TAM, LAN and Avianca-TACA are also offering a superior onboard product, making additional investment in Iberia's service levels necessary.

The long-haul woes are compounded by the ongoing problem of not being able to operate short-haul profitably, because costs are too high and the Spanish market has become weaker with the local economy suffering.

Walsh says that Iberia is “chronically uncompetitive against the low-cost carriers,” which long ago made Spain their most important destination.

One move to limit short-haul losses was the introduction of Iberia Express, an affiliate with lower labor costs and significantly higher productivity. But now serious doubts are emerging as to whether Iberia Express can continue to expand as planned.

The airline launched three months ago and has been an operational success so far. It currently flies 10 former Iberia Airbus A320s and reached a unit cost improvement of 30% compared to its parent, 10 points higher than forecast. Another four aircraft are to be added next year as the Express unit has already been profitable in June. “Iberia Express and Vueling (the group's low-cost affiliate) show that it is possible to make money in Spain,” Walsh notes.

However, Iberia may no longer be able to use Express as a cost-savings tool. The airline and its unions have been in arbitration over pay and work rules and the ruling—unpublished—is “unclear and difficult to implement,” Walsh says. If it is not changed, it could effectively lead to a cap on Iberia Express' cost-competitiveness, limiting the carrier to only 14 aircraft. Iberia wanted Express to grow to 40 aircraft and provide a substantial part of its European service by the end of 2015. Those plans now hang in the balance until at least October, when a court is scheduled to resolve the case. Walsh already indicates that while Iberia Express was the preferred option to address short-haul losses, IAG has alternatives. Iberia could outsource part of its network to an operator in which it lacks majority ownership, industry sources say.

Meanwhile, integration of BMI into British Airways is going smoothly. Eight of BMI's 25 aircraft have been taken on the BA air operator's certificate (AOC) and have been rebranded, and 87 pilots and 125 cabin crew have transitioned. BA will not continue to operate BMI's two remaining Airbus A330-200s. It has also decided to shut down low-fare affiliate BMIbaby on Sept. 9.

Iberia may be one of the most difficult restructuring cases among Western European airlines, but it is not unique. While even market leaders Air France-KLM and Lufthansa are in strategic trouble, smaller yet relatively large independent carriers such as SAS Group's Scandinavian Airlines are even more exposed. SAS is suffering because the overwhelming majority of its business is short-haul—and no European legacy carrier makes money on short-haul these days.

SAS has gone through several restructuring programs and leadership changes, with industry novice Rickard Gustafson at the helm since last year. But neither Gustafson nor his predecessors have managed to stop the airline's downhill slide. For the moment, he is responding with more staff cuts. Gustafson says that “delivering productivity gains and cost savings will create redundancies that must be taken out.” The airline is already eliminating around 300 administrative positions and has cut thousands of jobs over the past several years. SAS has not made a profit since 2007.

Gustafson has also launched the 4Excellence program that is aimed at returning the airline to profitability. Unit costs are to improve by 3-5% annually and SAS reached 4% in the first half of this year. However, that is excluding the significant rise in fuel costs. With fuel included, the revenue/cost gap is actually widening and no end of that dangerous trend is in sight. Gustafson also admits that SAS cannot raise fares to compensate for higher costs given intense competition, notably from low-fare rival Norwegian, which continues its strong growth in the Scandinavian market. The uncertainties are so great that Gustafson does not even want to give financial guidance for the full year.