October 2010

By Abdol Moabery

Like every industry cycle, this latest downturn has brought on new challenges and changes to industry norms that typically rebound after the economic recovery.  Current changes are obvious and evident, but will they have a hidden impact that will affect aircraft values? And  will this ultimately alter the future of air travel and the way aircraft transactions are done?

Almost since the beginning of jet travel, the industry has experienced its up and down cycles.  It seems that we can count on a downturn about every 7-9 years, with a rebound typically beginning 2-3 years after the trough.  These down cycles historically have been economically driven, with an occasional kink thrown in by outside agencies such as unions or regulatory authorities.  For example, in late 1999, at the tail-end of the dot-com bubble, the industry started to spiral downward due to a sudden drop in business travel, sprinkled with a little Y2K fear and the ICAO Stage 3 regulations. We had a full blown start of a down cycle based on all real issues, but surely the industry would rebound quickly. So we thought.

It wasn’t until the autumn of 2001 when things changed forever.  The terrorist attacks on the New York World Trade Center and the Pentagon caused the immediate acceleration of an increasingly difficult market towards a full blown recession.   Air travel stopped abruptly and many questioned whether the airline model would even work in a climate where airliners were used as weapons.  While unrelated, the world’s leader in energy trading also suddenly collapsed, causing massive disarray in the capital markets. The US and the European markets were flung into an instant recessionary period.  Simultaneously, and almost as if by design, the SARS epidemic broke out in Asia, global oil prices shot through the sky, and there was an outbreak of war.  Suddenly the world was facing a disproportionate economic crisis that was perhaps going to be the worst downturn the airline industry ever faced; or could face.

Airlines were hit hard.  Recession, disease, terrorism and fuel price spikes were all things that the industry had experienced before, but now they were facing them all at once.  Fuel prices seemed to go higher and higher while RSMs/RSKs were going lower and lower.  Governments instituted new agencies such as the TSA in the US, that were charged with implementing strict security measures. Air travel became difficult, especially for the leisure traveler.  Despite the US government’s thwarted attempt to bring liquidity to airlines via the ATSB, one by one, airlines started to file bankruptcy.  Certainly, at that point, the airlines that had hedged fuel were feeling pretty good about themselves, while those that didn’t were trying to figure out how to survive and put hedges in place despite their cash positions.  Once in bankruptcy, airlines started to formulate and publish emergence plans around fuel prices as if that was their only woe.  Fuel, as an op-ex turned out to be the tip of the iceberg, underpinned by massive union, pension, and debt maturity obligations that also had to be dealt with.     

In spite of all of that, and, as with every other cycle before it, the industry started to rebound after a few years, and by 2006 things started to turn in the right direction.  However, by 2007, even though airlines were still not making money (nor was there a foreseeable light at the end of that tunnel), they were accumulating cash and had the increasingly greater confidence of the capital markets and, more importantly, the flying public behind them.  Fuel prices started to dip and finally it looked like recovery was in sight. 

Looking back at the period between 1999 and 2007, there were a lot of new issues that changed the commercial airline industry forever and their impact obvious and well understood.  Frankly, that impact now, pales in comparison to what loomed ahead as it relates to commercial airlines and aircraft.  Even more dramatic changes arrived in 2008 and 2009, but they were under the guise of a worldwide banking implosion coupled with disastrous global economic performance.  The key for our industry is not to look at these obvious issues, but rather at the hidden impacts of changes in norms and to try to navigate around what will most certainly be deemed game changers. 

Environmentalism is the first factor that needs to be given a closer look.  The use of bio fuels and more fuel- and emissions-efficient aircraft are absolutely imperative as we move through this millennium, but should this be driven by government or by industry?  Our industry, by virtue of increased technology and development, has consistently improved upon itself year after year.  This happens because of competition, not because of regulatory standards set by the government.  Why is it suddenly important for governments to start to regulate and tax airlines on emissions that are in fact decreasing year-on-year for no reason other than innovation?  Ultimately, regulatory interference will result in more surcharges and higher taxes on the ultimate consumer and will therefore create a burden on the industry.   Unless the entire world adopts measures like the Kyoto Protocol to impede emission saturation into the environment, it is an unfair tax on those that do implement such measures.

Another ongoing challenge is the price of oil.  While oil prices have affected air travel in the past, never has it been as drastic or prolonged as that we have experienced over the last six years.  Certainly, supply issues resulting from the war played a role, but those supply channels were soon mended and, frankly, were irrelevant to many markets.  We were told that emerging economies like China, Russia and India were growing at such a fast rate that they were burdening the world’s oil supply.  Concurrently, major financial institutions like Goldman Sachs and JP Morgan were putting out estimates that oil would hit $200 per barrel by the end of 2008.   Was this a true supply and demand situation or was there something else afoot?  It was no secret that there was major discord at OPEC.  There were those members who were building entire economies on the basis of $100 oil and they were going to do what it took to keep it there.  Key OPEC member Saudi Arabia was on the other side of this argument - although they were benefiting from the spike, they much preferred stability.  They publically denounced the posture that OPEC took and stated that they could easily increase their drilling capacity if there was someone out there to buy.  Wait a minute, how could this be possible?  The world’s largest exporter of oil said they had surplus capacity, yet oil was priced at $140 a barrel?  It all came down to speculation.  While speculation is usually a vital tool to allow for a more predictable future, it was being used to manipulate oil prices.  Soon everyone wanted a piece of the action and this became obvious when the government of Dubai launched its own mercantile exchange to trade oil. That was just what the world needed; another place to stockpile and hide oil futures.  I suggest that what the industry did need was a global transparency mechanism and some form of regulation.  While I am probably the biggest believer in less government regulation, there was clearly a problem that needed intervention.  Oil speculators, through global exchanges, were buying oil, stockpiling it and creating a sense of a supply shortage.  All this was made possible through immense access to liquidity by oil speculators and the lack of transparency of what was being bought and by whom.  This ultimately led to fuel surcharges being paid by the ultimate consumer and therefore another burden on the airlines. 

Global airline growth between 2000 and 2008 was the greatest in history. This was not necessarily growth in terms of existing markets, but rather in emerging markets.  India, Russia, Eastern Europe, the Middle East, Africa and Southeast Asia, through new open skies treaties and deregulation, experienced tremendous growth.  Countries typically served by one airline now had many.  New airlines popped up and started to pick up any airplane they could get their hands on.  The manufacturers were literally back-logged until the next decade. 

There is such a thing as growing too fast and this was made evident by a rise in airline accidents and brings us to the third issue.  The problem was that many of the governmental civil aviation boards were just not geared up and therefore were not able to keep up with the airlines adding airplane after airplane.  These governmental agencies reacted by regulating the age of the aircraft being imported into their countries.  Thresholds started at 20 years and soon many countries reduced the maximum age of an imported aircraft to 15 years.  I guess on the surface it make sense.  New is better right? Not really.  Instead of governments regulating what is truly important - training and maintenance - they opted for the younger is better concept.  Let’s take a closer look at this to see if this theory actually works.  A typical Boeing or Bombardier commercial airplane will have its heaviest scheduled maintenance in years 8 and 16, while an Airbus will have the same in years 6 and 12. On the basis of their methodology, wouldn’t the worst year to import a Boeing aircraft be year 15, the very year immediately before the aircraft’s most heavy maintenance requirement?  Ultimately, this leads to a much bigger problem.  What does one do with 16- to 20-year old aircraft?

In the end, we will all pay the price.  Banks and financial institutions will eventually figure this out and will institute stricter guidelines in the financing of commercial aircraft.  For example, a typical bank will loan money for a specific period of time with an amortization of the loan balance being calculated by the ultimate utility of the aircraft.   This is typically 25 years, but I have seen deals with amortizations at 27 and even 30 years.  However, if aircraft useful life is now deemed to be between 15 and 20 years, banks will eventually reduce amortizations to 15 years and this will have a major impact on residual assumptions.  It will also wipe out the secondary debt markets for used aircraft.  Using the above example of an amortization being reduced from 25 years to 15 years there is an increase of approximately 40% in annual amortization cost.  Many lessors will be wiped out.  Ultimately, greater finance costs will be passed on to the ultimate consumer by way of surcharges or higher ticket prices and this will definitely have a future impact on the airline industry. 

Having to take off your shoes at the airport and to carry toiletries in three ounce bottles is a pain, but tolerable, considering the rationale behind the rules.  The industry as a whole needs to understand the long term effects of current issues, and the hidden impact that will eventually affect us all.  Environmental regulation, oil prices and aircraft age regulation will all play a major role in shaping the future of air travel, airlines, and aircraft values.  What we as an industry need to do is to make sure that the ultimate consumer - the passenger - isn’t taxed, regulated, surcharged and priced out of flying.  Otherwise, the game will be changed forever.


GA Telesis is the global leader in the commercial aerospace support industry. With sales, redistribution and component maintenance facilities throughout the United States, Canada, United Kingdom, Mexico, Dubai and Singapore, GA Telesis currently has one of the largest inventories of full traceable Boeing, Airbus, Douglas and Bombardier rotable components and is also the leading redistributor of engine components for the CFMI, GE, P&W and RR engines.  Our component maintenance services cover over 25 ATA chapters spanning over 10,000 part numbers.

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