Economic Slowdown Puts Pressure on Aircraft Orders

Orders for both narrow-body and wide-body aircraft have slowed dramatically in 2016 after several years of record orders. Global economic growth is waning, and carriers have begun to push delivery dates back or cancel orders for aircraft that are no longer needed in the same time frame. Has the down turn started? Recent examples include Delta Air Lines pushing back A350 and A330neo deliveries, and LATAM has large 787 and A350 orders and now deferring deliveries. Southwest is deferring deliveries of 67 Boeing 787 MAX8 aircraft as it rationalizes its fleet. Airbus net orders in the first quarter 2016 were for only 17 aircraft, certainly a fraction of the net orders expected for this year. Airbus has stated it expects to deliver more than 650 aircraft this year and "the order book will grow to more than 700." While the second quarter picked up a bit, the handwriting is on the wall. Boeing stated its 2016 outlook "reflects commercial deliveries of between 740 and 745. Boeing booked 121 net orders during 1Q16. Boeing's 2015 net orders were down 43% from 2014. Through May, Airbus booked 56 firm widebody orders which is slightly behind last year. Boeing secured 36 net widebody firm orders this year. The great rush to acquire aircraft appears to be over. The prospect of economic change and unpredictability, combined with low fuel prices that enable existing aircraft to remain profitable, are changing the landscape and delivery skylines at the OEMs. What’s behind this? There are several factors. The first is economic growth, which has slowed. China’s growth has slowed measurably. The Baltic Dry Index measuring shipping is at or near record lows. The US economy continues to struggle. It now appears Obama will be the first president in US history not to experience GDP growth of more than 3% in any single year in office, an abysmal record. Brazil is in a tailspin. The only bright spot for potential orders seems to be Iran, as sanctions are lifted and pent-up replacement demand is satisfied. The second is oil prices. New aircraft are costly, and when fuel prices are low, the differential between a high lease payments and small increments in fuel is telling. Today, aircraft are typically replaced when they are economically obsolete, not when they are physically obsolete. The Arizona desert is full of aircraft that could fly, but are fuel inefficient. In a low fuel cost environment, some legacy aircraft can continue to be as profitable as new aircraft, as the capital cost differential purchases a lot of fuel. While most analysts think oil prices will rise, few believe we will have the spike seen previously. Additional capacity that has been capped at lower prices can quickly be brought on line, providing a element to the supply-demand balance to keep oil prices steady. We don’t foresee prices above $50 per barrel in the next five years. The third is right-sizing aircraft. Most of the orders for new aircraft are larger than their predecessors. Many 737-700 models will be replaced by MAX8, such as at Southwest. But not all routes can sustain the traffic required to profitably deploy a larger aircraft. Many routes that Southwest began, and later abandoned for lack of profitability with low traffic, would be better served by a C Series or E2, right sized for those routes. We’re seeing a trend towards right sizing, with Air Canada and Delta orders for C Series being prime examples. This is good news for Bombardier and Embraer because neither the A319neo nor 737 MAX7 are competitive economically. The fourth is industry cycles. Economics slowdowns and exogenous events put the industry into recessionary periods that are typically followed by growth. While these impacts can be clearly seen on charts, when taken over the long-term they are minor blips on an overall growth path. But those blips result in orders being deferred, and picked up by airlines later as traffic increases. We’re seeing that this year as airlines have begun to reschedule deliveries. The orders are deferred, not cancelled, but will impact short-term production schedules and result in skyline juggling. The fifth is the supply chain. Suppliers are loathe to add capacity until they are certain that it is needed. Before investing capital in new facilities for increased output, they want to see an order backlog from the OEMs to ensure that an appropriate return is made on their investments. But as OEMs find aircraft deferred, they will have more difficulty convincing the supply chain that planned production rate increases will occur. Could we see more situations like Zodiac in which one supplier holds up deliveries? Without firm commitments to suppliers by OEMs, it is possible. The sixth is that the order bubble is bursting. We do not foresee Airbus and Boeing meeting their goals of 60 narrow-body aircraft per month by 2020, as the market simply isn’t there. Over the longer-term, 60 aircraft per month from the big two, combined with Bombardier, Embraer, COMAC and Irkut, would generate more capacity than either Airbus or Boeing’s 20 year forecast. And since that 20 year period typically starts from a smaller base and grows later in the forecast, 60 aircraft per month from Airbus and Boeing provides a considerable supply imbalance in early years of the forecast. We don’t believe that the current neo and MAX skylines will be delivered as currently scheduled, and project both increasing cancellations and deferrals over the next two years. On the wide-body side, orders for new wide-bodies have also slowed. Boeing’s aggressive two plant production of the 787 may burn through the backlog more quickly than thought, should additional deferrals occur. With production rate adjustments forthcoming for A330 and 777 as the neo and -X replacements come into play, wide-body deliveries are likely to remain relatively flat for the remainder of the decade. The Bottom Line: Production rates depend upon demand for aircraft. We foresee a drop-off in demand that will result in more limited growth for narrow-body production and flat production of wide-body aircraft in the short term. Neither Airbus nor Boeing will likely reach their target narrow-body production rates by 2020, and until the new wide-body programs are in place, a decline in deliveries is likely for both OEMs, even with Iran taking up some of the slack. The spin at the upcoming Farnborough Air Show will be interesting.

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