Oil prices are critical to airlines, the highest single element of cost. But when prices come down, the pressure often temporarily comes off, depending on whether the airlines are stuck with higher priced hedges. The impacts can be quite significant in terms of profitability, as the elasticity of downward yields has recently not been quite as rapid as declines in oil prices.
We are now in the midst of another drop in oil pricing. Of course, examining the long-term trends, airlines understand the cyclical nature of the market, and that they can’t be assured of lower prices forever. Some, like Delta Air Lines, have taken aggressive action to “backward-integrate,” purchasing a refinery to ensure supply and capture the “crack” spread of roughly 20 cents per gallon, which makes the payback for the refinery a “no brainer” economically, as shown in the following chart excerpted from Delta’s SEC filing.
The chart below illustrates the last five years of oil prices, showing the massive run-up that exacerbated the economic recession, and the most recent drop, in which prices reverted to the $80 per barrel level. The trend appears to be honing in on $100 crude as the new norm.If oil falls, and the pressure lessens for the more fuel efficient new models, will we begin to see a decline in demand for new aircraft, and perhaps a burst of the current “order bubble” that has Boeing and Airbus virtually committed for nearly the next decade.
We’ve already seen the first deferrals of aircraft orders, with Southwest pushing off some 737-800NG deliveries by 4 years to preserve capital expense. These are likely to be converted to Max models by the time they are delivered. Combined with the exhaustion of the Ryanair order book, Boeing will have a chance to balance its overcommitted 737 production line.
Both Airbus and Boeing are planning production line increases and considering additional capacity, given the high backlog of orders that have virtually sold out delivery slots thru 2015 for existing models and 2018 for the next generation of aircraft. We believe that might be a mistake.
There is a significant chance that the order bubble will burst, likely just after the OEMs and their suppliers add additional capacity. Airlines can’t afford to ground the current generation of aircraft in the short term and replace them all with the more fuel efficient re-engined models. Is a 15% reducing in fuel cost enough to obsolete the previous generation of aircraft? The short answer is no, but it will impact the market values of those aircraft negatively, as the market adjusts to the economic differences in the aircraft.
The market adjustment will take place through lower residual values that will offset the operating cost differential, and the values of 737NGs and A320 family ceos will necessarily fall once the 737Max and A320 family neos enter service. Once a critical mass of new technology aircraft are in service, lease rates will follow the lower values. We wouldn’t want to be taking delivery of new models of the current technology aircraft without substantial discounts over and above normal levels.
Historically, residual values for aircraft delivered in the last few years of production have not held their value as well as those delivered earlier, as their economic obsolescence arrives much sooner. With the new aircraft already in development, the handwriting is on the wall that newly delivered 737NGs and Airbus ceos won’t hold their values well after 2020.
Southwest’s decision to defer 30 737 deliveries for four years means those aircraft will likely change from 737NG to 737Max models, which makes good sense for the carrier. The bad news is that the carrier isn’t growing as fast as it has in the past, and can’t afford to fund additional growth. The good news from the deferral is that they will obtain a more fuel efficient aircraft when they do take delivery.