Even before the eurozone debt crisis ensued, 2012 was expected to be a difficult year for the global airline industry. But if things spiral out of control in Europe, the sector could be devastated.

“The biggest risk facing airline profitability over the next year is the economic turmoil that would result from a failure of governments to resolve the eurozone sovereign debt crisis,” the International Air Transport Association (IATA) says.

While the trade body maintains that 2012 might not turn out to be quite as bad as many expect, given the economic uncertainty globally, its forecast hinges on Europe restoring normalcy. Chief Economist Brian Pearce warns that Europe could slide into a deep recession if the debt crisis turns into a banking crisis, which would in turn cause a small recession in the U.S. and pull down China and other emerging economies as well. “Travel markets rarely decouple in economic downturns,” Pearce says.

The breakup of the eurozone would be a major disruption for carriers worldwide, although industry analysts say that would have more to do with the downturn in global economic growth that it would trigger than with airline-specific effects. Andrew Lobbenberg, transport analyst at the Royal Bank of Scotland, says that though the impact of a potential eurozone dissolution is hard to predict, airlines clearly would struggle to finance aircraft if banks were to fail.

Based on the latest economic outlook from the Organization for Economic Cooperation and Development, IATA has developed a secondary scenario for 2012 that takes into account the risk of the debt crisis turning into another banking crisis. In that scenario, with global GDP growth receding to 0.9%, the airline industry would lose more than $8 billion next year. European carriers would end up losing $4.4 billion; those in North America, $1.8 billion; and Asian airlines, $1.1 billion.

“This admittedly worst-case scenario should serve as a wake-up call to governments around the world,” IATA Director General and CEO Tony Tyler says. “In a good year, the airline industry does not cover its cost of capital, much less in a bad one. But in a bad year, aviation's ability to deliver connectivity and keep the heart of the global economy pumping becomes even more vital to initiating a recovery.”

IATA's negative outlook is based on the assumption that whenever global GDP growth plunges below 2%, the airline industry as a whole suffers losses. Moreover, IATA does not expect fuel prices to decline with a reduction in demand, at least not as much as in past crises. Pearce expects oil to remain at or above $100 per barrel next year. Airlines will pay $198 billion for fuel in 2012, according to IATA estimates, equivalent to 32% of their total costs.

Financing requirements for deliveries next year will climb to $95 billion, up from $77 billion this year, and grow to $106 billion in 2013, according to Kostya Zolotusky, managing director for capital markets leasing at Boeing Capital Corp. Unlike 2009, Boeing does not see a funding shortfall for 2012. For the main sources of delivery financing next year, the company forecasts that 25% of the $95 billion will come from equity, on par with this year, with export credit agency funding remaining roughly flat at 30%. Commercial bank lending will account for 21% of financing, a dip from 25% this year. Capital market financing, by contrast, will grow to 10%—or $10 billion—up from 5% of delivery monies in 2011.

Looking a little further ahead, export credit agency funding is expected to deteriorate in 2013, largely because this year's new rules for such financing have constricted lending terms. Many deals were grandfathered, but in 2013 the new terms will really come into effect.

Additionally, Boeing sees commercial bank lending tightening. That was already anticipated for 2013, when Basel III capital reserve rules (agreed by global banking regulators in September 2010) are to become stricter, but the current European financial crisis has accelerated that situation, Zolotusky says. He adds that fewer European banks will be making funds available, as it will be harder for them to access dollars.

Another area of strain is that airlines are no longer able to obtain pre-delivery financing from banks that provided it in recent years. Instead, Zolotusky sees a return to earlier models, in which carriers have to use equity or regional funding sources to make such payments. For lessors, the situation should be a long-term advantage, since airlines are forced to lease aircraft when purchasing them becomes more expensive, and new borrowing terms will allow lessors to better align lease and loan deals.

However, the implementation of the Cape Town agreement, which is designed to make repossessing aircraft easier in the case of default, will allow airlines to tap bond markets more easily. That source of capital has been largely limited to the U.S. but is becoming more global now. In the last three years, $72 billion has been raised from capital markets for aircraft.

If European governments manage to avoid the worst, including another credit crunch, IATA projects that airlines will nonetheless be unable to sustain this year's level of profitability. The association revised its baseline profit guidance downward for 2012, expecting global airlines to achieve profits of $3.5 billion in 2012, compared to its previous forecast of $4.9 billion. This outlook is based on the assumption that Italy's and Spain's financing problems will be resolved, though IATA believes a short-lived recession in Europe is unavoidable.

European airlines would lose $600 million next year, IATA anticipates, while North American airlines would turn in a $1.7 billion profit and 2.4% earnings before interest and taxes margin. A structural increase in demand will likely shield China and the rest of the Asia-Pacific region somewhat from the cyclical move downward. The $2.1 billion profit IATA forecasts for the region is still weaker than the latest guidance for 2011 of $3.3 billion (see chart, p. 27).

Middle Eastern carriers have to prepare for tougher market conditions, given their large exposure to the weakening European long-haul markets. IATA now sees them reaching a $300 million profit next year, down from its previous $700 million guidance. Latin America will amass $100 million in profits, while Africa faces $100 million in combined losses, the association projects.

“Even our best-case scenario for 2012 is for a net margin of just 0.6% on revenues of $618 billion,” says Tyler. “But the industry is really moving at two speeds, with highly taxed European carriers headed into the red.”

In the upcoming economic slowdown, passengers will be moving to less expensive classes within aircraft and to low-fare airlines, Pearce predicts. Low-cost carriers will grow more strongly than the rest of the industry, but they are also hit hard by high fuel prices that make it difficult to sustain rock-bottom fares.

“The growth rate of premium traffic is slowing,” says Lobbenberg. While it is still positive, the trend is coming down. “I think premium traffic is going to decline,” he notes. And with that decline, yields in the critical sector also are expected to come under pressure, hurting the bottom line of major network carriers. “We think the premium carriers are going to struggle quite badly” in Europe, Lobbenberg says.

IATA says airline financial performance so far is still “reasonably good,” in spite of the high fuel prices. Carriers were able to push through higher yields and cut non-fuel costs. Aircraft utilization was also kept high. “Airlines are resilient,” Tyler said at IATA's annual media day in Geneva last week. “The last decade has built an industry that is very experienced in dealing with crisis, shocks, downturns and twists of events.”

But Pearce warns that “excess capacity has made it difficult to make money.” In the U.S., carriers have been able to retire older aircraft, as they had already been written off. In Europe, cutting into capacity would be more difficult because fleets are younger and the use-it-or-lose it rule makes it difficult to pull out of markets, he notes.

“A consolidated industry will be a more profitable industry,” Tyler says. “It is quite possible that we will see further consolidation as the economic difficulties continue. That would be a good thing.”

The downturn in Europe and efforts by governments to improve their own fiscal balance are creating more acquisition opportunities. For instance, the Portuguese government has committed to selling TAP, and Ireland will unload its shareholding in Aer Lingus.

Despite those opportunities, International Airlines Group (IAG) Chairman Antonio Vazquez urges caution, noting that buyers risk acquiring problems as part of such deals. He says the key is not so much to be opportunistic about pricing but to focus on the strategic fit. Vazquez says he wants IAG to remain resilient enough to undertake a “transformational deal” once the regulatory environment permits such a move, a reference to the possible acquisition of American Airlines if U.S. foreign ownership rules concerning airlines are relaxed.

A European Commission official notes that a planned review of antitrust rules next year could also impact merger and acquisition activity in Europe: it will look at further limiting state aid provided to airports and airlines.