With high fuel costs placing increasing pressure on airlines, managers are looking at all avail-able methods to manage their costs. Expansion plans must be reconsidered as the cost of launching new routes that take time to become profitable outweighs the projected benefits of providing additional destinations.
Around the world, airlines are cutting back their fleets, with older, less fuel-efficient aircraft models retired to save money. In the US particularly, airlines are preparing to ground planes in unprecedented numbers.
More than 400 aircraft are set to be grounded, with United Airlines, the world’s second-largest carrier, announcing in June it would be laying off 950 pilots as part of the cutbacks.
Fuel efficiency is now so critical that, where they can afford it, airlines are only interested in acquiring planes from a small group of new aircraft models that can offer substantial savings. Older models, even those that have served the industry well for many years, such as the Boeing 767, are becoming too costly to run at current fuel prices.
The Middle East has been quick to respond to this reassessment in strategy. As one of the only markets in the world that is showing strong growth, it is unsurprising that aircraft leasing is also expanding rapidly to keep pace with the demands of the local carriers. Kuwaiti leasing group Aviation Lease & Finance Company (Alafco) indicated recently that it could spend up to $4.2bn over three years on narrow-body aircraft as it aims to expand its fleet to 100 planes.
Dubai Aerospace Enterprise made a huge impression on the industry when it launched its aircraft leasing business, DAE Capital, at last year’s Dubai Airshow with a $29bn order.
Unlike many of their global peers, airlines in the Gulf are continuing to plan for ever-more capacity, with record numbers of planes on order.
With the delivery slots of the major manufacturers full, the operating lease market offers carriers the chance to replenish their fleets on a short-term basis, handing the planes back if market conditions change and the extra capacity is no longer wanted.
“Low-cost carriers in the region are following the Ryanair leasing model,” says Bob Charlton, a Dubai-based partner at law firm Freshfields Bruckhaus Deringer who specialises in the aviation and leasing markets. “They have seasonal loads so they need flexibility in their fleet capacity and can use the operating lease to regulate their costs.
“For airlines like Emirates, at the other end of scale, owning their planes outright or using a finance lease makes sense so long as they are the right cost-saving aircraft models.”
Andrew Cowen, chief executive officer (CEO) of Saudi low-cost carrier Sama, which launched in early 2007, confirms that demand for planes drove up lease rates last year, even before the oil price began to surge. Sama has deferred taking on new aircraft this year as it waits for the impact of the oil price to take effect and prices to drop.
“We have started to see a drop in rates on older planes that few airlines want, but rates on new aircraft have yet to adjust,” he says.
Abdulqassim Redha, senior vice-president for business development and treasury at Alafco, says rates have started to fall, but only fractionally on the models used by Sama and other low-cost carriers. The Airbus A320 and Boeing 737 are staples of the sector. Fuel efficient, they remain in huge demand.
“We have done two deals to bring in A320s and we have placed them all,” he says. “We are trying to get more for 2009-10 and they will go immediately. Part of the deterioration in lease rates we have seen has been due to dropping interest rates, not because of a drop in demand. Several airlines in the region are still looking to expand aggressively.”
The disappointment that greeted the announce-ment of further delays to the Boeing 787 Dreamliner emphasised how critical this model and others like it are to the future of the industry. Billed as the most fuel-efficient long-haul aircraft ever built, production of the Dreamliner is now more than two years behind schedule. Unsurprisingly, it is also the most popular model, with about 850 already on order with the manufacturer.
“It has been calculated that compared to a Boeing 767, the saving on fuel from a 787 doing the identical mileage will reach tens of millions of pounds,” says Charlton. “Airlines must have these planes to boost efficiency.
“Airbus and Boeing are full up on orders so the only way to get access to them is to get them from operating lessors, who have bought up all the spare planes. Demand for these planes remains strong but there is a rump of older planes, especially in the US. As there is a contraction in the market, a lot of these planes will sit in the desert and will probably stay there.”
LCAL, another new Dubai-based leasing group, has built its strategy entirely around the Dreamliner. Recognising early the impact the aircraft would have, the company secured early delivery slots for a group of 787s and now has 21 of the planes on order. The business has inevitably been hit by the production delays to the plane but Steve Clarke, a member of the company’s board of directors, says the plane’s popularity has not diminished, and LCAL will be in an extremely strong position when the 787 is eventually available.
“We recognised the 787 had the potential to be a game-changing aircraft and we wanted to get in on the ground floor,” he says. “The delays push back our revenue stream but this is irksome not impossible.
“We are looking to add more 787s to our order, but fuel efficiency is so critical to airlines now that everyone is keen to hang on to their slots for these planes despite the delay.”
With discretionary travel one of the first luxuries to be abandoned by the public in an economic downturn, Clarke says the short-haul market is the most threatened at the current time. “The narrow-body market will be hit far more than the wide-body, and it will be the long-haul market that is first to start the upturn,” he says.
Certainly this appears to be the case in the US, where the low-cost and business-only markets have been hardest hit.
Conversely, however, this presents opportunities to alert lessors. Alafco, seeking to build up its fleet of narrow-body A320s and 737s, has identified a new opportunity in the US, where airlines that had secured early delivery slots next year or in 2010 are not keen to use them while costs continue to rise. These carriers are reviewing their order books and may offer up their slots for sale, or sell their aircraft to a lessor before leasing them back.
For groups that can manoeuvre skilfully among the varying needs of all these airlines and their differing cost pressures, there is a huge amount of money to be made.
“There are signs that some airlines, especially in the US, are delaying their deliveries,” says Redha. “Because of the credit crunch, a lot of airlines may not be able to find finance for their orders, or are finding financing expensive. They may now look for a sale-and-leaseback with us.”
Middle East lessors are still much smaller than most of their peers around the world, but as with the region’s biggest airlines, the spending power emerging from the Gulf is making the industry sit up and take notice. The fleets of Alafco and even DAE may be minuscule compared with those of their great US rivals - GE Commercial Aviation Services (Gecas) and International Lease Finance Corporation (ILFC) - but they have newer planes. Moreover, they have a captive market in the Gulf that is still growing strongly, unlike others worldwide.
“Alafco and DAE are pretty high in the pecking order because they just have such tremendous buying power and the manufacturers know they are good for the money,” says Charlton.
DAE Capital’s entry onto the market in the past 12 months has certainly been impressive. Its $13.7bn order from Boeing was the second largest at last year’s Dubai Airshow, demonstrating the group’s tremendous buying power. Meanwhile, the $500m sale-and-leaseback deal for eight Airbus A330s from Emirates demonstrated how the business can dovetail with the needs of its resident airline.
“There are a lot of synergies between what we are doing and Emirates,” says Bob Genise, CEO of DAE Capital. “DAE and Dubai go hand in hand. This is a very dynamic market and the government is very interested in pushing aerospace.
“The timing of our entry into the market was fortuitous because airlines were keen to defer their orders. They are looking to the sale-and-leaseback market - it gives them the security of knowing they can get those planes back, and puts us in a strong position.”
Genise says this buyers’ market will persist as airlines continue to reduce spending. And as with the carriers themselves, the burgeoning Middle East leasing sector is becoming a significant force in the market.
“We have to focus on airline credit quality and be more selective about the airlines we work with, but we will compete with any lessor,” he says. “We do not have the volume of Gecas but we can compete with anybody on price.
“The long-term growth for this market will be strong. About 25 per cent of all the aircraft out there are on operating leases, and that will go to 30 per cent or higher given the current economic situation.”
MIDDLE EAST MODELS
There are several business models used by airlines in the Middle East when it comes to leasing or owning planes. Those that have strong relationships with their banks, excess cash and confidence in their long-term expansion plans are likely to buy their aircraft outright. The big three Gulf Airlines - Emirates, Etihad and Qatar Airways - own the majority of their fleets.
Others will look to leasing as a means of moderating their costs. Operating leases are typically short term, running for 10 years or less. These are attractive for a start-up carrier or an established airline whose expansion is likely to be more tentative.
Alternatively, a firm can employ a wet lease, in which the plane is leased to the airline together with its crew. These are used on a short-term basis to cover bursts in demand, such as the Hajj pilgrimage or the summer rush abroad.
Another type of arrangement is sale and leaseback. Here, the airline sells its aircraft to a leasing firm for cash, and rents it back from the lessor for a periodic fee.
Finally, some airlines use a finance lease, which is a longer-term arrangement under which the operator owns the aircraft at the end of the lease. This is attractive because airlines can claim depreciation deductions over the plane’s life, offsetting profits from the lease for tax purposes, and deducting interest paid to creditors.
A MEED Subscription...
Subscribe or upgrade your current MEED.com package to support your strategic planning with the MENA region’s best source of business information. Proceed to our online shop below to find out more about the features in each package.