By Cyrus Sanati
FORTUNE -- The record-smashing number of aircraft orders announced this week at the Dubai Air Show by the big three Persian Gulf airlines could spell big trouble for the U.S. airline industry. The 355 wide-body jets ordered by Emirates, Qatar Airways, and Etihad to the tune of some $160 billion, arms the Gulf carriers with a huge fleet of aircraft, crushing their U.S. and European counterparts in terms of efficiency, comfort, and luxury.
This order may just be the beginning. Boeing (BA) estimates that airlines in the Middle East will need 2,610 new aircraft over the next 20 years, worth an astounding $550 billion. While around a third of the new jets will be slated to replace aging aircraft, the rest will be used to expand the various carriers' reach across the world. How they choose to expand should be of grave concern to the U.S. airlines as they could see some very unwanted competition from the Gulf carriers on a number of international routes they thought they had all locked up.
Last month Emirates flight 205 pushed back from Milan's Malpensa airport for the last leg of its maiden voyage. But instead of making the seven-hour trek back to the airline's home base in Dubai, the shiny, virtually brand new, Boeing 777 aircraft touched down at New York's JFK International airport. No, there wasn't a grave navigational error, the flight had landed in New York on purpose.
A few hours later, the plane turned around and headed back to Milan with hundreds of Americans on board bound for Europe. Passengers in first class paid thousands of dollars to enjoy the serenity of Emirates' private mini-suites -- a luxury not offered by any other airline flying on that route. Meanwhile, passengers in coach enjoyed Emirates' signature service, comfortable seats, and delicious cuisine, all while paying half as much as they would have if they had flown one of the more established U.S. or European carriers.
U.S. and European airlines are not happy with Emirates' move on their territory. How they choose to address the situation could have wide-ranging repercussions for the global airline industry. In the last decade Emirates, along with Gulf rivals Qatar Airways and Etihad, have risen from seemingly out of nowhere to become some of the largest and most envied airlines in the world. In 2002, the three Gulf carriers made up just 2% of the international air market, as measured by available seat miles. By the end of 2012, though, that number had jumped to 11% and is expected to rise further in the years to come. In contrast, U.S. airlines during the same time have gone from controlling 14% of the international market to just 11%.
But while the U.S. airlines have lost market share to the Gulf airlines, they have also managed to solidify their control over key airline markets, including the all-important trans-Atlantic route linking the U.S. and Europe. This was possible thanks to the competition-killing mergers and acquisitions that have left the U.S. with only three major international air carriers: United Airlines (UAL), Delta Air Lines (DAL), and American Airlines. Each heads one of the three worldwide frequent flyer alliances -- United with Star Alliance; Delta with SkyTeam, and American with One World. Through these alliances, the airlines successfully attained "antitrust immunity" with their main European partners, allowing them to legally collude to protect market share and profits.
After years of carefully crafting agreements, the U.S. carriers have started to see results from the alliances and mergers. United reported a 9% jump in unit revenue in the third quarter of the year on its trans-Atlantic flights, compared with the same time last year, while increasing capacity by just 2%. American fared better, reporting a 12% growth in unit revenue over the Atlantic after actually decreasing capacity by 2%. Meanwhile, Delta reported an amazing 20% increase in unit revenue on the all-important New York to London route, helping the airline post record profits for the quarter.
Over in Europe, the trans-Atlantic routes have helped protect the profits of the big airlines -- Lufthansa (Star), Air France/KLM (SkyTeam), and British Airways/Iberia (One World) -- which have come under heavy assault from the Gulf Carriers on connecting routes to Africa, the Middle East, Asia, and Australia. Emirates has managed to steal a great deal of market share on these routes by allowing passengers to skip Europe and connect through their massive hub airports in the Persian Gulf.
Emirates has successfully assaulted the European carriers at both the top and bottom ends of the market. Customers in Emirates' economy class usually pay less compared with competing flights, while still receiving a superior level of service. Upper class customers, meanwhile, usually pay more, but receive greater exclusivity and comfort compared to upper class cabins on European airlines, especially in First Class, where Emirates' customers have access to perks like onboard showers, personal suites, and chauffeured car services.
One of the key drivers that allows the Gulf carriers to bust up their competition is their virtually brand new fleet of widebody (twin aisle) jets. These new jets are cheaper to operate, as they require less maintenance and consume less fuel compared with those older jets flown by the U.S. and European airlines. Their massive size allows them to achieve scale on routes by packing in the passengers, but at the same time allows them to offer greater comfort with wider seats and more generous legroom.
Emirates has a fleet of 196 passenger planes, which is made up solely of widebody aircraft, like Boeing's 777 or Airbus' gigantic A380. At current count, Emirates already has more widebody aircraft in service than any of the major U.S. carriers, adding an average of two new aircraft every month. Its current order book after this weekend now comprises of some 385 aircraft, which is more than the current widebody fleet of all U.S. airlines combined. Meanwhile, Qatar Airways currently operates 77 widebody aircraft with another 115 on order. Etihad, which just celebrated its 10th anniversary, has a more modest fleet of 54 widebody aircraft, but has a whopping 171 on order.
Now, these aircraft will take years to manufacture, with many slated to replace planes that are currently in service. But orders this large clearly signal expansion -- massive expansion. Shaikh Ahmad Bin Saeed Al Maktoum, chief executive of Emirates, told reporters this week that he expects the airline will operate a fleet of between 350 to 450 widebody jets by 2025, which averages out to around double that of Emirates' current fleet.
So what is Emirates going to do with all that new capacity? That's the question on the minds of airline chief executives around the globe. Emirates already flies to 137 destinations in 77 countries, so it has a lot of the world covered already. But not everyone will welcome further expansion. For example, the Chinese government restricts the number of foreign flights allowed to land in its territory, limiting Emirates to just a handful of flights. The Chinese aren't alone -- even nations as liberal as Canada have thrown up restrictions of their own, limiting Emirates to only three flights a week.
The one place Emirates could expand where there would be limited restrictions and sufficient international demand is in the U.S. The current "Open Skies" agreement between the U.S. and the United Arab Emirates allows for an unlimited number of flights to enter and exit the U.S. from Gulf carriers, with no restrictions as to the destination of the outbound aircraft, as long as it ends up back in its home country. Cabotage rules still apply, though, meaning that Emirates, as well as all other foreign air carriers, are barred from operating point-to-point domestic travel within the U.S. But this shouldn't be of much concern to Emirates given its recently inked partnerships with U.S. domestic carriers JetBlue (JBLU) and Alaska Air (ALK). The agreements allow Emirates to tap their domestic feed to potentially create hubs in New York, Boston, Seattle, and Orlando. Its partnership with EasyJet in Europe serves a similar function on the continent.
Emirates has said it wants to double the number of cities it flies to in the U.S. from seven to 15 in the next few years. What it hasn't said is how it will connect those cities to its now vast network. Will it be through Dubai or will it be through another foreign city? Theoretically, Emirates could have aircraft operating from Dubai to Europe continue on to points in the U.S. Since there are no restrictions, Emirates could simply extend its network over the Atlantic, capturing the oversized profits currently being enjoyed by the U.S. and European airlines. Emirates could augment the routes with additional aircraft to maintain frequency on the expanded routes.
Such a scenario would undoubtedly inflict major damage to the bottom lines of U.S. airlines. As expected, the airlines have responded to Emirates' incursion over the Atlantic with rock bottom prices on the New York to Milan route. That's great news for passengers traveling between the two cities as fares have been sliced nearly in half, but it's bad news for the airlines, which almost surely are operating the route at a loss. Eventually one side will blink and either raise fares or withdraw from the market. Emirates has a huge war chest, but all this expansion has decreased its profit margins. It is unclear how long it can continue to hang in and fight. It may be wise to withdraw and reenter the market when it can launch service to a number of locations all at once.
But instead of fighting Emirates, the big U.S. airlines could try to co-op the airline by enticing it to join one of the alliances. One World nabbed Qatar Airways last year, effectively shutting down a threat from Doha. As long as Emirates continues to operate outside the alliance structure, it will be the U.S. airline's biggest threat. For now, Emirates says it wants to remain solo, preferring to enter into bilateral agreements that appear to offer Emirates access to domestic feeders. It seems disinterested in colluding -- just conquering. The battle for skies, it seems, as just only begun.
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