MADRID, SPAIN - SPANISH national carrier Iberia and British Airways said on Tuesday they were holding merger talks as the aviation sector battles soaring fuel prices that are hitting its bottom line.

'We would create the third largest airline in the world in terms of income with more than 16.5 billion euros (S$35.2 billion), with the fifth largest fleet of nearly 450 aircraft,' BA chief executive Willie Walsh told a joint news conference in Madrid with his counterpart from Iberia, Fernando Conte.

An all-share tie-up would rival Air France-KLM, the world's biggest airline that was born in 2004 after the merger of France's national carrier and Dutch peer KLM.

It would create an airline that is dominant on both the north and south Atlantic routes. Iberia is the market leader on flights between Europe and Latin America while BA is strong on routes from London to the United States.

Under the tentative proposals BA and Iberia, are both part of the 'One World' alliance, would retain their separate brands.

The dramatic merger plan comes as the world's biggest airlines face commercial headwinds from record high oil prices, which ramp up jet fuel costs, and weak consumer spending that dampens demand for air travel.

The adverse business climate has caused the collapse of 25 carriers since the start of 2008. Only airlines owned by oil-producing Gulf states, such as Emirates, appear immune to the aviation downturn.

'The aviation landscape is changing and airline consolidation is long overdue,' Mr Walsh said earlier on Tuesday in a press release.

The tie-up talks have the support of both company boards but Mr Conte said they were expected to take several months.

BA has had a stake in Iberia since 1999, which it increased to 13.15 per cent earlier this year.

Iberia announced Tuesday that it had bought a 2.99 per cent holding in British Airways and has the option to buy another 6.99 per cent.

'We've worked together for nearly 10 years and a tie-up would build on that success,' said Mr Conte.

BA had abandoned takeover plans for the carrier in November last year after Spanish savings bank Caja Madrid, which is partially controlled by the regional government of Madrid, built up a substantial blocking position.

Caja Madrid is now Iberia's main shareholder with a 22.99 per cent stake in the airline.

The tie-up talks also come as airlines seek to take advantage of the newly launched 'open skies' agreement that has loosened restrictions on airlines flying between the United States and Europe.

BA, which unveils first-quarter results on Friday, is pushing ahead with its OpenSkies trans-atlantic airline amid reports that it also plans to slash short-haul flights because soaring fuel costs.

OpenSkies, which was created to take advantage of the more flexible rules on carriers across the Atlantic, said on Monday it would launch a new daily service between Amsterdam and New York.

The carrier, a wholly-owned subsidiary of British Airways, was launched in June as a 'premium' airline initially on the New York-Paris route.

Shares in BA and Iberia spiked in London and Madrid in reaction to the announcement.

BA and Iberia a combined stock market capitalisation of about US$8.6 billion dollars (S$11.8 billion) according to AFP calculations using current share price values. -- AFP