Premium #166 – Fuel Efficiencies and Aircraft Pricing

When most analysts think about the airline business, they almost immediately move to the price of fuel, its highest cost element. Fuel prices have plummeted over the past year. There is no oil shortage and the airlines have exploited the decline in costs without giving up anything in fares in the US market. This is much to the annoyance of consumers and a source of happiness to Wall Street -- but with an oligopoly determined to not compete on fares, that is to be expected. So much for capitalism and enforcement of anti-trust laws. When oil prices were surging, airlines were clamoring for improved fuel efficiency, and adding fuel surcharges at every opportunity. At the same time, new technology aircraft enabled the airlines to reduce their fuel burn. The following chart illustrates the amount of fuel burned among US airlines per available seat mile. The improved fuel efficiency is impressive. The blue line, which shows gallons per available seat mile, is the more relevant factor financially, and the orange line offers an intriguing perspective, showing fuel used in relation to the number of seats offered. The data show a 23% improved fuel efficiency between 2000 and 2014. If the trend line holds by 2020 we could expect to see the improvement rise to 37%. This is clearly an even more impressive improvement. How might this impact the huge OEM backlogs, especially at Airbus and Boeing? The demand for better fuel efficiency brought about the new aircraft entering service; CSeries, neo, MAX and E2. By 2020 all should be in service. As fuel efficiency has improved, the fuel cost impact is dropping at the same time, a double benefit. While the fuel price drop has helped airlines, will it have a negative impact on the demand for new aircraft? After all, at the latest fuel prices, undue haste to retire older aircraft is unnecessary. Will it be more cost effective to fly older aircraft a bit longer, perhaps all the way to their next big maintenance check, before replacing them with new aircraft? If the cost of the fuel input stays low, the financial benefits from the next generation aircraft also drop. In short, with lower fuel prices, does the 16% improvement in fuel burn cover the additional capital costs, and are new aircraft still worth it? The short answer is that it is still likely to be yes, but by a much narrower margin than if prices remained high. With a narrower benefit, the option of running current aircraft longer becomes a viable consideration. At the January Airline Finance Conference it became clear this issue is near and dear to industry thinkers. As a group, they all believe that the current low fuel price is NOT here to stay. Airlines still want these new aircraft as soon as they can get them. The current fuel price drop is welcome relief, and airlines will continue to try keep fares high to repair weak balance sheets as they re-fleet with more fuel-efficient aircraft. But you can be sure that in future negotiations with the OEMs, lessors and airlines are going to use the current mathematics to drive down prices mercilessly. Customers see the OEM seven year backlog and, despite the urgency to obtain delivery positions, know that their backlog is not impervious to being picked apart with deferrals and cancellations. The OEMs have not helped themselves by saying at ISTAT in March that they knew all along that not all the backlog is going to be delivered, but are still increasing production rates to record levels for narrow-body aircraft. Will sustained lower fuel prices be the impetus that breaks the order bubble? Meanwhile another aspect to take note of among US carriers is the fleet growth. Growth occurs naturally as the demand for travel expands. But as an oligopoly industry the US carriers have shown remarkable discipline in capacity control – no more seat dumping sales as in the days of Crandall vs Wolf. As the chart below shows, immediately after 9/11 the industry took a big hit as older wide bodies left service in a hurry. But since 2003 the industry has slowly clawed back capacity even as a lot of traffic was directed to smaller regional aircraft. As 50-seaters gave way to 70 and then 80-seaters, the average has kept going up. Mainline carriers have seen moves away from the 737-500s and even the -300s. It is a slow but distinctly steady evolution. In the narrow-body market, we have seen Delta and United move towards the 737-900s and American to the A321s to replace aging 757s. Consequently we expect to see the seats per aircraft number to keep rising. The next chart illustrates just how the fleet is evolving. Although the US commercial passenger jet fleet declined by ~1% between 2010 and 2014, there have been some big changes in aircraft size among the Airbus and Boeing single aisle fleets. These selected aircraft are the heart of the US fleet. Of course larger aircraft are more fuel efficient. We can see that US carriers are being rational in changing their fleets most rapidly with larger narrow bodies, while ignoring the smallest models. Bottom Line In summary the US airline feet is evolving to larger aircraft and this is based on an established trend. The force of economics drives this process, and even though fuel costs were important at the start of the process, it is less so now. Yet the trend does not seem to be slowing down because airline managers do not believe the current oil price slump is going to remain for long. The orders the big four US carriers have announced amount to 887 and this constitutes 35% of the in-service single aisle fleet. At less than a third in line for replacement, we would agree there is upside for further fleet growth among US carriers. If we see sanctions on Iranian oil lifted and that country starts to deploy stored oil into world markets, expect oil process to fall again. The Saudis and Iran are involved with a proxy war in Yemen. Typically conflicts drive up oil prices and since the conflict abuts the Straits of Hormuz, we would expect to see market panic. But there isn't any. We do not expect to see this conflict impede oil supply, since both sides want their exports to continue – which only helps airlines because oil prices will stay soft. Even as US carriers therefore continue their fleet evolution, with low oil prices they will almost certainly revisit orders and put pressure on OEMs by wanting to revise delivery dates. The further airlines can push them out, under current market conditions, the better for them.

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