Pent up demand from pandemic lockdowns. Government stimulus ($5 Trillion). The Fed’s past abnormally low interest rate policy. These are the causes of the current distortions in economic activity. U.S. annual Core consumer price inflation remains high, 5.3%[1]. Wage growth continues. American Airlines pilots agreed to a new contract that boosts pay by 21% in 2023. Recent Class One national labor agreements resulted in a 24% wage increase during the five-year period from 2020 to 2024[2].
Current travel demand has driven Air Carriers back to nearly 100% of 2019 operations. Even with higher ticket pricing, there has been no slowdown in bookings. The lack of currently available new equipment[3] has resulted in a strong demand for immediately available narrowbody aircraft. Air transport markets are highly competitive, with low-profit margins. Fuel and labor are significant components of Air Carrier operating expenses. Any variation in these costs directly impacts operating profits. Lower energy prices and new engine technology provide direct economic benefits allowing more competitive pricing. Crude oil prices are down. July contracts for West Texas Intermediate (“WTI”) crude recently settled at $72.58 a barrel while Brent crude (the global benchmark) was $77.14 a barrel. China’s economic restart is stalling, Russian crude is continuing to flow, and the uncertain direction of the global economy is driving crude oil down further (WTI closed at $69.51 after the Bank of England raised interest rates to 5%). Without substantial technological improvements in alternative propulsion systems (or significant increases in the cost of crude), current equipment will remain competitive.
U.S. GDP data shows consumers are spending, and companies are hiring. In their June meeting the Federal Open Market Committee (“FOMC”) decided to leave interest rates unchanged (target range now between 5%-5.25%). Fed Chairman Powell signaled two more increases this year. Individual members of the FOMC expect a rate of 5.6% by the end of 2023. Rising interest rates paired with persistent inflation have led the Conference Board to predict, “A contraction of economic activity leading to a mild recession.” The Conference Board’s Leading Economic Index (“LEI”) is designed to provide an early indication of turning points in the business cycle. It’s declined in each of the last fourteen months. But 339,000 net new jobs were created in May (double what economists expected), auto sales are holding up, and April single-family housing starts were the most in four months.
Air transport is integral in the globalization of transport networks. More efficient engines and better aerodynamics have improved with each new generation of aircraft. Underlying price pressures and recession fears may lead to a slowing economy, but the U.S. economy continues to perform. The result is far fewer mid-life narrow-body aircraft are being retired. The pivot toward clean energy has begun but will take time and investment to complete.
It’s clear Aero and Rail needs will continue. Positioning transportation investment for the future requires underwriting discipline and an understanding of what drives demand for existing midlife Aero and Rail equipment. Build your portfolio strategically by focusing on practical solutions and best practices underwriting strategies. Call RESIDCO.
Glenn Davis, 312-635-3161
[1] Trading Economics, May 2023 data.
[3] “We cannot make planes fast enough to satisfy demand” Guillaume Faury, Airbus, Paris Air Show.
Locomotives, typically classified as 50-year assets, are primarily electrically driven. Despite the common label as ‘diesels,’ they are better described as ‘hybrid-electric’ vehicles. This is because their diesel engine powers an alternator which generates the electricity required to operate the electric traction motors mounted on the locomotive’s axles. As reported by the American Association of Railroads, transporting freight by rail is three to four times more fuel-efficient than highway transportation. Trains are capable of moving a ton of freight, approximately 492 miles on just a single gallon of fuel1. Yet, investing in a current Tier 4 locomotive today implies that you may still be burning carbon-based diesel well past 2050.
As both the Aero and Rail industries strive to incorporate cost-effective zero-emission technologies, there is active investigation into next-generation equipment and fuel alternatives. Among these is the application of hydrogen, a ’clean’2 fuel, either through a hydrogen internal combustion engine or via a reaction with oxygen inside a hydrogen fuel cell. These fuel cells use hydrogen to generate electricity. The world’s first passenger trains powered by hydrogen fuel cells, which produce the electric power to drive the traction motors, are already in commercial service in Germany, specifically for short-haul suburban rail services. In the U.S., companies like Caterpillar, Wabtec, Progress Rail, Cummins, and others are undertaking efforts to verify the feasibility of hydrogen as a viable substitute for traditional fossil-based fuels in line-haul services.
There exist alternatives to batteries for achieving net-zero transportation. Fuels made from non-petroleum sources, often labeled as ‘sustainable’ fuels, are derived from alternative sources in contrast to fossil-based fuels. These include oils from plants, algae, greases, fats, waste streams, alcohols, sugars, or captured CO2. Hydrogen, the simplest known chemical element, offers the highest energy density of any fuel. The byproducts of using hydrogen as an energy source are environmentally friendly heat and water.
Aviation fuels are distinctive due to their ‘specific energy’3, or energy per unit of mass. The current Jet-A fuel is a carbon-based kerosene fuel. While hydrogen offers three times the energy of kerosene per unit of mass, it demands four times the volume of the current Jet-A kerosene-based fuel to achieve the same outcome. The possibilities for hydrogen-based aircraft propulsion include electric motors powered by fuel cells, hydrogen-powered gas turbines, or hybrid systems that incorporate both fuel cells and hydrogen-based gas turbines. For short to medium-range aircraft, conventional gas turbine engines could be modified to use liquid hydrogen combustion. Hybrid aircraft, powered by hydrogen fuel cells, are currently being explored as zero-carbon alternatives. However, integrating hydrogen as a fuel source will likely necessitate the redesign of aircraft configurations4.
New technologies frequently come with high costs and are not instantly practical. The economics and investment timelines needed to transition to reduced carbon alternatives remain subjects of exploration. This transition will entail long-term efforts in designing new equipment, developing necessary material supply chains, devising cost-effective energy production alternatives, and establishing Aero and Rail fuel distribution and logistics networks. Despite the remaining challenges, investment in current midlife Aero and Rail equipment appears more attractive. Opportunities with lower risk and existing cash yielding attributes are available. Call RESIDCO.
Glenn Davis, 312-635-3161
1. Aii – Do Longer Trains Pose Problems or Solutions?
2. Office of Energy Efficiency & Renewable Energy – Hydrogen Fuel Basics
3. Wikipedia: Aviation fuel – Energy Content of Aviation Fuel
On March 23rd, 2023, the Federal Reserve voted unanimously1 to raise the interest rate paid on reserve balances by a quarter of a percentage point to 4.9%, marking the highest level since 2007. Although the federal funds rate range of 4.75% to 5% is above the Federal Reserve’s 2% target inflation rate, the annual inflation rate in the United States remains high at 6% for the 12 months ended February 2023, as per U.S. Labor Department data published on March 14th. This suggests that the Federal Reserve will continue to raise its benchmark rate. However, for Aero and Rail borrowers, higher interest rates will affect their ability to refinance maturing debt. Moreover, the banks are not accounting for duration risk in their ‘risk-weighted’ capital calculations. According to US GAAP, the value of “held-to-maturity investment assets” can be reported on the balance sheet at maturity values, which does not reflect their lower current market values in a rising interest rate environment. This is causing the current banking turmoil, which the Federal Reserve is addressing with a new Bank Term Funding Program (announced on March 12th), lending to banks at par against their held-to-maturity assets.
According to records dating back to 1988, February rail freight recorded its lowest total carload volumes (excluding intermodal originations). The decline in rail freight demand began in mid-2022. As retailers faced declining sales, they became more cautious and cut inventory levels. This was reflected in U.S. retail sales which were down 0.4% in February, the third decline in four months. In the first 11 weeks of 2023, rail freight volumes were down 5.2% compared to last year. February container imports at the ports of Long Beach and Los Angeles (the nation’s busiest) were down 38% year over year. Intermodal truck-rail was down 9.6% in the same period, with a 15.2% dip in the week ending March 18th. There is good news though. The Surface Transportation Board approved the CP/KCS merger2 4-to-1 on March 16th. The Board expects that this new single-line service will foster growth in rail traffic, shifting approximately 64,000 truckloads annually from North America’s roads to rail, and will support investment in infrastructure, service, quality, and safety. Moreover, rising interest rates make equipment leasing more attractive for both shippers and Class Ones, as they opt to maintain liquidity. This same dynamic will also influence commercial air carriers as they face similar market conditions. Although growth prospects for rail freight are mixed, these factors may help mitigate the decline in demand.
According to Delta’s Chief Executive, Ed Bastian, the airline recently had its highest sales days3 in its history. With more normal levels of aircraft utilization returning, air carriers are finding that the latest generation turbines (the LEAP and GTF engines used on the A320neo and 737MAX) are more fuel-efficient but not as reliable as existing technology CFM56 engines. The newer engines run hot, turbine components wear more quickly, and engine time on wing before removal and maintenance is required is not meeting expectations. Once in the shop, there are long waits for parts, and the availability of engine components is being impacted by the Airframer OEMs high demand for new engines. As a result, existing equipment remains in demand, as Air Lease Corp. Chairman Steven Udvar-Hazy stated that roughly 90% of aircraft leases are being renewed due to production delays at Airbus and Boeing.
The Bank stress that has appeared results from the extended period of unusually low interest rates. Equipment valuations and lease pricing will adjust in response. Regardless of ambiguities in the direction of demand, inflation, and geopolitics, capital should be allocated to productive opportunities. Existing Aero and Rail assets provide those opportunities. Call RESIDCO.
Glenn Davis, 312-635-3161
[1] Implementation Note issued March 22, 2023 – https://www.federalreserve.gov/newsevents/pressreleases/monetary20230322a1.htm
[2] STB Approves CP/KCS Merger With Conditions and Extended Oversight Period – https://www.stb.gov/news-communications/latest-news/pr-23-07/
[3] Delta Air Lines CEO Ed Bastian: There is still unmet demand for airlines due to the pandemic – https://www.cnbc.com/video/2023/01/13/delta-air-lines-ceo-ed-bastian-there-is-still-unmet-demand-for-airlines-due-to-the-pandemic.html
The International Air Travel Association expects the global aero industry to earn a $4.7 billion profit in 2023. U.S. and major European air carriers are better off than Asian (particularly China) carriers. Coming out of the pandemic, pent up air travel demand increased domestic load factors. Equipment and labor became operational challenges. As capital costs increased lease rates climbed. Both major airframers, Boeing and Airbus, continue to deal with supply chain issues1 and are unable to ramp up production as much as they would like. Inflation continues to drive increasing labor costs. Delta pilots reached an agreement (after three and a half years of negotiations) for an immediate 18% pay raise and a cumulative raise of 34% after three years. To deal with the pilot shortage, single pilot commercial aircraft operations are being explored. Over 40 countries including Germany and the United Kingdom have asked the United Nations body that sets aviation standards to help enable single-pilot flights. In November, Congressional action blocked a rail strike with a 24% pay increase over five years through 2024.
The $1.65 trillion Omnibus Appropriations bill funds the government through September 30, 2023. More spending will drive inflation down and continue job market strength. The Services PMI strengthened in November and is firmly in “expansion” mode. According to the “third” estimate released by the Bureau of Economic Analysis, the real gross domestic product (GDP) increased at an annual rate of 3.2% in the third quarter. The U.S. Bureau of Labor Statistics reports over the last 12 months the Consumer Price Index for all urban consumers increased 7.1% before seasonal adjustment2. At its December 14, 2022 meeting, the Federal Reserve raised its benchmark rate a half-point to a range of 4.25% to 4.5% (its highest level in 15 years). All indications point to higher rates in 2023.
Exemptions for the 737 Max 7 and 10 were included in the Omnibus Appropriations bill. Requirements include retrofitting with a synthetic enhanced angle-of-attack system and the ability to shut off stall warning and overspeed alerts. The retrofit work is to be completed (at Boeing’s expense) within three years from the time the 737 MAX 10 is certified and will be required on all 737 MAX jets.
Forecast farm net income is expected to surge to $160.5 billion this year3, the highest since 1973 when adjusted for inflation. Prices for corn and wheat have soared since Russia’s invasion of Ukraine. Reduced grain stock and continued pressure on Black Sea exports mean pricing strength will continue. Carloads of chemicals and grain are the second and third highest volume carload commodities for railroads. Carloads of coal are the single highest volume carload commodity4 at 28.4%, twice as much as chemicals at 14.2%, and three times as much as grain 9.6%. The International Energy Agency has stated, “Coal will continue to be the global energy system’s largest single source.” In Europe, coal use has returned with coal plants brought back online. In the first two weeks of December, Germany generated 49% more power with coal than in the same period a year ago as Russian coal has been banned as a result of sanctions on Moscow’s invasion of Ukraine.
Despite current macroeconomic conditions, lessors and equipment producers are seeing higher lease rates and equipment demand. We’re optimistic about 2023 opportunities. Call RESIDCO.
Glenn Davis, 312-635-3161
[1] Boeing suspends Russian titanium as Airbus keeps buying, Mar. 2022
[2] CPI Up 7.1% over the year ended November 2022, Dec. 2022
[3] High Commodity Prices Feed a Boom in the U.S. Farm Belt, Dec. 2022
[4] Rail Traffic for December and the Week Ending December 31, 2022, Dec. 2022
Aero and Rail equipment investors focus on both current short term challenges and longer term benefits that support the underlying strategies of their transportation equipment clients. Short term headwinds include inflation, interest rates, a rail strike yet to be resolved, resurgence of COVID-19 in China, deglobalization, a strong U.S. dollar, and continuing gridlock in Congress after the recent midterm elections. It’s the expected future benefits of current capital investments that are a big deal for commercial air carriers and class one railroads. Investments that expand market share or improve efficient network operations appear over a number of years. Short term cash flows vary with operating labor and fuel, which is highly unpredictable in the current environment. Both are the largest components of variable operating cost. The Union Pacific’s operating expenditures were over $12 billion in 2021, with 33% allocated to labor and 16% to fuel. American Airline Group’s operating expenditures were over $30 billion in 2021, with labor and fuel accounting for 38% and 22%, respectively.
Fuel prices have increased significantly in 2022, however, the U.S. Energy Information Administration’s November 2022 short term energy outlook1 expects weakening global economic conditions to limit demand and create a potential for lower oil prices, even after considering Russia’s invasion of Ukraine. The Organization of Petroleum Exporting Countries and their Russian led allies are expected to leave their production cuts in place given the softening forecast for global oil demand. The European Union plans to ban Russian crude imports, forcing Russia to seek alternative markets, pending a price cap that remains to be negotiated.
Labor issues continue in both equipment markets. In the rail industry, the combination of precision scheduled railroading and accompanying labor force reductions during the pandemic, meant to reduce operating cost, are driving rail labor to strike. The earliest possible strike date is now early December as the International Brotherhood of Boilermakers voted down the Presidential Emergency Board recommendations2, which asked Congress to intervene and avert the strike. In the aero industry, global demand for pilots is expected to exceed supply. In North America alone, a shortfall of 30,000+ pilots is predicted by 20323. Continuing labor issues ultimately will lead to network capacity constraints.
The focus of network equipment investment is to provide current cash operating income along with longer term equipment benefits. GATX, whose existing railcar supply agreement with Trinity Industries is expiring at the end of 2023, entered into a new ‘cost advantaged’ multi-year agreement for delivery of 15,000 railcars from 2024-2028 to provide for base fleet reinvestment needs in North America. On October 26th, Boeing released Q3 2022 results and is expecting to deliver 375 737 MAX jets in 2022. Since June, Boeing’s 737 program has been producing 31 aircraft per month despite ongoing supply chain issues. Airbus released Q3 2022 earnings on October 28th and maintained its target of 700 commercial aircraft deliveries this year.
Addressing current opportunities that midlife equipment investment presents, and comparing those to expected future alternatives, require an enhanced capacity to perceive, interpret, and respond. In the real world all investment involves choices. Call RESIDCO.
Glenn Davis, 312-635-3161
[1] EIA Short-Term Energy Outlook, Nov. 2022
[2] Boilermakers Reject Labor Agreement With US Freight Railroads, Nov. 2022
[3] The U.S. Has a Pilot Shortage — Here’s How Airlines Are Trying To Fix It, Sept. 2022
A strong labor market is driving wage inflation and a falling unemployment rate (now 3.6%, just above the 3.5% it was before the pandemic). Even though the U.S. GDP was down 1.4% in the first quarter, rail carloads originated in March were up 1.2% year over year. The unexpected GDP drop was driven by a decrease in exports (due to a stronger U.S. Dollar), and an increase in imports (which are a subtraction in the calculation of GDP). The Ukrainian conflict and China’s continuing lockdowns (Xi Jinping’s zero-Covid policy) are extending global supply chain disruptions. The International Monetary Fund reduced their 2022 global growth estimate to 3.6% from 4.4%, citing the Ukrainian war’s disruption of global commerce and its impact on oil and agricultural exports from Russia and Ukraine. While inflation is reducing consumer purchasing power in the U.S. (consumer prices are up 8.5% from a year earlier), the Conference Board is forecasting 3% growth for the U.S. economy.
High steel prices[1] are driving premiums on new railcar deliveries. This new equipment inflation has created opportunities in the secondary markets, benefiting existing equipment values and allowing lessors to reprice lease rates up. Overall rail traffic remains mixed. Chemicals, crushed stone and sand, food and wood products are up; grain, motor vehicles and parts, lumber and wood products, and petroleum and paper products are down. Coal is benefiting from an increase in coal-based electricity generation as natural gas prices have increased (coal’s share of U.S. electricity generation rose to 21.8% in 2021 from 19.3% in 2020). Corn and soybean prices have risen to near records (corn is more than twice as expensive than before the pandemic). Auto inventories remain at historical lows (the average new vehicle cost is $46,000 and used car prices are up 40%).
Domestic U.S. aviation passenger demand is growing[2] and business travel is returning. American Airlines said its bookings and revenue in March were the best month in the company’s history; “business travel is on track to reach 90% of 2019 levels in the second quarter.”[3] Given current world events, the international long-haul market remains a moving target and is not expected to recover until at least 2023. U.S. and European countries have closed their airspace to Russian aircraft and Russian carriers are not operating foreign leased aircraft outside of Russia’s borders. Sanction related shifts in economic activity, geopolitical uncertainty, and China’s lockdowns are impacting Boeing and Airbus order books[4]. Air freight load factors are lower, but prices are higher. Although Russia is party to the Cape Town Convention, Russia’s move to reregister Western lessor owned aircraft operating in Russia will impact the values of this equipment when (if) returned as without access to up-to-date flight and maintenance records aircraft are not considered airworthy.
Crude oil remains over $100 a barrel and elevated energy prices are a concern. Delta reported a 33% increase in jet-fuel prices for the first quarter to $2.79 a gallon with the expectation of $3.35 in the second quarter. In its efforts to reduce inflation, the Federal Open Market Committee is expected to raise its benchmark rate 50 basis points this month, and again in June with a target rate of 2.25% to 2.5% by the end of the year. The Bank of Canada has already raised its key rate by a half-point to 1%.
Existing midlife Aero and Rail equipment is significantly less expensive than new. Whether rebuilding and reconfiguring or managing aftermarket teardown and part out, there are opportunities in these hard assets. Headwinds will continue. The key to long-term portfolio profitability requires equipment specialists. Increase returns, control risk. Call RESIDCO.
Glenn P. Davis, 312-635-3161
[1] Two-thirds of the 6 million metric tons of pig iron imported by the U.S. came from Russia and Ukraine.
[2] 2.1 million people passed through airport checkpoints in late April, up from 1.4 million three months earlier.
[3] CNNBUSINESS, April 21, 2022
[4] Air Lease said it has written off more than $800 million in assets
Investment and financing decisions involve an evaluation of risk, amount and timing of cash flows, and expected equipment values over an investment horizon. The outlook for Aero and Rail cash flows for the balance of 2022 have changed as the Global community reacts to Russia’s invasion of Ukraine. Even though Russia is a signatory to the Cape Town Convention it is holding more than 500 Western owned aircraft inside its borders in response to the European Union requiring lessors to terminate contracts with Russian airlines by March 28. Operating in an environment without the oversight of Western regulators will impact the value of these units when (if) they are recovered. Its evident values are lost when social and economic cooperation is stressed.
The U.S. has banned imports or is increasing tariffs on Russia’s top products including crude oil, petroleum, petroleum fuels, liquefied natural gas, coal, and iron and steel. Russia and Ukraine combined are the world’s second largest steel exporters and together supply almost one-third of the world’s wheat, a quarter of its barley, and three-quarters of its sunflower oil. Companies (and Countries) that rely on these products and raw materials will suffer. Crude oil and steel prices are up. Energy security in the U.S. (and more so in Europe), is now more important. Falling back on fossil fuels (coal), and boosting drilling is a likely immediate path for the U.S. as the transition to renewables will take years to accomplish.
Domestic freight rail will benefit. The conflict will drive U.S. domestic transport of agricultural and petroleum products, crude oil and coal. Recall that according to the American Association of Railroads, moving freight by rail is 4 times more fuel efficient than moving freight on the highways. Trains can move a ton of freight approximately 492 miles on a single gallon of fuel. On the aviation side, fuel is typically an airline’s second biggest expense after labor. But the surge in domestic air travel[1] is allowing air carriers to cover fuel price increases. In February, domestic ticket bookings and revenue rose above 2019 levels (for the first time since March 2020), and corporate travel booking has reached 70% of 2019 levels, the highest since the start of the pandemic.
In recent quarterly earnings calls railcar manufacturers and lessors are upbeat about rail market prospects. Rail traffic is continuing to improve driving fleet utilization, new equipment orders and lease renewal rates. Fourth quarter 2021 freight railcar orders grew by more than 50% from the third quarter. Orders in the fourth quarter of 2021 were 13,477 railcars compared to 8,607 railcars in the fourth quarter of 2020. The order backlog has increased sequentially for the past five quarters. Total rail carloads for the week ending March 19 were 232,770 carloads, up 1.1 percent compared with the same week in 2021. Five of 10 carload commodity groups posted increases compared with the same week in 2021 including coal, up 4,182 carloads to 63,929; chemicals, up 2,656 carloads to 34,178; and nonmetallic minerals, up 1,984 carloads to 31,151.
With the Consumer Price Index up 7.9% over the last 12 months the Fed is raising interest rates (.25% at its March meeting[2]). Expectations are rates will rise at each of the remaining Fed meetings this year while balance sheet reductions could start in May. Odds don’t favor stability as Geopolitical risk has splintered Globalization. Negative real rates persist and will continue to drive asset values up.
Be prepared for turbulence. Opportunities exist. Call RESIDCO.
Glenn P. Davis, 312-635-3161
[1] “We’re seeing an increase in demand that is really unparalleled” Delta Air Lines, investor conference, March 2022.
[2] Rates were last raised in December 2018
Coming out of the pandemic and in the early stages of a recovery, the world is responding to Putin’s choice to invade Ukraine. The impact on investor confidence is reflected in the market’s volatility. Crude oil prices are up. Rail and air freight capacity from Asia to Europe has been eliminated. The European Union Aviation Safety Agency (EASA) advises Ukrainian airspace and airspace within Russia and Belarus within 100 nautical miles of Ukraine borders pose flight risks (recall the Malaysia Airlines flight MH17 which was shot down over eastern Ukraine in 2014). Air carriers and countries are shutting down commercial flights. The UK banned Aeroflot (the Russian Flag carrier) and all Russian registered aircraft from landing in Britain. In response, Russia banned British airlines from landing at Russia’s airports (and from crossing its airspace). Hungarian airline Wizz Air and Ireland’s Ryanair have suspended flights. Poland and the Czech Republic have closed their airspace to Russian airlines. The FAA expanded the area in eastern Europe and Russia where U.S. airlines cannot operate. The expanded area includes all of Ukraine, Belarus and a western portion of Russia. Russian companies have 980 passenger jets in service, of which 777 are leased. Of the 777 aircraft, 515 are leased from foreign firms (generating $100 million every month from Russian firms to Irish based leasing companies). Dublin based AerCap has 118 aircraft managed or operated by Russian based carriers. As international payment transfers through SWIFT (the “Society for Worldwide Interbank Financial Telecommunication”) are disrupted, leasing companies will be forced to develop contingency plans.
Ukraine is a significant producer of uranium, titanium, iron ore, steel, ammonia, and agricultural products. Rising fuel, commodity, and fertilizer prices will impact inflation in Europe and the U.S. Prior to the invasion the U.S. Bureau of Labor Statistics reported the consumer price index rose 7.5% over the last 12 months (core inflation which excludes food and energy rose 6%). U.S. consumer price inflation is at its highest level in the last 40 years and is now expected to go higher. Fourth Quarter 2021 U.S. GDP growth was 7%[1] . For the year 2021, GDP grew 5.7% over 2020. The uncertainty of the impact of the Russian invasion of Ukraine on U.S. economic activity complicates the Fed policy response to domestic inflation. With the Fed balance sheet at $9 Trillion and U.S. debt approaching 130% of GDP, the Fed said last month it would approve a final round of $30 billion in bond purchases in February before ending its portfolio expansion in March. Fed officials are now expected to raise interest rates at their March 15-16 meeting. The question is by how much?
Solid growth in domestic freight rail traffic is expected from the Infrastructure Investment Jobs Act. The Railway Supply Institute’s American Railway Car Institute Committee (ARCI) reported a 50% increase in fourth-quarter 2021 freight railcar orders (compared to third-quarter 2021). Backlogs increased to 42,993 railcars. Class One profitability continues. Even with rail traffic totals down 9% year over year (through February 5th), coal carloadings are up (due to natural gas pricing inflation), crushed stone and sand gravel loadings are up, chemicals up, and grain loadings up. Auto component shortages continue and primary metal products, and lumber and wood product loadings are down (home sales reached a 15 year high in 2021). Labor force participation is at 62.2% in December, the highest since the pandemic (but inflation is causing adjusted wages to fall).
As the pandemic becomes a memory, the U.S. faces twin geopolitical challenges (Russia, China). With Globalization fractured, new equipment inflation and rising interest rates will create opportunities for placement of existing midlife Aero and Rail equipment.
Glenn P. Davis, 312-635-3161
[1] Bureau of Economic Analysis.
Unlocking Aero & Rail Equipment Values Amidst Surging Inflation
Global growth continues but is expected to slow to 4.1% in 2022 (down from 5.5% in 2021[1]). In the U.S., 2022’s growth is expected to be 3.7% (down from 5.6% in 2021). In the fourth quarter of last year, the U.S. GDP grew at a 6.9% annualized rate. With the domestic economy stronger, inflation has returned and labor markets are much tighter. Unemployment is down to 3.9% (December) from a record 14.7% in April 2020. The Fed is set to raise rates and conclude its purchases of Treasury bonds and mortgage-backed securities[2]. Expect a ‘bumpy’ transition.
Air carrier operations staff shortages and quarantine rules for air crew members complicated flight operations and led to flight cancellations last quarter. Fleet equipment and air crew planning became a challenge, even for freighter operations. In the fourth quarter of 2021, United lost $646 million, American $931 million, and Delta $408 million. Southwest reported net income of $68 million, its first quarterly profit during the pandemic (without the help of government aid). The good news is domestic leisure travel demand is back, and above 2019 levels (business and international travel recovery remains delayed). Carriers are facing steeper costs for labor and fuel. Jet fuel cost is expected to rise to $2.35 to $2.50 a gallon in the first three months of 2022, up from $2.10 a gallon in last year’s fourth quarter. Crude oil pricing is at its highest level since 2014 (West Texas Intermediate, the main grade of U.S. crude was up to $86.61 January 27th). Flight operations are being further disrupted by the 5G rollout, which impacts the reliability of radio altimeters used for low visibility approaches at airports with runways close to 5G C-band network antennas.
Boeing sold more aircraft than Airbus last year, but delivered half as many passenger jets. Boeing won orders for 909 planes (535 net new orders), while delivering 280 (up from 157 delivered in 2020). Airbus delivered 611 jets in 2021 and won orders for 771 (507 net). Backlogs for both airframe competitors extend out over the next several years. Boeing remains hampered by its 737 MAX crisis and production issues with its 787 Dreamliner (100 undelivered Dreamliners wait for regulatory approval). While Airbus’ A321neo family is outselling Boeing units, Boeing’s equipment availability led Allegiant to buy up to 100 MAX jets (new Airbus units could not be delivered until the end of the decade). A 12-year maintenance agreement with the engine provider (CFM International) is expected to lower Allegiant’s operating cost. United’s 777s (Pratt & Whitney engines) are expected to return to service this quarter. Qatar Airways recently agreed to purchase 34 freighter versions of Boeing’s 777X (777-8), which are not expected to be delivered until late 2023 at the earliest. Once the pandemic fades, air carriers are expecting traffic to surge.
Because of infection or Covid exposure, rail operations performance were similarly impacted by lack of operating crews on any given day. CSX is facing staffing shortages, offering $3,000 referral bonuses for recommendations for new hires, and spending $20 Million on initiatives to attract and retain workers. Slower train speeds, higher steel prices and railcar scrapping are helping support the railcar leasing markets.
As the Fed raises rates and global tensions continue (Ukraine, Taiwan) this year’s recovery will be bumpy and characterized by market volatility and inflation. With the improving outlook, inflation in new equipment pricing will favorably impact existing mid-life asset values and lease rates. To identify those investment strategies that unlock air and rail equipment values,
Glenn P. Davis, 312-635-3161
[1] World Bank forecast, January 11, 2022.
[2] The Fed balance sheet is now approaching $9 trillion, $8.3 trillion comprised of Treasuries and mortgage-backed securities.
The pandemic stopped a decade of profitable air carrier operations (in 2020 U.S. air carriers lost $35 Billion compared to a $14.7 Billion profit in 2019). In today’s lower traffic environment single aisle jets remain attractive, accounting for 70% of expected new equipment deliveries over the forecast horizon (split between the 150-seat market A320, Boeing 737MAX8 and the 180+ seat market A321neo and B737Max10[1]). Twin aisle aircraft will wait for the return of international travel as 2022 world travel is forecasted at 61% of pre-pandemic levels[2]. It is air cargo demand that is expected to exceed pre-pandemic levels by 13% in 2022. A desire to avoid crowded terminals, as well as major carrier cuts to smaller communities, resulted in more than 323,000 private jet flights this past October (the first 10 months of 2021 were up 9% from the same period in 2019 and were ahead of the previous high in 2007). Orders for new business jets are up more than 50% over the past year (new private jets sell for between $5 Million to $ 70+ Million). An example is the A220-100 (the “TwoTwenty”) operating as a (large) private business jet with 33% lower operating cost and a 5600 nautical mile range. The regional market is testing zero emission hydrogen/electric engines and United is planning to retrofit its existing United Express fleet with the ZeroAvia2000-RJ engine as early as 2028.
Unlike restrictions that have been imposed on people’s movements around the globe, global government policies are oriented toward maintaining the flow of goods and commodities. Freighter demand is benefiting, being driven by the growth of e-Commerce and continuing supply chain congestion. Record cargo revenues are expected to continue ($175 Billion in 2021, $169 Billion in 2022). Freighter equipment will split 70/30 between conversions of existing units and new deliveries. Increasingly newer generation aircraft are being converted including the A321, B737-800, A330 and B777-300ER. UPS recently ordered 19 (additional) 767s. UPS was the launch customer for the 767 freighter in 1995 and has ordered 91 of the type since. They operate Boeing 757s, 767s, 747s, MD-11s and the Airbus A330. Midlife equipment continues to operate even though the aircraft survivor curve analysis used for modeling forecasts an average economic life of 22 years for single-aisles and 20 years for twin aisles.
Market fundamentals for railcar leasing will improve in 2022[3]. Through November U.S. rail freight carload traffic is up 7% over 2020 (but remains down 8% from 2019). Freight rail traffic growth is projected in the mid-single digits for 2022[4]. November coal carloads were up over 11% reflecting the rising price of natural gas which is up more than 180% over the last 12 months[5]. High steel prices (up 137% October over October) are causing a 15 to 30% premium on new railcar pricing. Cars in storage are down from 32% in July 2020 to 20%. The Class One’s focus on precision scheduled railroading can be expected to continue low rail industry operating ratios which were above 85% in 1990 and now have declined to under 65%.
While the pandemic shut capacity, demand was driven by Washington’s fiscal stimulus. Spending came back faster than supply. The result – higher prices. The pandemic also led to the early phasing out of a number of relatively young aircraft. The high cost of new equipment now makes midlife air and rail equipment more attractive. Market disruptions often work to provide investment opportunities. As activity improves targeted midlife transportation investment opportunities exist.
Glenn P. Davis, 312-635-3161
[1] Cirium Fleet Forecast, cirium.com (Indigo Partners ordered 255 A321neos during the recent (November) Dubai air show to be placed with low-cost carriers, Wizz Air, Frontier Airlines, JetSmart and Volaris.
[2] IATA outlook, Boston, October.
[3] Trinity Industries, Railway Age, October 21, 2021.
[4] Cowen and Company Freight Transportation Equipment Analyst Matt Elkott, October 25, 2021.
[5] Coal will account for 23% of U.S. electricity generation in 2021, up from 19% in 2020.
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