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TRANSPORTATION REPORTER

Speculation that Air Canada's AC.B-T new management may rip up its agreement with regional affiliate Jazz Air Income Fund JAZ.UN-T has rattled some investors, raising fears that service to smaller cities will be scaled back or cancelled.

Under a "capacity purchase agreement," Jazz is paid by Air Canada to operate a wide range of regional routes, such as Winnipeg to Thunder Bay. In effect, Jazz serves as a charter airline for Air Canada, collecting fees through the pact, which was renewed in early February and doesn't expire until the end of 2011.

But with Air Canada's new chief executive officer Calin Rovinescu sharpening his knife for cost savings, investors are getting nervous he will look at gutting the pact with Jazz, based in Halifax.

Jazz units fell as much as 20 per cent yesterday, marking their fifth consecutive day of declines.

Research Capital Corp. analyst Jacques Kavafian said the fastest way for Mr. Rovinescu to break the Jazz contract would be to have Air Canada seek court protection under the Companies' Creditors Arrangement Act (CCAA).

Tom Varesh, an analyst with Canaccord Adams, reckons Air Canada could be six months away from a CCAA filing, and Jazz would survive and even thrive in the long term.

But Mr. Kavafian said bankruptcy protection could come sooner, giving Air Canada the flexibility to chop roughly half of its routes, including removing 155 planes from a fleet of 333 aircraft painted with Air Canada and Jazz logos. He estimates that 118 of 133 planes under the Jazz banner could be removed from service and 37 Air Canada jets could also be cut from active duty.

Besides axing service to smaller cities, Air Canada hubs in Calgary, Montreal and Halifax could be reduced in importance, he said.

A source familiar with Air Canada said the scenario of cancelling the Jazz pact is "far-fetched," but industry observers warn that the relationship between the two carriers is bound to come under Mr. Rovinescu's scrutiny.

Jazz is insulated from most variable costs because Air Canada is responsible for paying for Jazz's fuel costs, airport user fees and navigation fees. Jazz covers wages, salaries, maintenance and aircraft leases.

Drastic steps are necessary to restore cash-strapped Air Canada to financial vigour, Mr. Kavafian said in an interview.

Canada's airline industry needs to be reshaped, and small independent carriers could expand and new ones emerge to fly regional routes that may be abandoned by Air Canada and Jazz, he said.

Mr. Kavafian said that if the Air Canada-Jazz pact were to be ripped up, cities affected in Canada may include the B.C. communities of Terrace, Smithers, Kamloops and Kelowna, as well as Gander, Nfld.

Porter Airlines Inc., based at Toronto City Centre Airport, plans to fly this summer to Thunder Bay - one example of how a regional carrier could help fill the void, if Jazz were to falter.

Thousands of jobs at Air Canada and Jazz are at stake, but if niche carriers expanded services, some of the laid-off workers would be hired elsewhere, industry experts say. Regional players - whose aircraft vary widely from bush planes to 120-seat jets - include Pacific Coastal Airlines, Hawkair, Central Mountain Air, West Wind Aviation, Bearskin Airlines and Air North.

JAZZ AIR (JAZ.UN)

Close: $2.32, down 34¢

AIR CANADA (AC.B)

Close: 82¢, up 4¢