Editorial: Irrational Exuberance?

Mixed in with the unusual, the unfortunate and the unprecedented events in commercial aviation last year were two highly expected developments that did not materialize: A significant slowdown in deliveries of large transport aircraft accompanied by a decrease in production rates. Instead, notwithstanding historically steep declines in passenger and cargo traffic and revenue, Airbus and Boeing rolled out a record 979 aircraft in 2009, delivered nearly all of them, and expect to do pretty much the same thing in 2010.

This paradox received a good deal of attention at the SpeedNews 24th Annual Commercial Aerospace Suppliers Conference last month (SpeedNews and ATW are both owned Penton Media, Inc.). To Teal Group VP-Analysis Richard Aboulafia, the situation is "the strangest thing I have ever seen . . . Zero planes are needed yet we are at record rates of output."

Morgan Stanley MD Heidi Wood asked "Where's the recession?" and remarked on "a glut of supply, from real estate to aircraft."

Avitas Senior VP Adam Pilarski was succinct: "Demand is weak, but supply is strong," he observed.

Airbus and Boeing OEMs are unapologetic: Backlogs are healthy, as is demand for their products, they argue. Why should they cut production, with all that such a step implies for unit costs, employment levels and the aerospace supply chain? In fact, Airbus says it is boosting production of its A320 family line from 34 per month to 36 starting in December. But average aircraft utilization declined 6% from peak last year, according to IATA; and as Wood noted, there is "almost a year's worth of [aircraft] supply in the desert."

Clearly, the historical link between supply and traffic demand has been disconnected. In the past, this kind of situation would have been described as a bubble market. Yet as the analysts noted, Airbus and Boeing are making decisions that internally at least are completely rational, even if the outcome is not. After all, the US Exim Bank and the European Credit Agencies have launched their own "Cash for Clunkers" program (to use Aboulafia's description) by greatly expanding their credit coverage for new aircraft deliveries, allowing airlines to replace older, less fuel-efficient jets with shiny new ones. Such financing supported up to 40% of deliveries in 2009 and the OEMs expect a similar level this year. As long as Exim and the ECAs are willing to guarantee financing to cash- and credit-strapped airlines, why should OEMs trim output?

Moreover, both companies face heavy cash outlays: Airbus is still trying to fix A380 production problems and the A350 program is entering its peak R&D period. Boeing, meanwhile, is hurting from delays to the 787 and to a lesser extent the 747-8. Maintaining high delivery rates of narrowbody aircraft generates much-needed cash flow.

There is also the matter of the Prisoner's Dilemma. Although the industry as a whole theoretically would benefit from a reduction in seats, each OEM has an interest in maximizing its own returnwhich is why Boeing may find itself under pressure to raise the 737 rate in order to maintain equilibrium and prevent Airbus from getting an advantage by being able to offer more aircraft sooner. Lastly, the arrival of a third competitor in the under-150-seat marketBombardiermay upset the balance of power. Airbus and Boeing have an interest in making sure they have delivery positions to sell in the same timeframe that the CSeries rolls out.

Underlying OEM confidence in the level of production is the (unspoken) belief that long-term traffic demand ultimately will absorb any short-term excess. The magic number these days is somewhere around 4.6% CAGR over the next 20 years.

Not everyone is convinced of this rosy future. At SpeedNews, the AeroStrategy consulting firm suggested that such optimism may be misplaced. Noting that world traffic growth averaged 6.9% between 1970 and 1990, then 4.6% between 1990 and 2002 and 4.2% from 2002 to 2009, the analysts questioned why it should return to earlier growth levels, particularly in light of factors such as market maturation, the cost of fuel, sociocultural factors (rising environmental consciousness), infrastructure constraints and potential substitutes like high-speed rail and teleconferencing.

It is worth noting that at this year's FAA Forecast Conference, the agency predicted that US airlines will reach the 1 billion passengers per year mark in 2023. It sounds like a fairly safe prediction given that the industry carried around 709 million last year. But it also represents significant backtracking from just three years ago, when FAA predicted that US airlines would reach the 1 billion mark by 2015. Still, that's better than the prediction made in 2000: That US carriers would reach the magic figure in 2010. We wouldn't bet on that one coming true this year.