Premium #156 – Are Recent Increases in Deferrals and Cancellations a Warning Bell for the Industry?

Last week, we saw two major aircraft order deferrals, with Philippine Airlines deferring a large order from Airbus, and then reports that Boeing is in talks with several Russian airlines regarding delivery deferrals. And we’re only in January. If this trend continues, the backlogs for the big two OEMs could push further to the right. With low fuel prices enabling existing aircraft to increase profitability, and signs that the lower oil prices could remain more stable as energy production shifts, order deferrals can be expected from carriers that might take one additional maintenance cycle with an older aircraft rather than replace it with a new one. The Order Cancellation Trend We’ve also seen a recent trend of cancelled orders in the industry. Airbus historic data from 2005-2014 shows a rise in cancellations in recent years, peaking at 18.9% of gross orders in 2014. When nearly 1 in 5 cancel, you need to significantly increase the order book to ensure continuing production. This level is a new high for Airbus, as shown in the chart below. Of course, some of the cancellations in 2014 can be explained, and some, such as Emirates cancellation of 70 A350XWBs, may be revisited in the near future. But an order taken off the books is simply that - a slot that will need to be filled by another customer. Is 18.9% a reason to panic? Perhaps not, as Boeing had significantly higher cancellation percentages in recent years when the 787 delays caused cancellations during the height of the industry recession. In 2009, Boeing had 263 gross orders and 121 cancellations, a 46% cancellation rate. A similar chart for Boeing is shown below: We’re seeing more cancellations recently than ever before. One reason is that the OEMs have been late with programs - A380, 787, CSeries, and even A350XWB from its initial targets. With delays in deliveries and OEMs not meeting contractual obligations, it is much easier for an airline to recapture progress payments made to OEMs. This has been one of the drivers for the increase in cancellation of orders. The following chart illustrates the percentage of gross orders cancelled by year from 2005-2014: While we are not in panic mode, such as when the 787 cancellations impacted Boeing in 2009 and 2010, the cancellation percentage remains higher than normal in 2014. However, with the 787 solidly in production, and the A350 entering service, there are few excuses for order cancellations today. Has the industry reached a new norm in which 1 out of every 8 orders will be cancelled, and do we now need to incorporate a new factor into our long-term forecasting? Post-787, there seems to have been a step function increase in the cancellation rate. Or put another way, do you really think LionAir will accept delivery of the more than 500 aircraft it has on order? Production Capacity Continuing to Rise At the same time, we’re seeing production rate increases at Airbus and Boeing moving forward. This article indicates Boeing is planning to ramp-up production to more than 900 aircraft per year by the end of the decade. With 723 deliveries in 2014, this represents a 24% increase over the next six years, about 5% per year. But with COMAC, Bombardier, and Irkut entering the market over the same period, and Airbus also considering a production rate increase, can the market absorb these new aircraft? We don’t believe it can. Is the Industry Creating a Bubble that will Burst by 2020? We see the first signs of trouble beginning to emerge with continued high cancellation rates (despite no further program delays) and signs that airlines may defer deliveries, which may be exacerbated by lower fuel prices. The difference in overall operating costs between an NG and MAX is about 5% at $100 fuel, and decreases as fuel prices drop. At today’s prices, that differential drops to between 3-4%, and the difference in capital costs is substantial when compared to a 5 year old aircraft. With today’s lower fuel prices, airlines will be able to keep existing aircraft in their fleets economically for a longer period of time. While the Philippine and Russian order deferrals may be the result of other reasons, we expect to see airlines carefully re-analyze the capital versus operating cost tradeoffs with new aircraft at alternative fuel price assumptions. Few are expecting sustainable $40 oil over the longer-term; industry expectations are for a level-off at $70 rather than a return to record levels of $120 seen in 2014. That changes the relative economics between new and used aircraft, and key parameters in the fleet renewal decision process. Oil prices do impact economic growth, which is the driver for traffic demand. If reduced oil prices can create positive economic growth, the industry could be in a position to avoid a recession and continue to sell aircraft. However, if we study history, the cyclical nature of the industry, with a recession about once a decade, indicates the next recession might be due just about the time the production ramp-up is completed. While we remain optimistic in the short-term, we foresee the potential for a medium-term disruption that could negatively impact airlines, aircraft OEMs and the supplier community.

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