Outlook for 2009 December 2008

The difficulty for aircraft values over the course of the next two years is that manufacturers are reaching record production levels at the same time, naturally, as demand slumps. Delivered aircraft will act more as replacements rather than grow capacity, so older aircraft will be displaced, leading to rising availability and lower values and lease rentals. On the other hand, the previous high price of fuel made it all but essential to acquire new aircraft, underpinning values and rentals, but a much lower fuel price will make new aircraft relatively less attractive. The better economics of the 787 are less relevant in an era of $50 a barrel pricing than $140. Therefore the application of any premium to the value of new aircraft due to greater fuel efficiency needs careful assessment.

In the widebody sector, Boeing is currently manufacturing only the 777–300ER and Airbus the A330 in any meaningful quantity, and so the focus of any potential excess is clearly on the narrowbody sector. The A320 and 737NG families are most at risk from excessive supply and the values of both types have already weakened materially. Even though the strike at Boeing has been resolved, production of Boeing aircraft during 2008 has been reduced by at least 10% from expected levels, providing some relief to the market (although not to those operators needing the lift).

Airbus has announced that a planned hike in production will be put on hold. Instead of the planned 40 A320 family members to be produced each month, this will be held at the current 36. Widebody production will remain at 10 a month rather than rising to 11. However, the combined production of Airbus and Boeing may therefore still be nearly 1,000 aircraft a year. As large numbers of older aircraft have already been retired, the 1,000 new deliveries have the potential to affect newer aircraft types by prematurely displacing existing equipment. Values of aircraft were already expected to fall in 2009 and 2010, but recent events have accelerated such declines. Residual forecasts for 2011 through to 2017 are, however, likely to remain reasonably consistent with previous predictions for those aircraft in production.

The prospects for the industry are far from promising. The fact that oil prices have halved from the levels of only a few months ago and are far removed from the speculated $200 a barrel level, combined with shift from an economic soft landing to a probable global recession of unknown duration, demonstrates the danger in extrapolating long–term trends from short–term changes. Fleet planning is a long term commitment and making decisions based on short–term market fluctuations can be premature and costly.

Basel II implications

The need for some major players to dispose of assets has the potential to influence values as sale prices reflect book value more than market values. Larger organisations, having previously acquired aircraft at large discounts, have written down such assets to levels that may be considerably less than current market values. With the lack of credit in the market and the need to raise cash to perhaps finance new aircraft, some companies have the potential to sell existing assets. The selling price could still achieve a book profit, but be significantly lower than current market values. While not strictly representing a distressed sale, the effective substantive discounting can then be viewed as the new benchmark for future transactions, undermining book values in general. European banks, falling under Basel II regulations (a capital adequacy framework), may then in turn be forced to dispose of some assets to reduce the perceived risk associated with aircraft financing. A further tightening of banking regulations was already being sought before the latest financial problems. In July 2008, the Basel Committee proposed an incremental risk charge that would capture price changes due to defaults as well as other sources of price risk, such as those reflecting credit migrations and significant moves of credit spreads and equity prices.

The Basel Committee also proposed improvements to the Basel II Framework concerning internal value–at–risk models. Prudent valuations for positions subject to market risk are also required. In addition, it has been clarified that regulators will retain the ability to require adjustments to current values beyond those required by financial reporting standards, in particular where there is uncertainty around the current realisable value of a position due to illiquidity. Such illiquidity has yet to emerge, but with a requirement to sell aircraft within a limited timeframe, sale prices may again be less than market values, consolidating the perceived downturn in values, precipitated by the extensive discounting afforded to companies previously ordering large quantities of new aircraft. The very means of facilitating the expansion of the operator base, and therefore an improvement in values, can also be a cause of subsequent asset decline when the market faces more challenging times.

A deterioration in values has already been felt by mostly older aircraft types as a consequence of higher fuel pricing and weakening demand in some areas. However, newer aircraft are becoming increasingly vulnerable to the vagaries of the cycle. Financing for new aircraft will have been put into place some months ago but as a means of mitigating risk, advance levels have fallen from perhaps 85% to 70–80%. This has meant that not only has the remaining equity portion of any financing increased, but that the associated cost of finance has also increased. Securing the equity portion of a transaction is becoming an increasingly difficult task.

There are, however, still sources of finance emanating from the Middle East, Japan and the expanding German private investor market, and potentially China. The delay in deliveries from Boeing, due to the strike, has allowed more time for financing to be found. The Export Credit Agencies (ECAs) such as ECGD in the UK, COFACE in France, Hermes in Germany and EX–IM of the US will increasingly be used as a means of securing financing should it be forthcoming, albeit at a price that will be passed onto the operator. Transactions are still taking place for both new and nearly new aircraft, so the market is far from illiquid.

Confidence and pricing

The difficulty in finding finance has been compounded by the consolidation of the banking industry. Banks previously active in aircraft financing have been acquired by other financial institutions, or even government entities, that may have little interest in such assets. Cash for planned deals may not be forthcoming and existing portfolios may be placed onto the market as prudence takes hold. Having acquired ailing or targeted financial institutions at a discount, selling the existing aircraft portfolio will also be made at an attractive price to a subsequent buyer. As the crisis in confidence causes further problems for the economy — and therefore airlines — the collapse of more operators will cause the remaining more conservative financial institutions to seek other investment vehicles. For operators, financing aircraft is therefore becoming more expensive, and generous sale and leaseback terms have become much more elusive. A rapidly changing financial structure is likely to fuel the migration of a decline in values of older aircraft to newer examples, even though the latter may be fuel efficient and feature an extensive, if fragile, backlog.

While both manufacturers have traditionally engaged in strategic pricing for just one or two orders each year, used values have not been impacted. Where such a policy becomes the norm rather than the exception, there exists a real possibility that the combination of higher production rates and lower pricing will also impact used values. Manufacturers are in the business of manufacturing new aircraft rather than supporting the residual values of used equipment, though to ignore used value trends can cause problems. Any cutback in production by Airbus or Boeing will only be a consequence of lesser customer interest rather than as a consequence of a move to stabilise values. If values of used equipment decline, this reduces the incentive to buy new, particularly if escalation clauses on new deliveries are exceptionally high.

As soon as the short–term shortage eases (about 900 aircraft were being actively marketed two years ago, representing nearly 6% of the world jet fleet; today availability has fallen to 500 aircraft or less than 3% of the fleet), any previous heavy discounting of new aircraft affects used values to a far greater degree, particularly if accompanied by production levels that have been generated by low pricing.