The Stengel Angle

I’ve written before that the airline industry is not exactly a globalized industry, but carriers have made significant progress over the past few decades with increasingly liberalized markets and relaxed regulations and oversight. While the revenue benefits of a larger network and scale are obvious, there are also the risks associated with becoming a larger global player, such as higher exposure to geopolitical and macroeconomic phenomena that can be beyond the control of the CEO. Currency exchange rates are perhaps the most dynamic of these factors, and recently have shifted enough to create a noticeable adjustment in transatlantic network strategies.

So, what happened with European currencies? After a period of stability throughout 2013, a series of events in 2014 strengthened the US dollar significantly versus many European currencies, with some exceptions. The principal drivers are:

1. The United States is viewed as the strong point in the global economy, making it an attractive destination for foreign capital. An improved trade balance, budget deficit, and higher interest rate relative to other developed economies is also working in favor of the dollar.
2. Oil prices are at a six-year low, driven by increased US oil production and the decision by Saudi Arabia to maintain production to protect its market share. Oil prices are traded in dollars, thus the dollar strengthened with falling prices. The decline in oil prices also adversely impacted large oil-based economies and currencies, such as the Norwegian Kroner and the Russia Ruble.
3. Speaking of Russia, the Russian Ruble has been hit by a double whammy of lower oil prices and sanctions implemented against the government for actions in Ukraine.
4. The Euro has weakened against the dollar as the European Central Bank is expected to implement their own form of Quantitative Easing, much like the US did following the Financial Crisis of 2008.

With respect to the strong dollar, it would appear that the opportunity is ripe for US carriers to add capacity to European cities. In reality, the answer has not been as simple. The factor complicating the response is that, unlike oil contracts or commercial airplanes which are traded and purchased globally in US dollars, airline tickets are denominated based on the point of sale. Travel agencies in the United States will sell tickets in US dollars, a Danish businessman searching for airfares over the internet will purchase a ticket in Krones, and so on.

This all means that the real goal of US carriers is not to blindly add capacity to Europe, but rather add capacity to European cities where the mix of US dollar-based passengers, or traffic, is the highest. Which destinations in Europe fit that profile? They are the smaller cities, vacation, and cultural destinations for US leisure travelers. Some of these cities may not yield the most absolute passenger numbers and will probably be served with smaller aircraft and fewer frequencies, but they will be composed principally of traffic that purchased tickets in US dollars. On the other hand, the cities that are unattractive to US carriers are the more business-focused destinations, where a higher percentage of passengers are purchasing tickets in Euros and other currencies.

How does this compare with the response of US airlines? According to data from the UK-based firm OAG (Official Airline Guide), the European cities with the largest traffic gains over the 2014-2015 period from US airlines on a percentage basis have been: Birmingham, Reykjavik, Pisa, Malaga, Athens, Istanbul, Venice, Copenhagen, and more modest growth in a handful of other cities. At first glance, Birmingham may be a surprising result; however, the British Pound has been fairly stable against the Dollar over the last two years and the culinary scene and nightlife is receiving more attention. In addition, the city receives a lot of Visiting Friends & Relatives (VFR) passenger traffic and is the gateway to the Midlands. The other cities also appear to fit the hypothesis posed earlier.

On the opposite end of the spectrum, the cities that have seen the largest US airline traffic losses are business destinations like Stuttgart (German automotive hub), Dusseldorf (German telecommunications and automotive hub), Frankfurt (German financial hub), Zurich (Swiss financial hub), and Geneva (Swiss financial and global political hub). In addition, cities in countries that are suffering from economic malaise, like Moscow, are seeing lower traffic. Helsinki is a unique case, as American Airlines was the only US carrier to serve the city on a route to Chicago, but discontinued the route and in its place, Oneworld partner and native carrier Finnair has taken over with seasonal summer service.

That seems to be the current state of transatlantic networks for US carriers, but what does the future hold? At the moment, it’s murky. The Federal Reserve’s potential decision to raise interests rates is receiving a lot of attention and would certainly impact the currency balance, but their decision is being made even harder with the currency developments. In addition, this development poses wider network challenges for US air carriers since they may have to reposition certain aircraft elsewhere in the network. For example, it’s plausible that United is bringing back ten widebody 777s from the international network to the domestic market because flights to large hubs, like Frankfurt, have been de-emphasized, but yet the aircraft are too large to adequately serve smaller city markets. For now, the hand is dealt in favor of leisure US travelers who want to take that vacation to getaway European cities.