RichardAboulafia.com 

:: December 2007 Letter ::

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Dear Fellow Carbon Footprinters,

As an aircraft forecaster, I like things simple. Expensive fuel = high ticket prices = fewer passengers. Airlines get squeezed between slack demand and higher fuel-related operating costs. Airlines buy fewer jets. Bad. All bad.

Unless of course high fuel prices are good. The recent Dubai Air Show confirmed what we’ve suspected for years: the Gulf States are converting their oil wealth into an aviation industrial policy. A rainstorm of jetliner orders in a desert of aviation in a strained metaphor going nowhere…let’s look at the facts. If you take the current jet backlog and run it through Teal’s pricing estimates, you come up with impressive numbers: Mideast carriers represent 14% by value of the total Airbus/Boeing backlog (492 jets worth $66.4 billion out of a total backlog of 6,329 jets worth $486.6 billion) and 21% of the twin aisle backlog (421 jets worth $63.2 billion out of a total backlog of 2,168 twin aisle jets worth $291.1 billion).

Contrast these backlog figures with Airbus and Boeing’s latest 20-year demand projections. Airbus says the Mideast should account for 4% of future jet deliveries (by planes). Boeing says 7% (by value, so the two forecasts are compatible). Mideast orders, therefore, are running at twice the anticipated rate. Three ways to explain this:

1. It’s a bubble. The traffic numbers sure look that way. Mideast origin & destination traffic growth figures don’t justify that backlog (again, see those Airbus and Boeing forecasts, which are based on traffic). But if a bubble is well-funded, it’s not a bubble. If oil stays above $60-70/barrel, the money will be there. Bill King, Washington State’s Aerospace Trade Manager, Dubai show attendee, and fellow metaphor dispenser, went skiing at that legendary indoor shopping mall. As he explained, that desert ski slope is an artificial creation, like an airline capacity bubble. But as long as somebody pays the snowmaking bills, that ski slope is with us. So rule out a bubble, leaving two other options:

2. Mideast airlines are hunting other people’s traffic. Yep. Singapore has done a great job playing the Sixth (and Fifth) Freedom game for years—using Changi as a hub for traffic between two other points. Now imagine the Mideast as Singapore, only with better geography and an awful lot more cash. Emirates is just the start. Qatar, Etihad, and Yemenia (Yemenia???) all want in on the action too.

3. Mideast lessors are hunting other people’s leasing business. Also likely. Orders at Dubai positioned DAE Capital to be the world’s third largest lessor, right after ILFC and GECAS. As with Emirates and the Emirate wannabes, DAE is inspiring many other Mideast lessors to get in the game. Sure, they’re buying at the peak of the market, but they don’t care. Like Mideast carriers, they’re a lot less focused on profit and have access to virtually limitless capital. They’re also hiring talented people. Legacy lessors face the unpleasant choice of yielding market share or competing on price, watching margins erode. This is totally compatible with the traffic explanation. Mideast lessors can work in tandem with local airlines to absorb and re-market excess or retired jets.

Most other airlines and lessors care solely about profit. They price their products and run their businesses accordingly. These Mideast players are trying to preserve oil wealth by converting it into something tangible—airlines, aircraft leasing, and aviation services. They don’t need to make money, at least in the short term. Even an A380 won’t lose value the way money can—dollar reserves in central banks have lost 25-30% of their value over the past year.

This is the part of the letter where I state the obvious: as a result of this aviation industrial policy, these Mideast airlines and lessors are the Aggressive Competitors From Hell. Maybe Mideast carriers’ operations aren’t subsidized, but their working capital is provided by governments and government-affiliated funds. It’s also possible that their infrastructure and fuel costs are largely taken care of. Just so long as these businesses don’t lose too much value, they can price to gain market share. The established legacy international carriers have little recourse. If the Airbus/Boeing trade dispute sprains the WTO, an airline trade case would smash it into a thousand pieces.

The big beneficiary of this oil-fueled aviation market share grab: Airbus. The numbers are clear. After Dubai, Airbus has a 65% share of the total Mideast backlog by value. Mideast orders comprise 9% of Boeing’s backlog and 13% of its twin aisle backlog. But the Mideast market accounts for 19% of Airbus’s total backlog by value and an astonishing 33% of Airbus’s total twin aisle backlog. Some reasons why:

1. The A380. Airlines that focus on profitability can only use the behemothliner on a handful of routes. But if you’re out to grab market share, the A380 has its uses. Accordingly, Emirates is the only airline to make a large commitment to this plane, holding about 30% of the total order book. These orders increase the mid-term outlook for this otherwise marginal aircraft and help Airbus’s widebody standing until the far more relevant A350 comes on line. An old airline maxim is that nobody ever went bankrupt flying a plane that was too small. Emirates has turned that on its head—anybody can grow market share flying a plane that’s too large.

2. A350 XWB. Boeing has won the 240/280-seat battle. For profit-focused airlines, the 787 is basically unbeatable. But Mideast carriers are emphasizing bigger planes (why focus on the front cabin when you can fill the whole plane?). The 787-8/9 is playing a minor role in the Mideast, and for some odd reason Boeing hasn’t definitized the 787-10. This leaves the A350-900 to attack the 310-seat market. Also, while Boeing slowly contemplates its 777-X/787-10+ roadmap, the A350-1000 is starting to take orders from the almighty 777-300ER. If a carrier really isn’t too concerned about fuel costs, even the pokey-looking A350-800 makes some sense. Hell, given Mideast carriers’ fuel cost apathy, even the fuelaholic A340-500/600 makes sense. Almost.

3. Politics. The US isn’t exactly winning the popularity war in the Mideast. Since Mid-East airlines are owned or heavily influenced by governments, aircraft purchase decisions are often made at the top. Favoring Europe for large aircraft contracts—civil and military—expresses diplomatic disapproval and avoids annoying the anti-US crowd. Access to European airports could play a role too.

Jet orders aren’t the only Mideast boost for Airbus. There’s also:

1. Equity. Mideast sovereign wealth funds and their semi-private cousins could take a stake in Airbus parent EADS, replacing some of the stakeholder equity that’s withdrawing. Even a modest Mideast stake would encourage private investment funds to join in, helping EADS create a new ownership structure. Think of this Mideast money as a Deus Ex Machina for Airbus. That’s no surprise—divine intervention plays a big role in Mideast thinking.

2. Defense Contracts. Parent company EADS is a major beneficiary of the biggest oil-related defense contract of all time—the Saudi order for 72-96 Eurofighters. They’re also benefiting from tanker, helicopter, and missile sales. That revenue will help pay for Airbus’s ambitious product development needs.

Like irony as much as I do? Consider this—after years of surreal, incompetent management, horribly dumb product launch decisions, dysfunctional unions, angry, bickering governments, and toxic office politics, Airbus, an aviation company, is saved by…high fuel prices. There goes my simple view of the world.

The only negative: As a result of this Mideast emphasis, Airbus is considerably more vulnerable than Boeing to an oil price drop or anything, such as a terrorist incident, that threatens the Mideast’s aggressive aviation market grab. Also, another complication (how I long for simplicity…):if Emirates and its wannabes are attacking legacy airline traffic with cheap A380s and A350s subsidized in part by EU development aid, and if the Mideast carriers are being favored with EU airport market access, then is Europe basically hurting its big international airlines to boost Airbus? Perhaps Air France/KLM, Lufthansa, and BA will start to notice.

Final thoughts. Of the top ten oil exporters, only one—Norway—is a free and open society. Mexico ain’t too bad. Two—Kuwait and the UAE—are relatively tolerant but authoritarian. The other six are ruled by some kind of repulsive dictatorship or another. Therefore, expensive oil means a vast transfer of wealth from the civilized democracies to far less appealing governments. But at least there’s an upside if you’re in the jetliner business.

This month’s Aircraft Binder supplement focuses on military programs—F/A-18, Su-27/30, AH-64, B-2, E-8 JSTARS, E-737/E-3 AWACS and the F-14. There’s a World Aircraft Overview update, plus the Falcon, A.109, and Bell/Agusta 609. A new report covers Mitsubishi’s MRJ. Have a great holiday season.

Yours, Until Life Gets Simple Again,
Richard Aboulafia

 

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