The Coming Bubble in Narrow-Body Aircraft

Airlines and aircraft manufacturers periodically get into trouble when they over-commit to new aircraft and the OEMs raise production rates to levels that are unsustainable. We believe that another bubble situation is currently developing, and will result in an oversupply of narrow-body aircraft, lower residual values, earlier retirements of current generation aircraft, and will negatively impact the leasing market.

The old rule of thumb is that airlines order airplanes in good times they take delivery when things turn down. Fortunately times have changed,  both groups have gone to great lengths to try and smooth out peaks and valleys. The speculation on delivery positions that once occurred overtly has become much more subtle – but still exists. An example of this is Lion Air, which has more aircraft on order than currently operated by all airlines in Indonesia.

Today the backlog for aircraft over 100 seats is quite robust. As of the end of last year, firm backlog for more than 7,600 aircraft was in place from the six manufacturers, as shown below:

In their 2012 Commercial Market Outlook, Boeing indicated that 12,610 single aisle aircraft were in service at the end of 2011. If one were to assume an average 25 year lifespan for these aircraft, replacement would require production of 504 aircraft per year.

Production rates for these aircraft are also quite robust, and growing. Airbus and Boeing have each raised their production rates for narrow-body aircraft to 42 per month from 38. Bombardier plans to produce 10 CSeries per month, and Embraer has the capacity for 17 EJets per month, with the majority of the re-engined models likely to be larger E190 and E195 models. COMAC and Irkut will be entering the market with the C919 and MS-21 respectively by the end of the decade, and likely to produce at least five per month, and possibly more, for each model, as shown in the following table.

If we look towards 2018, when all of the new models are in production, we can expect a total production of 121 aircraft per month. Discounting a one month halt in production at Airbus, for the summer holiday, this would still total 1,410 narrow-body aircraft annually.

Airbus and Boeing, in their most recent Global Market Forecast and Commercial Market Outlook, show demand for narrow-body aircraft over the next 20 years at 19,518 and 23,240 units, respectively. But if the world’s airframers will be producing 1,410 per year, or roughly 28,000 aircraft over this period, assuming no further growth from today’s plans, a significant overcapacity gap emerges.

That gap, unless production rates are curtailed, would result in a major supply-demand imbalance; marking an additional 43% excess supply over Airbus forecast, and a 20% excess supply over the Boeing forecast. Of course, these forecasts don’t account for dramatic unanticipated events, as seen with the post 9/11 period or even the recent recession that has dampened traffic growth. What happens if we are faced with another event that causes growth to be curtailed? With current demand dropping back closer to replacement levels, even if only for a temporary period of a year or two, the pending bubble would only be exacerbated.

Why is the industry increasing production to unsustainable levels? For Airbus and Boeing, it is to try and tie up as much business as possible without giving the new entrants a foothold. Airbus and Boeing have generally conceded the 100 to 140 seat market to Bombardier and Embraer, and the marketplace agrees.  Customers have not ordered the re-engined A319neo (only 26 orders to date) and 737-7 Max (zero orders to date) in favor of larger aircraft from the Big Two, or the more cost-effective new technology models from the upstarts. Airbus and Boeing are now focusing their competition on larger narrow bodies, and also don’t want the C919 and MS-21, which are similar in size to their best selling models, to become successful. As a result, they are trying to tie up airlines both in China and Russia with new aircraft to reduce the potential impact and success of these new models.

At the same time, Bombardier, Embraer, COMAC and Irkut are trying to compete against a duopoly that is able to deeply discount their aircraft at will, in an attempt to price them out of the market on competitive deals. Bombardier has been a particular target of Airbus, who indicated they wouldn’t make the same mistake that Boeing did when it ignored a fledgling Airbus, and have been quite aggressive in campaigns against the CSeries.

But superior technology will prevail, and the four new technology airplanes will be more efficient than offerings from the Big 2., Each will be using the same engine technology as the Big Two, but with more modern airframes, materials and designs, and will therefore have lower operating costs than the re-engined compromise neo and Max solutions emerging from Airbus and Boeing.

The Bottom Line:
This doesn’t bode well for Airbus and Boeing being able to maintain their production rates at current levels over the longer term, unless they take lower margins and compete on pricing. That won’t make Boeing shareholders happy, although it might be acceptable in Europe as jobs will be maintained.

If the market demand is really in the ballpark of 21,379 aircraft, the average of the Boeing and Airbus forecasts, and the new entrants produce at modest rates, how much will Boeing and Airbus need to reduce their production to balance supply and demand? If you do the math, the answer is right around 30 aircraft per month, a significant reduction from today’s 42 aircraft per month.

A difference of 12 aircraft per month for each firm is quite significant. Having that many excess aircraft in the marketplace on an annual basis will have a deleterious impact on pricing, residuals, and the ability to recover purchase prices in lease contracts. The handwriting is on the wall, and it has been written by forecasters at Boeing and Airbus. Let’s hope the other parts of their organizations pay attention, before the bubble bursts.

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