Analyst Warns of Catastrophic Downturn

Both of the major civil aircraft manufacturers, Boeing and Airbus, remain upbeat about the outlook for orders despite the impact that high fuel prices and the global economic slowdown are having on the airline industry. Indeed, the chief executive of US aircraft giant Boeing, James McNerney, has described soaring oil prices as an 'opportunity', which will speed up orders for new aircraft that consume less fuel than their predecessors.

"The high price of oil is speeding up the process of the oldest, least-efficient planes being taken out of service because they are no longer profitable," McNerney told the weekly Journal du Dimanche in July.

"We are already seeing it in the United States and it is starting to happen in Europe," he said, adding that the phenomenon would speed up orders for more recent models, which consume 30% to 40% less than the oldest planes still in service.

EADS is equally positive. Speaking at the Farnborough Air Show in July, chief executive Louis Gallois told the BBC that he also believed that the rising price of oil was encouraging airlines to buy new, more-efficient aircraft. He did concede, however, that there was a danger that airlines in financial difficulties might delay or even cancel orders, but added that, "we are not seeing that at high levels at the moment."

But while the manufacturers are still putting a positive spin on the influence of the worsening economic climate on the industry, analysts are predicting an altogether darker conclusion. Nick Cunningham, an analyst at Evolution Securities in London, told us his version of events.

Anthony Beachey: Do you think the likes of Boeing and EADS are being overly optimistic?

Nick Cunningham: Of course they are. The aerospace companies always say stuff like that and you would too if you were in their shoes. They are engaged in development programmes that cost more than $10bn each.

If you are going to get up in the morning and go to work every day as an air framer, you need to believe that everything is going to be fine. But I also think you need to plan for it not being fine. Post-2010 deliveries are going to drop sharply and given the lead times on production they need to start planning for this eventuality now.

AB: That is a pretty gloomy prediction about the prospects for the airline industry. What makes you think that the outlook is so bleak?

NC: We need to think in terms of two timescales. Firstly, there will be the immediate impact of a credit-crunch-driven recession and escalating airfares as surging fuel prices hit the airlines. The impact of these developments will affect the aerospace aftermarket over the next two years.

The effects on the original equipment market probably won't be felt until around the second quarter of 2010 because most of the aircraft currently being built, which account for most of the next 18 months' worth of orders, will get delivered. It's very hard to stop the assembly lines or slow them down significantly because there's already so much money invested in the aircraft that have already been ordered.

But from the second half of 2010 onwards, there is a real problem. That's because there is always a capacity overshoot during a recession as airlines continue to receive aircraft for up to two years after they have realised they don't need them and this overcapacity problem will be substantially exacerbated during the current downturn by the decline in traffic that is going to take place because of high fuel costs.

AB: What level of overcapacity are we looking at?

NC: I think we could end up with an oversupply of 30% too many aeroplanes. Some of that overcapacity could be accommodated by accelerated retirement programmes, but not that much. If you're looking at 30% overcapacity, that translates into an excess of about 5,000 aircraft. Given that the annual delivery rate 25 to 30 years ago, which is the age of aircraft you'd be looking at retiring, was only between 300 to 500 aircraft, even retiring five years' worth of aircraft would
only dent the oversupply problem.

So, to reiterate, I believe that post 2010 we will see a sharp drop in deliveries. Remember, in a regular recession deliveries halve and we will see deliveries remaining depressed for a very long period of time, as they were in the 1970s and right through the 1980s.

AB: Would a sharp fall in oil prices have an impact on this outlook?

NC: Yes, it would, but we would still have a recession, that was happening anyway. You can't forget that there is a credit crunch taking place for the first time in living memory, so the situation facing the aviation industry was always going to be serious, particularly as we are also coming off a bubble in terms of the number of aircraft that have been ordered. But it wasn't going to be catastrophic, but rather a more normal downturn. It's the impact of surging oil prices
that pushes the situation over the edge and into an unusual cycle.

AB: What is the scale of the casualties that might take place among the airlines, and what might be the outlook for the aerospace manufacturers?

NC: Regarding the airlines, that's a really difficult question to answer. I think it's worse for the aerospace industry than it is for the airlines. We have seen some casualties and we will see more, particularly among those airlines that are carrying too much debt and have embarked on expansion programmes that are too rapid.

Some of the low-cost carriers are vulnerable because fuel accounts for a much higher proportion of their costs. But broadly speaking, the escalation in fuel costs is a problem shared by all airlines and ultimately they are just going to have to price them into fares.

Everybody is going to have to put their fares up and this will take place over two years as hedging runs out. The effect of that will, of course, be to reduce traffic, but the airlines have got two years to adapt to this state of affairs. They could downsize by the necessary amount, perhaps 15% to 20% over the next two years. The aerospace manufacturers are in a much more difficult position. They are going to suffer from the overcapacity that the downturn in air traffic is going to
create.