Costly Oil, Slumping Dollar Spell Trouble For Airlines, Aerospace Companies

In many ways, it's the best of times for the global aerospace, defense and airline industries. Production lines are humming at Boeing, Airbus and business aircraft manufacturers as they book orders at a record pace. U.S. defense spending has defied predictions of a slowdown. Almost every U.S. aerospace company outperformed Wall Street's profit expectations in the third quarter. And airlines are flying packed aircraft and generating profits.

But economic headwinds are blowing into this idyllic landscape, introducing tough challenges for key segments of the industry. In the U.S., record oil prices are threatening to short-circuit the airline industry's recovery, which might force carriers to further defer purchases of new aircraft. "If oil really is going to be at $100 a barrel, we've got to look at restructuring of the [industry] yet again," US Airways CEO Douglas Parker told investors this month at a Goldman Sachs conference. "I'm not certain that where we are today as a business we can handle $100 oil."

In Europe, the pressure is on aerospace manufacturers and suppliers, which sell their products in U.S. dollars but pay their employees in local currencies. In the midst of soaring sales and deliveries, Airbus's parent company, EADS, recently lowered its profit forecast for 2007 by $580 million—to zero. The dollar's decline has subtracted nearly $19 billion from the value of EADS's backlog during the past year.

The impact is even more painful in the export-dependent Canadian aerospace industry, where an unexpectedly rapid appreciation had the Canadian dollar trading as high as $1.10 this month, up from less than 90 cents earlier this year and 62 cents in 2002. "We were pushing productivity improvements to position our industry to be able to face parity" with the U.S. dollar, says CMC Electronics CEO Jean-Pierre Mortreux, chairman of the Aerospace Industries Assn. of Canada. "But no productivity plan or process improvement could compensate for a 25% valuation rise in just six months."

Looming in the background is a shaky U.S. economy, which could reduce demand for everything from business aircraft to airline travel and make it harder for carriers to raise fares to offset rising fuel costs. U.S. Federal Reserve Chairman Ben Bernanke is predicting economic growth will slow in the fourth quarter and into 2008, though he downplays fears of an outright recession.

And then there's defense spending. Though immune from economic downturns, conventional wisdom holds that the U.S. military will at best keep pace with inflation after President Bush leaves office in 14 months. "The base budget is likely to flatten out and wartime spending presumably will start coming down," says Steven Kosiak, vice president for budgetary studies at the nonpartisan Center for Strategic and Budgetary Assessments in Washington.

Put that all together, and it's not difficult to see why angst is rising in corporate suites on both sides of the Atlantic, despite sturdy airline profits and robust demand in commercial aerospace and defense. But the "pain points" vary widely by region, industry segment and company size. Among the key challenges:

  • Soaring oil prices.
  • U.S. airlines have been able to offset rising oil prices through a combination of cost cutting and capacity restraint, which has led to fuller aircraft and enabled carriers to raise fares. In the third quarter, Delta Air Lines posted record revenues and Northwest Airlines had its best results in a decade. "We as an industry have been pretty darn successful at passing on higher crude prices," United Airlines CFO Jake Brace told investors this month.

    But with crude prices nearing $100 a barrel, airlines are scrambling again. Brace says that if oil prices remain high and demand slows, United could be forced to ground up to 100 or more of its aircraft. "The third quarter may well turn out to have been a high point," says Standard & Poor's airline credit analyst Phillip Baggaley. (S&P, like Aviation Week & Space Technology, is a unit of The McGraw-Hill Companies.)

    Southwest Airlines and Alaska Airlines are the only two U.S. carriers that hold long-term fuel hedges to protect against price spikes. "Most carriers have limited or no hedge positions beyond the first quarter of next year," notes Calyon Securities analyst Ray Neidl.

    In Europe, airlines generally are better positioned to cope with $100 crude. The soaring value of the euro has helped offset some of the bite of rising oil prices, and many European carriers have robust fuel hedges in place. And European carriers derive a larger portion of their revenues from international routes, where there is less or no competition from low-cost carriers.

    Even though oil prices moderated last week, analysts predict they will remain high over the long term. Julius Walker, an analyst at the Paris-based International Energy Agency (IEA), says supplies remain tight, with OPEC's spare capacity limited to just two million barrels a day. That means the oil cartel has little leverage to limit a future price spike caused by a geopolitical or weather crisis.

    Meanwhile, thirst for oil continues to rise in China and India. Eduardo Lopez, IEA's senior demand analyst, says consumers in those nations have little incentive to limit fuel consumption because heavy government subsidies shield them from price spikes. He believes that if governments in China, India, the Middle East and Southeast Asia were to lower energy subsidies, global demand for oil could fall sharply, leading to an easing of prices.

    A similar situation exists in Europe, where high energy taxes -- not government subsidies -- keep consumer behavior in check. Lopez says European consumers and businesses already pay high prices for fuel and are less likely to moderate their travel and purchasing behavior due to rising oil prices. While that's good for European airlines, it keeps pressure on energy demand.

  • A shaky economy.
  • A big concern is that high oil prices will push the U.S. economy into a recession. That would reduce demand for air travel, making it much more difficult to raise fares to offset higher fuel costs. U.S. demand for transport fuels already is slowing, says Lopez. That may just be a reaction to rising oil prices—or it could be related to the unfolding economic consequences of the subprime mortgage crisis.

    John Heimlich, chief economist at the Air Transport Assn., says airlines are especially concerned that a weakening economy and higher energy costs will prompt corporations to slash travel budgets. If that happens, demand for lucrative business fares would drop.

    "The combination of a slowing economy and the high oil prices is the danger for the airlines," says S&P's Baggaley. "Either one of them they'd be able to deal with, but the combination is likely to cause considerable pain."

    Such a scenario might impact demand for aircraft from Boeing and Airbus, which have seen orders soar during the last three years, largely on the strength of sales outside the U.S. The two aircraft manufacturers are aggressively ramping up to meet demand, but production could be peaking just as the next downcycle looms. If high oil prices make that downcycle worse, they could see some orders deferred or canceled.

    Boeing and Airbus have long argued that high fuel prices will spur U.S. airlines to replace their older gas guzzlers with new fuel-efficient models. But while North American carriers have parked a lot of their older aircraft, such orders have yet to materialize. If legacy carriers start losing money again, it's unclear how they would be able to finance such purchases.

    Randy Tinseth, vice president of marketing at Boeing Commercial Airplanes, says while oil prices will likely remain high and volatile, the impact on aircraft makers and the economy is hard to gauge. "We continue to see strong fundamentals," he says.

  • A weak dollar.
  • The decline of the dollar to as low as $1.47 per euro is forcing EADS to look for additional savings under its Power8 cost-cutting effort (AW&ST Nov. 12, p. 52). CEO Louis Gallois declines to say if that will mean more layoffs beyond the 10,000 job reductions already announced. But he recently described the currency situation as "unbearable." The low dollar also is complicating EADS's efforts to sell off some of Airbus's industrial operations in France, Germany and the U.K. Like Airbus, any buyers would have a euro cost basis and a dollar revenue stream.

    But larger companies like EADS at least have the financial wherewithal to hedge currency, which limits their exposure in the near term. EADS is hedged at $1.15 per euro in 2008 and $1.24 in 2009. That buys the company two years of breathing room to continue to drive down costs. Smaller suppliers that don't have the financial savvy to hedge are much more exposed to sharp currency swings.

    The same holds true in Canada, where Bombardier and CAE have so far weathered the sharp rise in the Canadian dollar. CAE, which exports most of the aircraft simulators it sells, just reported a 25% increase in net earnings and a 26% gain in revenue. But Mortreux, the aerospace association chairman, says currency hedges provide only temporarily relief. "If the exchange rate stays the same, it will have a major impact on manufacturing in Canada in six months to two years," he predicts. "The risk is we will lose new contracts because we are too expensive, or we have to reduce R&D, or we relocate our workforce to stay competitive. In the paper industry they've already started to lay off people and stop production."

    Conversely, the slumping greenback benefits Boeing and other U.S. aerospace exporters by making their products cheaper abroad. It's also a benefit to U.S. airlines, which are deriving more of their business from international routes and can repatriate fares charged in foreign currencies.

    But there's a double-edged sword: The low dollar is forcing European companies such as Airbus to become leaner. "It gives them an incentive to get that much more efficient," says Pierre Chao, a senior fellow at the Center for Strategic and International Studies in Washington. "Then, when the dollar reverts, as it has a tendency to do, you suddenly end up with a very competitive European industry."

  • Moderating defense spending.
  • U.S. military spending is in its 10th consecutive year of above-inflation growth and has defied predictions of a slowdown for several years. Adjusting for inflation, the Pentagon's budget has risen 31% since 2000 -- and 58% if the cost of supplemental war funding is included.

    But current spending plans call for the core defense budget to decline in real terms after 2009, though the next president will help decide if that really happens. "Take out the war funding and there are a number of indications that suggest defense spending is flattening out," says budget analyst Kosiak. "Historically this is about as long a buildup as we've had."

    But while defense spending can't keep rising at a rapid clip, nobody expects a decline comparable to the 1990s "peace dividend" that followed the collapse of the Soviet Union and the end of the Cold War. And supplemental budgets for war funding in Iraq and Afghanistan continue to serve as a relief value to fund other defense priorities.

    "The angst level is rising steadily, yet the near-term outlook continues to be robust," says Chao. He admits he's been surprised by the resiliency of military spending. "Good things last longer than most people expect."

    With Robert Wall in Dubai.

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