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Aviation Energy Economics Reshape Flight

Air carriers invest to improve profitability and expand share in the markets they choose to serve.  Selecting the right aircraft and engines are vitally important to financial success.  The process requires input from marketing, maintenance, engineering, finance, and the flight operations teams.  There are numerous factors to consider, beginning with the composition of the carrier’s existing fleet.  While newer aircraft are more fuel efficient, the issue is whether advanced technologies will give enough of a bottom line boost to supersede what is being enjoyed with the current fleet or available market alternatives.  

The answer to that question has been the price of a barrel of oil.  How much fuel does an aircraft burn in relation to the number of passengers, or ton of freight, for the distance flown?  A review of air carrier earnings performance compared to fuel cost volatility shows an inverse correlation.  Jet fuel pricing peaked in 2008 (fuel was 36% of total operating expense).  Fuel prices then dropped significantly.  The global airline industry’s fuel bill was $133 billion in 2016 (accounting for approximately 19% of operating expenses [Brent oil averaging $43.55 per barrel]).  The forecast for 2017 anticipates an average oil price of $54.0/barrel for Brent Crude reflecting a balance between OPEC supply cuts and new supply from U.S. shale oil producers.  Fuel burn per available seat mile (fuel productivity) and gallons consumed per block hour are part of the solution to this business management puzzle.  Technology, load factors, and flight operations are other critical variables that can  maximize flight segment earnings.

Since the first jet airliners in the 1950s, little has changed in basic designs.  Gas turbines were conceptualized at the turn of the twentieth century though practical designs did not emerge until the late 1930s (too late for WWII).  Rapid development followed.  With their high ‘thrust to weight’ the deployment of gas turbines made affordable intercontinental flight possible.  They have become so reliable that two-engine aircraft now fly not only across the Atlantic but also on many transpacific routes.  Added fuel efficiency gains have been made with improvements in airframe aerodynamics, materials, and engine designs.  Lighter planes burn less fuel, alternative fuels reduce carbon emissions, new carbon fiber materials weigh less (and withstand higher heat, allowing more efficient fuel combustion), new engine gear systems for the fan and turbine enable more thrust with less fuel, winglets reduce drag (and cut a plane’s fuel emissions).  The global market for jet engines is dominated by four makers.  Rolls Royce first in 1953, followed by General Electric and Pratt & Whitney, and CFM International, a joint company established by GE and French Snecma Moteurs in 1974.  Pratt & Whitney’s ‘Geared Turbofan’ engine is expected to cut operating cost 20% (about $1.7 million per plane per year), dampen noise, and reduce CO2 emissions.  By using lightweight composite materials, such as carbon fiber fan blades to achieve energy efficiency gains, the CFM International ‘Leap’ engine achieves many of the same benefits (while using tested conventional turbofan architecture, and without the added weight of a gear box).

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Confident About Growth

Aviation investment is driven by profitability and the prospect for future growth. Recent mergers have resulted in the number of major carriers in the U.S. decreasing from 10 to 4[1]. This consolidation has created an oligopoly and helped the remaining players[2] take a more balanced approach to capacity management. They now control 80% of the domestic market and a good portion of the international market. With better control of available seat capacity and a developing consensus that jet fuel pricing is going to stay low for the foreseeable future, the industry has become attractive to investors[3]. Add new sources of revenue like charging for baggage, premium seats, and early boarding, combined with fuel saving new engine and equipment technologies and you have double digit returns on invested capital. With high barriers to entry, pricing control, and management talent, the industry appears positioned for a bright future.

Operator fleeting decisions are based on mission, seat mile profits, operating cost, maintenance requirements, reliability, flexibility, and fleet commonality (for pilot substitution, training and spares inventory purposes). Earnings and profit making capability of equipment is valued. Newer aircraft have higher ownership acquisition cost but lower emissions, lower fuel cost, maintenance savings, and a better passenger experience; but, in the current fuel market, the efficiency gains of newer models do not offset their higher ownership cost. New equipment will be needed to serve market growth, but the economics of investing in mid-life aircraft remain.

Since demand is sensitive to the business cycle and equipment supply, investment horizons require the ability to identify appropriate market entry and exit opportunities. Long asset lives require knowledge throughout the investment term and skill to determine the impact of new technologies, exogenous market events, replacement demand, competing aircraft values and investment economics[4].

There are a lot of different kinds of planes. Which are the most profitable? What is the optimal time to enter and exit? Keys include age, seats, units sold and remaining in service, combined with an analysis of a carrier’s mission, market, models, engines, avionics, and fleet operations dynamics. Is the equipment market liquid, can equipment be traded, reconfigured or parted out? Knowledge of asset values and lease rates allow a connection of investment choices with outcomes and translation of these opportunities into action. It requires searching for the best opportunities, both here and abroad, and an experienced management team with a focused investment strategy.

With profitable experience and deep relationships, we effectively manage asset concentrations, credit exposures, and counterparty risks. For long-term strategies and an in depth understanding of the characteristics of aviation equipment combined with the ability to select and manage asset investment for better than average returns contact us directly.

RESIDCO, aviation and transport investment specialists.

[1] Consolidations include Delta and Northwest in 2008, United and Continental in 2010, Southwest and AirTran in 2011, and American and US Airways in 2013.

[2] American, Delta, United, and Southwest.

[3] Warren Buffet picks a company or industry based on his estimate of its success over the next 10 to 20 years. He’s recently invested in U.S. airlines. Why? The industry is enjoying strong finances and good control over capacity.

[4] United Airlines, for example, recently decided to refurbish all 21 of its B767 aircraft that had originally been slated for retirement. Delta extended the use of 15 of its B757s.

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Transportation Asset Values and Tax Policy

Government taxes to encourage (or discourage) a variety of economic activities. The rates set influence the market’s required before-tax rates of return for both individual and business investments. From a social standpoint, taxes are designed to finance public projects, redistribute wealth, and provide basic services. Since self-interest is basic to human nature this creates private incentives to engage in tax planning. Such planning has long earned the blessing of the U.S. Courts.

When you invest, whether you are an individual, or a business owner, the taxing authority is your silent and ‘uninvited investment partner’. Effective planning involves more than being aware of current marginal rates; it requires an evaluation of the longer term results of your decisions, not just for yourself but for all participants. Each party and counter party has their own current and future marginal tax rates. These future expected after tax cash flows affect current actions and decisions. Understanding this concept is important since it directly influences the prices at which assets are traded now, and, what future pricing might be.

Naturally, most taxpayers pay no more tax than they believe they must. And they spend their time and money to arrange affairs to keep their tax bite as ‘painless’ as possible. Remember, money spent on tax planning is ‘tax deductible’, and the tax savings generated are ‘tax exempt’ because they reduce taxes payable.

Are increased taxes good policy? In 1997, Bill Clinton agreed to lower capital gains rates to 20% based on economic literature suggesting the lower rate would yield more tax revenue. It did. Yet Hillary has proposed to nearly double the top tax rate on long term capital gains to 43.4% from 23.8%. Under current tax policy, ‘capital gains’ are taxed as ‘ordinary income’ if an investor has held an asset for less than a year. After 365 days the current top long term gains rate of 20% applies (plus the 3.8% Obama Care surtax on ‘unearned’ income). Hillary has suggested a ‘sliding scale’ approach requiring ‘capital gains’ tax rates during the first two years holding period of 43.4%, year three, 39.8%, and 35.8% in year four. Investments would have to be held for more than six years to qualify for the current 23.8%[1].

Economists generally will agree that a system of competitive markets is remarkably efficient. Remember Ronald Reagan was elected in 1980 with his message that government is ‘the problem’ and economic freedom was ‘the answer’. The dominant lesson of the Great Depression and the Great Recession is that when Government overspends, overtaxes, and over regulates, economic freedom is suppressed and economic growth is impacted[2]. How is transportation investment best and ethically encouraged? Transportation asset Investors with a sound investment strategy hold diversified asset positions intended to weather volatility on the way to their longer-term objectives. Working with a firm that has a history of excellence, expertise and ethics produces results.

Call the air and rail transportation experts. Call RESIDCO!

[1] National Center for Policy Analysis, Hillary Clinton’s Capital Gains Tax Proposal, Brief Analysis No. 825, April 14, 2016 by Pamela Villarreal.

[2] WSJ, “Why This Recovery is So Lousy”, August 4, 2016, Phil Gramm and Michael Solon.

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