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Rising Oil Price Unlikely to Thwart Aero and Rail Transport Demand

Global Economic Forecast

Investment forecasts are driven by models built on expected levels of economic activity. Shifting international dynamics and the impact of the U.S. Administration’s economic policies are driving changes.

While oil prices remained below $50 for most of 2017, recent volatility reminds us there is uncertainty as to their future direction. OPEC has raised its oil supply forecast based on US output growth. The U.S. is expected to be producing a record 10.5 million barrels a day according to preliminary weekly data from the Energy Information Administration (quickly approaching top producer Russia, which pumps about 11 million barrels daily).

Apart from the U.S., global economic growth is open to impacts from U.S. trade policy and sanctions on Russia and Iran. OPEC, along with Russia has been limiting output since January 2017, in order to drain a glut of oil that caused a historic price crash. The decision to exit the Iranian nuclear deal will mean the U.S. will restore wide-ranging sanctions on Iran, OPEC’s third-largest producer.

This and the movement of the U.S. Embassy to Jerusalem are likely to cause turmoil in the Middle East which will act to support crude pricing. Brent crude oil spot prices averaged $72 per barrel in April, an increase from March, and the first time monthly Brent crude has averaged more than $70/barrel since November 2014 (West Texas Intermediate crude is expected to average $5/barrel lower in both 2018 and 2019).

Transportation Investments Remain Promising

The U.S. and World economies are the basis for longer-term growth for both aviation and rail. The FAA baseline forecast for U.S. air carrier passenger growth over the next 20 years averages 1.9%. This baseline forecast assumes economic growth remains solid as both consumer and business spending expand (the recent Tax Cuts and Jobs Act acting as a near-term stimulus for both).

Compared to the baseline, optimistic cases are marked by more favorable business environments and lower fuel prices. Pessimistic cases are characterized by weakened consumer confidence, higher energy pricing, and higher interest rates which lead to a contraction in the commercial real estate and curtailed investment and spending. Will rising oil prices, rising interest rates, and an international shock lead to a stock market that falls sharply and an end to our long-running expansion?

Rail investment

For Rail, volume growth is continuing. Both petroleum and coal car loadings are improving. Total U.S. rail traffic for the first four months of 2018 has risen 3.2% year-over-year, is a shade below where it was in 2015, but otherwise is higher than it’s been in the last 10 years. The number of railcars in storage continues to decrease (but an oversupply remains which continues to impact demand and suppress pricing). The industry reported quarterly orders of 10,000 railcars for only the second time since the second quarter of 2015. While challenging, the North American railcar markets are improving.

Aviation investment

The Aviation industry consolidated with three major mergers in the last five years*. The bankruptcy of Republic Airlines in February 2016 is a reminder that the resulting financial pressures on regional carriers have not abated. But buried in United’s fleet plan for 2018 is the addition of 40 Bombardier CRJ200s and one Embraer ERJ-145 resulting in a net increase of 38 small regional jets in its feeder fleet. With crude oil pricing increasing, will carriers act to remove older less fuel-efficient aircraft? And, how will the U.S. act to engage with the rest of the global economy?

Industry knowledge, experience, and analysis allows us to adjust for unexpected variances in key variables. RESDICO has the investment insights that produce results. Contact us today!

 

 

*The top six, American, Delta, United, Southwest plus Alaska/Virgin and JetBlue account for more than 85% of U.S. airline industry capacity and traffic.
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Tax Cut & Jobs Act Un-Levels the Rail & Air Investment Playing Field

Investment in air and rail assets involves complex disciplines.

These include financing, legal, bankruptcy, jurisdictional analysis, documentation skills, insurance knowledge, residual collateral value expertise, tax structuring, accounting (under the new lease accounting rules), and an understanding of the after-tax cash economics of loan vs. tax lease pricing.

Secured lending is a credit risk and collateral value game. Lease finance is the preferred option, deriving value from the tax benefits the lessor passes to aircraft and rail equipment end-users. These tax benefits take the form of lower rents, flexible terms, early buyout options, upgrades, and the equipment maintenance and remarketing skills the lessor provides.

The Tax Cuts and Jobs Act and Impact on Transport Investment

The Tax Cuts and Jobs Act (TCJA) changed aircraft and rail equipment investment economics. It will change end-user equipment procurement strategies.

C Corporation tax rates have been permanently reduced to 21%, and the corporate AMT eliminated. Non-corporate pass-through entities access to a 20% ‘Qualified Business Income’ deduction is subject to various inequitable limitations and to sunset at the end of 2025.

The Act’s swift passage left application of many of its provisions unclear. As a result, technical corrections through legislative action or regulatory guidance will be required. Some of the significant provisions that affect both C Corps and pass through entities include the following:

100% Expensing

100% Bonus Depreciation is available when equipment is placed in service: 7-year MACRS for aircraft or rail equipment used predominantly in the United States, 12-year straight line for aircraft or rail equipment used predominantly outside the United States.

If the equipment is eligible for 7-year MACRS, the TCJA will permit U.S. taxpayers to elect the higher 100% bonus depreciation (or fully expense the acquisition). Access to bonus depreciation phases down for property placed in service after December 31, 2023, by 20% every year thereafter until it disappears completely in 2027. A significant change allows bonus depreciation for used equipment if the property is ‘new to you’ (note that bonus depreciation would not be available to purchases from related parties).

Ultimately, this full expensing combined with the new interest expensing limitations (see below) will make leasing more attractive.

Sale-leaseback

For example, consider a sale-leaseback. The TCJA will allow the lessor in a sale-leaseback to claim full expensing even though the user of the equipment remains the same. That means end users who have acquired and depreciated air or rail equipment will be able to enter into a sale-leaseback with a third-party lessor and continue to use the same equipment.

The sale proceeds could be used to reduce outstanding debt eliminating interest expensing limitations described below. Each pass-through entity or corporation (including members of a consolidated group) can make their own depreciation election for property placed in service, in each year, by each asset class (disregarded entities or trusts are not allowed separate elections).

However, such depreciation elections will apply to all assets in each class. That means if an entity makes a certain election for rolling stock, that election will also apply to commercial aircraft since both are in the same depreciation class.

Interest Limitation

The TCJA changed financing economics by including a limit on the current deductibility of interest expense. Section 163(j) limits the deduction of “Net Interest Expense” to 30% of the taxpayer’s EBIT (starting in 2018) or tax EBITDA starting in 2022, with any interest expense disallowed carried forward indefinitely. Eliminating a current deduction for 100% of interest translates into higher financing cost. Asset-based Bank Lenders will not be as impacted as non-bank lessors. Non-bank lessors may have to use Section 467 rent structuring to create ‘deemed’ interest income for tax purposes.

The Tax Cuts and Jobs Act provisions will require technical corrections. RESIDCO is leading a pass-through entity interest group that will explore investment alternatives and advocate for private non-corporate owned lease finance investment.

The goal? Level the competitive playing field!

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