Premium #310 – The widebody market dependence on the ME3

There was an economic slowdown for the Middle East Three (Emirates, Etihad, and Qatar Airways or ME3) in 2016, after multiple years of substantial growth in revenues, yields, load factors, and profitability. Whether due to a lack of oil-related business traffic as oil prices went south, or the lack of political stability the Middle East having a carry-over effect on the relatively safe parts of the UAE, yields and profitability have fallen for the ME3 in the second half of 2016, with revenues not keeping up with growth in traffic. While the ME3 are still growing, have they reached the point of diminishing returns from that capacity growth? The short term evidence, at least for two of the ME3, is beginning to point in that direction. While we aren’t forecasting that an immediate recession is looming for these airlines, there is cause for concern, as the ME3 comprise a substantial portion of the new technology widebodies on order from Airbus and Boeing. With relatively young fleets, those orders are primarily for expansion. But diminishing returns could result in deferrals or cancellations, which could upset the order books for Airbus and Boeing, and potentially production rates. As we have seen Emirates do with the A380s. Let’s take a look at the new technology airplanes, which we define as re-engined or new models that only recently came into production or are still in development, and examine how each is exposed to orders from the ME3. The ME3 account for 26.6% of wide-body orders for new technology aircraft orders over the last decade. The largest percentage of orders from the ME3, for a new model, is for the Boeing 777-X, which is yet to enter service. The chart below shows the percentage of program orders, clearly illustrating this aircraft’s dependence on the ME3 for its success. It appears that Boeing designed the 777-X around the requirements for the ME3, but hasn’t as yet had much luck selling this new aircraft to carriers based elsewhere. With extensive hub and spoke networks, the ME3 have been able to integrate larger aircraft in their fleet because of their connecting traffic. Emirates is the largest user of the A380, and is also the largest user of the Boeing 777. It has a substantial order for the 777-X which accounts for nearly half of the 777X orders. But Emirates recently deferred additional A380s, an indication of traffic and earnings weakness. If those weaknesses persist at Emirates, how robust does the 777-X backlog look? The answer is perhaps not robust, and deferrals are possible - but these are orders Boeing is counting on delivering when the aircraft arrives at 2020 to restore the 777 production rate, which has fallen with a lack of orders for the existing 777-300ER model. Airbus faces its biggest threat with the A380. Emirates accounts for about half the in service fleet and the ME3 accounts for 44.7% of new orders since 2007. The success or failure of the A380 program will likely be determined in Dubai. The most recent deferrals by Emirates have resulted in an additional production cut in Toulouse, with some analysts indicating that this will move the program back into red ink. The new technology medium twins are also popular with the ME3. The A350-1000 has 64.8% of its orders from the ME3, and 21.9% of the A350-900 orders coming from the ME3. The ME3 accounts for 19.5% of the 787-10 orders, and 13.6% of the 787-9 orders. These three airlines carry a lot of weight in the wide-body market. But should they encounter economic difficulties, any order deferrals will impact widebody production rates. It seems nearly inevitable that since several countries in the Middle East, dependent on oil revenues, could enters a recession, as lower fuel prices are likely to stay. Governments that built their budgets around $90 oil prices have adjusted to the new $40-50 reality. When oil prices move over $50 per barrel, fracking operations in North America return to profitability and capped operations re-start pumping. Therefore the question of a cyclical Middle East recession isn’t if, but when - and leading economic indicators are projecting this to to be sooner rather than later. Longer term, electric vehicle penetration in the 2021-2030 time frame should result in a dramatic reduction in demand for oil, and Middle East economies will need to diversify their economies. While the ME3 are part of that diversification, they are also dependent on business travel yields. The ME3 are highly dependent on connecting traffic. Will lower oil prices that hurt the domestic ME3 economies spur growth elsewhere sufficient to keep these airlines growing? While the ME3 did order existing technology widebodies, the level of these orders was smaller for existing technology aircraft than newer technology aircraft. Their strategy was to differentiate themselves by operating newer aircraft than legacy competitors, and that strategy was successful. The ME3, between 2007-2016, ordered 24.78% of the Boeing 777-300ERs, with Emirates as the largest customer for that aircraft type. Apart from the 777-300ER, very few older model aircraft were ordered by the ME3, which tend to look forward and order the latest technology to maintain a competitive advantage. With most of those orders now delivered, the impact on production rates for existing technology aircraft should be minimal. The Bottom Line: Emirates, Etihad and Qatar can’t continue to grow at their historic rapid rates forever. When a slowdown comes, and it looks like its coming, there will be an impact on Airbus and Boeing. These three carriers account for a disproportionate share of the market. While we don’t expect a rapid change or economic disruption, we do expect an economic adjustment as lower yields lead to lower costs and trimming of unprofitable routes. That is likely to result in a additional order deferrals in 2017 and the need for Boeing and Airbus to find other customers in their planned skylines for their most important new technology models. The ME3 demand that has sustained high widebody production rates over the last decade may have peaked.

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