Farnborough Air Show

Fuel prices, scarce credit could depress lease rates

 - July 3, 2008, 6:28 AM

Recent demand for younger airliners has ensured lease market buoyancy, but rental rates could fall if more operators release capacity or collapse under the pressure of fuel prices and scarce credit. Major lessor International Lease Finance Corp. (ILFC) has warned that air traffic growth might slow down, potentially causing “a negative impact on future lease rates.”

U.S. bank Citigroup shares that perspective. “It would seem that absolute lease rates have probably stopped rising, especially for narrowbody aircraft,” the company said in a recent statement. “The recent demise of several airlines has [made] about 60 aircraft available for leasing.”

The last several years have seen ever-increasing demand driven by market growth and operators needing extra capacity, said Jeff Knittel, transportation finance president at lessor CIT. He predicted that the proportion of leased aircraft will grow from 30 percent of the world’s airline fleet today to 50 percent “within five to ten years” as airlines seek greater flexibility.

“Operators are looking for the most efficient capacity possible, so lessors with newer models see brisk activity,” he told AIN. He expects to see airlines, especially U.S. carriers, releasing older, less valuable capacity by the fourth quarter of the year. Outside of North America, airlines have benefitted from the weak dollar, which is the currency of fuel, rental and sometimes maintenance contracts.

Citigroup aviation analyst Andrew Light predicted that of the aircraft released, those that are less than 10 years old will be easiest to place. “They are still in high demand in growth areas such as the Middle East and Latin America, and are also likely to benefit from the retirement of fuel-inefficient aircraft like [older] Boeing 737s and [McDonnell Douglas] MD-80s,” that will be the hardest hit by rising fuel prices.

Light suggested that the lease rates and aircraft values for younger narrowbody
airplanes should hold steady unless there are further airline bankruptcies. He added that such bankruptcies are “a real possibility,” especially among smaller U.S. and European low-fare airlines, U.S. legacy carriers and smaller European flagcarriers. In the short term, some older narrowbodies have benefited from a “ripple effect, whereby lack of availability of more modern equipment has forced airlines to seek capacity from [types] no longer in production,” according to The Aircraft Value Analysis Co.

Widebody aircraft should hold their values and lease rates because of the delay of two (or more) years in the Airbus A380 and Boeing 787 programs, according to Light, who pointed out that long-haul routes remain generally profitable and are operated by more creditworthy airlines, such as Asian and European major carriers. “Less creditworthy airlines tend to be the major lessees, [although] defaults have historically been rare,” he said.

According to Knittel, the credit crunch has reduced available liquidity. “The entire debt market has ‘detracted,’ but increased in spread, offset by [reduced] total interest rates, which has allowed [lease] rates to be [remain] at current levels over the past year,” he said.

Demand for leased aircraft has exceeded supply for several years, but that won’t necessarily continue. “We will see if that changes as more older aircraft hit market,” said Knittel. “We think demand for newer equipment has been maintained.” He believes trends are predictable “insofar as history can be a guide, but airlines have never operated at $130 per barrel [of oil] and current business models were not designed for $130 to $150 per barrel.”

Shrinking Market for Fuel-thirsty Airplanes
Citing early May prices, Light said, “Crude oil at $123 per barrel and jet fuel refining margins at $35 per barrel–both records–are not healthy. We expect more financial difficulties in the U.S. and Europe.” In his view, lease rates and residual values are falling as operators release inefficient aircraft. “Older generation narrowbody aircraft are losing value rapidly as oil prices are increasingly forcing airlines to park them,” Light stated. “Lease rates on the Boeing 737-400, for example, have fallen by around 25 percent over the last six months, from $160,000 per month to $120,000 per month. This is likely to lead to a 25-percent fall in market value.”

While demand may remain robust, airlines have ultimately to pass on higher costs to passengers to protect their balance sheet and stock value, said Knittel. “Everything depends on the elasticity of demand,” he said. “If it doesn’t fall there will be no issue, but if there is a drop, then there must be a cut in capacity.”

How demand for newer, more efficient equipment is met will depend on available capital, according to the CIT executive. “If operators are suffering a constraint on purchase capital, they can turn to a lessor, who may have access to finance,” he said.

Where might industry trends go from here? “Overall demographics say there are more people needing to fly in future, so there is a natural need for more aircraft.” The question for Knittel is how the world will adapt to a change in potential liquidity. “More specifically, higher fares can decrease growth. If oil [price] is in a more realistic range, then there is more room for growth,” he argued.

Knittel said that after the 9/11 terrorist attacks airlines responded well by reducing costs. “Now that they are facing the next layer of pressure on costs, [the question is] how will they adapt and what will be the effect of capital,” he asked. So which lessors will be winners and losers? “Ultimately, a winning strategy is to have a good franchise of new fleets less than five years old, an efficient tax structure and access to capital,” he concluded.

According to Citigroup, lessors with “an unbalanced fleet” are the most vulnerable, because their fleet depends on the success of a smaller number of options. It cites as an example AerCap, whose portfolio value it sees as being “highly dependent” on Airbus and engine maker CFM International. At the beginning of last year, Airbus accounted for 85 percent of AerCap’s total net book value; the A320 family represented 66 percent of the portfolio and all outstanding orders are with Airbus.

“This concentration could expose shareholders should the A320 family suffer technological obsolescence or unforeseen events that could materially reduce the residual value of the fleet,” said Light. Also, AerCap’s available leasing market is restricted due to its not having a relationship, via new aircraft orders, with Boeing.

For its part, ILFC derives about 90 percent of revenue from non-U.S. airlines, maximizing lease placements in strengthening regions such as Asia, Europe and the Middle East. It maintains a mixed fleet to provide balance and to maximize its opportunities, concentrating on new and used aircraft that will have the greatest demand and operational longevity.