even more interesting is the various options being offered to the market. Boeing and Airbus will continue to battle for new freighter orders in the large widebody market, but Boeing may for now have the upper hand with the 777 freighter, 747-400 freighter and the 747-8F.
The A380 freighter may be doomed as a result of FedEx recent cancellation of its order for 10 A380s freighters in favor of 15 777s.
While Boeing can already offer the 767-300BCF in the medium widebody freighter market, it remains to be seen how restructuring, A380 delays, and A350 re-engineering affects Airbus' anticipated launch of the A330-200 conversion program as well as the development of the A320 conversion program.
Beyond the two manufacturers, several maintenance and overhaul companies are aggressively seeking a slice of the conversion market. Beyond FedEx's announcement of the 767-200 conversion decision, there are the following developments to consider: PEMCO delivered the world's first 737-400 freighter to Alaska Airlines; Alcoa-SIE received its FAA STC for its' 757-200 product; IAI and Mitsui announced their intentions to form a joint venture aimed at the 767-300 conversion market; and Precision Cargo Conversions has garnered strong interest in its 15-position 757-200 freighter conversion. We expect this marketplace to remain dynamic over the next year as airlines look to renew aging fleets, reduce operating costs, and add capacity to meet the expected long-term growth outlook for air freight.
Beyond that, 2007 may be the year where we see increased consolidation.
Given that several of the large U.S. legacy carriers have either exited or in the final stages of reorganizing under bankruptcy, and overall global airline profits are expected to turn positive for the first time since 2000, the time may be right for a few of these airlines to consider merging to maintain long-term profitability.
Although it is only speculation at this point, a wave of consolidation, if only a few major carriers, would have a ripple effect across the entire air freight industry.
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