Premium #206 – Backlogs and Fuel

Last year at North American ISTAT event, AVITAS’ Adam Pilarski delivered his annual market review and pointed out that there looked like a bubble in orders. Predictably, the OEMs present snorted in derision. Well in two weeks’ time it’s the annual ISTAT event again and we suspect Dr. Pilarski is going to offer new data to support his thesis. No doubt he will also predict the price of Jet-A – we were present two years ago when he predicted a major decline if fuel prices. There were lots of scoffers then too. But here we are today, and fuel prices are even lower than Adam dared predict. Today we focus on the relationship between fuel prices and orders -- those massive order books and mountainous backlogs. The chart below illustrates a history, showing backlog and Jet-A fuel price. Historically, there has been a strong correlation, but today orders keep rising (albeit slowly) as fuel prices fall. We opined more than once last year that we felt a bubble was forming. We reiterate our opinion, with a picture showing a major disconnect from historic behavior. Note how the backlog grew for Airbus and Boeing as fuel prices rose. In 2009 there was a dip in fuel prices and the backlogs softened. In 2016 the backlogs are at all-time record high levels. Fuel prices are at low levels and are likely to decline even further as Iran begins to once again sell its oil after the embargo. The Impact on Aircraft Demand The demand for fuel-efficient aircraft is no longer the same as it was even a year ago. We expect airlines and lessors to defer deliveries. Outright order cancellations are unlikely, because oil prices can easily spike due to an exogenous factor. For instance, if Iran were to fight an open war against Saudi Arabia rather than a proxy war in Yemen, resulting in Iran shutting the Straits of Hormuz. That would certainly move oil prices higher instantly. Airbus and Boeing have kept orders robust even as they have been disciplined with output and deliveries. Note how both firms have seen orders slowdown from 2014. They wisely have spoken about significant production increases, but have been more measured in actually accomplishing those increases, which do take time. These high backlogs are primarily in the single aisle segment. Talk of each manufacturer producing 60 aircraft per month is likely going to remain just talk for a while, and we believe both Airbus and Boeing will be forced to defer production rate increases to 60 per month to the 2022-2025 time frame, rather than later this decade. The news from ICAO about replacing all aircraft that do not meet their new emissions specification by 2028 provides a comfortable cushion for airlines. Aircraft operators simply have more than a decade to accomplish fleet renewal, and replacement of older aircraft. By that time, it is likely that Airbus and Boeing will be offering all new narrow-bodies to replace the neo and MAX, each of which is an older design. The Bottom Line Replacing aircraft today is no longer driven by fuel burn. Retiring an aircraft now is centers more about maintenance economics and major overhaul costs, as the differential in operating costs between older and newer aircraft shrinks dramatically with low fuel prices. Only the most worn out and maintenance-heavy aircraft are going to be replaced, rather than repaired, as the differential in capital costs for an existing aircraft against a new aircraft buys a boatload of fuel. In other words, the demand rush for fuel-efficient aircraft that began in 2010 with the introduction of the A320neo family is over. This makes it difficult for all those neos and MAXs about to be delivered as originally scheduled. We are not surprised Qatar delayed its neo delivery – the engine issue was a most convenient excuse. It is quite possible IndiGo’s comments can also be seen in that same light. The backlogs are going to shrink and get moved out to the right. Airbus and Boeing are going experience lower cash flows as customer’s delay deliveries, slowing down the payment stream. We believe both OEMs are likely to maintain or only slightly increase current production rates, rather than move to 60 per month before the end of the decade. Unfortunately, their supply chain is already spending money to increase their capabilities to meet the 60 per month goals, but may not be ready if the OEMs “cry wolf” the next time they plan an increase. Some of Airbus difficulties with the A350 result from an unwillingness to commit to planned volumes, and a reluctance of suppliers to increase capacity without firm orders. There are two sides to every story, and the long-term impact of production decisions put Airbus and Boeing in a difficult position. If they increase rates, they could more quickly burn through a large backlog, resulting overcapacity six years down the road requiring a rate reduction. If they don’t, they could alienate their suppliers who are already investing in capacity growth. All bubbles eventually burst, and we believe the production bubble will do so by the end of this decade.

US Flight Planner - US DoT On-Time Data	Airbus vs Boeing - Official OEM Data
US Airline Schedule Performance - US DoT Data	Daily OEM Production & Deliveries -

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