The end of la Belle Époque of Russian aviation

Protracted crisis caused by unfavorable macroeconomic conditions and geopolitical shifts is reshaping Russian commercial aviation market

By Andrey Kramarenko and Alexey Sinitskiy

In the wake of the deepening recession in the Russian economy and the rapidly weakening national currency, the Russian air transport industry began its plunge into a system-wide crisis in late 2014. The result was the largest redistribution of the commercial aviation market witnessed since the fall of the Soviet Union. The ongoing process and a more organized market will not give way to a stable situation instantly—other economic factors prevent that from happening. But in the meantime, the Aeroflot group is clearly gaining access to the privilege of market dominance—more than 50% of Russia’s total air traffic and an almost unabridged monopoly on long-haul routes—surpassing its largest competitor by 200%.

It has not been said with any certainty that the abnormal growth in Russian air passenger traffic from 2011 to 2014 was supported by any substantial macroeconomic factors. This growth, which reached 16% per year, was the result of artificially spurred demand. Along with objective factors—growth in GDP and household income inherent to a period of high oil prices—the state offered airlines subsidies for regional and even some mainline routes, amounting to 10 billion rubles per year. Agitated price dumping in this period of fierce competition certainly contributed to this growth as well.

According to Russian Aviation Insider’s estimates, the total dead loss sustained by Transaero and UTair in the period from 2011 and 2014 amounted to nearly 120 billion rubles. Aeroflot also played its own role in the price war, and other carriers were forced to constrain the growth in air fare to well below the inflation level just to compete.

Such a system cannot last forever. Political and economic factors, namely the international sanctions against Russia and the economic recession, caused the loan pyramids to collapse at two of Russia’s largest air carriers. Transaero’s bankruptcy in 2015 became the most appalling case in the history of Russian aviation, and perhaps, in the whole of Russia’s non-financial sector. UTair and a number of smaller carriers were forced to scale down their business substantially in order to stay afloat.

Surviving under protracted crisis conditions may very well become the new reality for Russian airlines for the next several years. This article is not meant to analyze macroeconomic challenges, but it must be noted that there are no observable internal or external prerequisites for sustained growth in the foreseeable future.

Crisis of demand and anti-crisis measures

Capacity reduction played a major role in neutralizing plunging demand experienced by Russian airlines, which otherwise may have experienced ever more serious losses. A demand highly sensitive to exchange rates, travel on international routes, continues to shrink following the devaluation of the ruble. Adding to the problem is the daily fluctuation of the course of the Russian currency by several percentage points, in effect deriving Russian carriers of the ability to forecast costs or consumer demand, even in the short term.

Dependence of demand on international lines on ruble-dollar exchange rate, 2012-2015

According to Russian Aviation Insider’s estimates, from early September 2014 to the present Russian airlines grounded or returned to lessors a total of 254 aircraft, which is 34% of the cumulative fleet operated in 2014.

By segments, the entire Russian short-haul fleet was reduced by 27%, the regional fleet by 42% and the long haul fleet by 55%. In two waves, partly compensated by new deliveries, 22% of the pre-crisis fleet was reduced. After Transaero went defunct, its entire fleet was grounded, effectively reducing the available seat-kilometers by 19%, while the load factor experienced a 0.9% slip.

Politics also play their role in the crisis, as already fading international traffic took another blow with the complete ban on air connection with Ukraine and Egypt, and a ban on charter flights to Turkey. In 2014, Russian airlines carried 13.6 million passengers on flights to Egypt, Ukraine, and charter flights to Turkey—this amounted to over one third of all international traffic carried on Russian airlines. Undoubtedly, loss of three out of the four most-demanded international destinations (Ukraine held the fourth position in the most popular destination rating in 2013) dealt a heavy blow to Russian carriers and airports, all against a background of a deepening economic recession.

European leisure destinations are no alternative for Egypt and Turkey; being in a completely different price segment, they also require visas for Russian citizens. Transaero’s market exit also had an effect on the market as a whole. One consequence is that Southeast Asia has become practically inaccessible, due to a great shortage of long-haul fleet after Transaero left the market. At the moment, there are fewer than 20 long-haul aircraft engaged in charter operations on the Russian market. Russia does have its own resorts on the Black Sea, but these vacation destinations operate only during a short, four-month-long summer season.

These factors explain the 28.7% fall in international traffic last November. Had the exchange rate been the only factor, the airlines would have lost perhaps only 15% of traffic.

Costs and Fares

Increasing ruble fares in 2016 is an evident measure for Russian airlines. A substantial share of their costs is in foreign currency, so the continuing devaluation of the ruble dictates fare increase, even on domestic lines.

Traffic YOY dynamics (%) on international lines (dotted line shows correction against external factors) and estimated dependence on ruble-dollar exchange rate, 2014-2015

Decreasing competition creates favorable conditions for increasing fares. This is strengthened by the fact that for the first time in Russian aviation’s contemporary history, one of the players obtained true real market power: in November-December, Aeroflot Group’s share on domestic lines had grown to 49.2%, on international lines – to 39% (factoring in foreign airlines). On many international routes, Aeroflot enjoys either an unabridged monopoly or comfortable coexistence with one other international airline in which both carriers sustain relatively high fares on the route.

By way of recompense for taking care of the majority of passengers remaining in the wake of Transaero’s collapse, Aeroflot received designations for all of Transaero’s commercially attractive international routes from the Russian aviation authorities, a move that wiped away years of achievement in terms of creating a competitive playing field amongst international lines. Aeroflot operates 70% of Russia’s cumulative long-haul fleet, including almost all of the aircraft operated on regular routes. Thus, international routes with low levels of competition are the most obvious candidates for fare growth.

On domestic lines, major obstacles to profitability recovery are increasing competition and seasonality. Several relatively small players, which used to operate in the domestic tourist segment, have entered the market. Despite their modest capacities, they may very well impact price levels, as demand is aligned with the lowest-priced offer. Shift of the consumers’ focus from international to domestic destinations leads to increasing seasonality, due to the climatic limits of the Black Sea resorts. Decline in demand tied to seasonality was observed up until 2013, but in 2015, especially in the second half, the yearly demand curve started to resemble mid-2000s once again.

However, in 2005, 75% of passengers were carried on Soviet-built aircraft, which were generally owned directly by the airlines, so their grounding in the low season did not incur substantial expenses. On the contrary, 95% of traffic today is carried on leased Western-built aircraft, and operators are forced to sustain at least minimal revenue generation in the low season. Along with this, the situation is aggravated with high credit interests for sustaining day-to-day liquidity, and banks’ reluctance to provide loans to the highly risky industry. This winter has shown that despite the illustrious case of Transaero’s bankruptcy, Russian carriers are pressed to sustain low fares to stimulate the weakening demand.

Seasonality of demand for Russian airlines’ services (% share of monthly traffic from peak month)

Obviously, the losses that are piling up during the winter will have to be set off in the summer. However, effective demand may reach its limits much sooner than the losses are set off, even more so, since premium demand is still focused on international lines. Economically justified fare upgrade on domestic lines may seem excessive and not find support with the state authorities or antitrust regulators. There is a risk that airlines will be pressed by the government to keep fares level on many domestic routes, as seen repeatedly in the past.

Ruble fare upgrade (on international and domestic lines alike) will result in the trimming of the most elastic demand, and consequently, to growth of unit costs and need for further fare upgrade. In a worst-case scenario, the “cost upset recovery” will only be possible after the major share of consumers with demand price elasticity of over 1 will be cut off, i. e. after return to mid-2000-type market. Shrinking of real disposable household income will further decrease demand, especially in the segment of population that uses air transport for vacation travel needs.

Market redistribution

Inefficient operational practices and business models, hardly noticeable in periods of expansion, always reveal themselves in times of crisis. Market redistribution in favor of the most efficient and adapted businesses is a natural after-effect of a recession.

YOY traffic and PKM dynamics of Russian mainline carriers in November – December 2015 (to 2014)

Upon Transaero’s going defunct, the redistribution of passengers formerly served on Russia’s second-largest airline was not evenly spread: in November and December, Russian carriers (excluding Transaero) carried cumulatively 139,000 passengers more than in the same period of 2014. But the growth was entirely attributed to Aeroflot: its traffic increased by 614,000 passengers, and as a result, its market share exceeded 52%, which is almost four times more than its largest competitor, the S7 Group.

Charter carriers have found themselves on the brink of extinction—firstly, after the ban on flights to Turkey; and once again, after several large tourist agencies, affiliated with Turkish companies, fell prey to anti-Turkish sanctions. If Russian foreign policy continues to affect business, it is highly probable that several specialized carriers will stop operations—without partner tourist agencies, these charter carriers are left unviable.

Despite Transaero’s exit, by the end of 2015 several mainline carriers found themselves in the red. We believe, that market reshuffling will continue, and several Russian airlines are risking their business.

By the end of 2015, several mainline carriers found themselves in the red despite the exit of the major competitor, Transaero. It is the belief of this publication that market reshuffling will continue and that several Russian airlines are risking their business.

Forecast

An unusual, but expected, consequence of fleet cuts and increasing seasonality is capacity shortage in the summer of 2016. About 30 aircraft, previously operated by Transaero, will be inherited by the renewed Rossiya Airlines, and a number of other carriers will take delivery of two dozen aircraft. But unless the political relationships with Turkey and Ukraine normalize, or oil prices rise, this will not be enough.

Since Transaero’s bankruptcy and UTair’s coming dangerously close to the same fate, the other players’ attitude and behavior have shown the tendency to be significantly more rational than before. Many carriers have finally started thinking about revenues, not market share. There is little hope that such rational industry-wide behavior should last more than a couple of years, since the level of competition is still very high. At present, however, it may help the carriers stay afloat during these difficult times.

In order to make ends meet and prove profitable, airlines will be forced to raise the average annual fare in rubles by 15-20%.

Several factors may provoke some Russian carriers to look for new markets outside the ruble zone, including unpredictable domestic demand, high political and administrative risks, and expenses issued in foreign currency. Demand for transit flights between Europe and Asia is virtually endless, as is proven by the expansion of Emirates and Qatar Airways.

The ongoing recession will not be over in a year or two. Airlines will have to adapt to weak and unstable demand, and the government should comprehend that one-time rescue measures will prove inefficient already in the mid-term perspective. A radical shift of business paradigm from “growth” to “efficiency” is required to bring the industry back to profitability, which Russian airlines have not enjoyed since 2010.

Prolongation of the crisis and the associated asset concentration process will result in a situation in which only two or three network carriers will stay in the mainline business, complemented by specialized carriers on niche (regional or charter) markets.