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“Residual Cascade” Sees Need for Fresh Risk Analysis

December 9, 2019

Values May See Fundamental Change in 10 Not 20 Years

The market is potentially at a turning point when a series of events will initiate a “Residual Cascade” whereby residual values may irrevocably deviate from the current expected path.

As the year ends, residual values need to be viewed in the context of the future rather than the past. The ever-present danger for residual value calculations is to assume that the status quo will be maintained into the long term and that currently popular types will remain in demand such that residual values will remain strong in comparison with other types. Yet, history has already demonstrated how the market can change from the current conditions, leading to a much more rapid fall – or indeed sometimes a rise – in value than was previously expected. Fifteen years ago, the A380 was under development, the B787 had just morphed into the B7E7, the B737MAX/A32neo were not even being considered except in the context of all new types, and the B777-300ER had only just entered service heralding the end of the A340. Twenty-five years ago, the MD90 was in production, the B737-300 was the most favored of narrowbodies, the Embraer and Bombardier regional jets were only just underdevelopment or entering the market and the A320 was beginning to be viewed as a competitor to Boeing and McDonnell Douglas. Residual value calculations have always needed to be cognizant of the likely changes in market structure and the resulting alteration to the product line. To date, the changes have been relatively slow with manufacturers taking measured steps in developing a new aircraft as any such an investment can still sometimes be viewed as “betting the company” just as with the B747-100 although neither the A380 nor the B787 seem to have precipitated corporate collapse. Aircraft manufacturers have historically sought to marry the needs of the market with technical feasibility there has been little in the way of external interference. There were, however, such factors as deregulation and easing of bilateral capacity limits although environmental compliance in terms of Chapter 2 and Chapter 3 had a modest impact on product development with Carbon trading in the EU having no effect.

The product line that exists today will not meet the needs of the market structure in ten to twenty years and most residual value forecasts will have sought to incorporate the expectation of change and gauge the risk to existing residual values forecasts. But as 2019 draws to a close, the aviation market is facing a new dynamic whereby Residual Cascade sees the emergence of external forces that could dictate the pace and path of change. Consequently, the aircraft that currently held in high regard may be displaced sooner than might be expected with traffic patterns also significantly altered. The issue of climate change may be viewed as the catalyst for this Residual Cascade. While some may view it as a nuance and fad infecting the youth of post-industrialized countries, soon to be supplanted by another topic hyped by social media, the majority of air transport markets both today, and in the future, are just as much aware of its significance and the need for a response on a personal, governmental and inter-governmental basis. Tim Clark, of Emirates, was a long-time sceptic of climate change but has now accepted the scientific evidence and the need for aviation to make significant changes. In 2035, the year 2020 may be seen as the origin of the Residual Cascade event when stress analysis and risk assessment became ever more essential.

There is an increasing ground swell against aviation due to its perceived rather than actual contribution to the environment and man-made global warming. Aviation has always been an obvious target for environmental controls stretching back to before the protests against Concorde. The issue of flight shaming is already gaining hold in Europe and elsewhere with air travel viewed as a negative resulting in a direct reduction in traffic in some countries. Travel in business class is increasingly viewed as an issue and as long-haul airlines generate most of their profit from high yielding passengers this may see some change in configurations. Some airlines are promoting rail travel for shorter journeys coordinating their marketing with rail companies. There is increasing emphasis on operating the most environmentally aircraft with airline marketing focusing on carbon emissions. Airports are increasingly seeking to dissuade passengers from arriving and departing by car. Car emission restrictions in Europe are already destined to be much tighter as from next year and in the following years such that aviation will have to be seen to also reducing its emissions. There are regular protests outside airports that cause sufficient disruption for passengers to consider their future air travel plans. Governments are considering imposing tax on aviation fuel and oil companies, restricting airport expansion, limiting carbon emissions and also the amount of air traffic either in terms of aircraft movements or passengers.

The carbon trading scheme in Europe is far from public friendly and has not prevented the expansion of operators nor prompted a change in their fleet strategy. In association with other intranational organizations, there will likely be increased emphasis on restricting the operation of older aircraft just like Chapter 3, as well making it necessary for manufacturers to reduce emissions on new and possibly, existing aircraft. The engine manufacturers are already offering more efficient engines to the airframe manufacturers so more environmentally technology exists. There will be greater emphasis on developing more efficient engines that much sooner with government being at the vanguard. While there is a reluctance of some nations to become part of the solution by stymieing the work of international organizations that have the ability to precipitate change, there will be much more willingness to act on a unilateral regional, national and airport basis. Starting this year with the emphasis on climate change, there will likely be a range of factors emerging that will make it necessary for airlines and aircraft manufacturers to change their operations and for owners and investors to manage their long-term expectations.

The net effect may be a shift in product line that much sooner and for traffic to be curtailed on shorter sectors. Larger capacity aircraft are obvious in reducing the carbon footprint for narrowbodies and with 45 percent of the A320neo family orderbook being for the A321neo then a step change is already apparent. While Boeing may be focused on returning the B737MAX back to service, thereafter the emphasis will be on developing a replacement for the type as the -8 is becoming too small for the market. The short haul market – sector lengths of less than two hours – will increasingly see larger aircraft being used which will see less frequency. The production forecasts made by the manufacturers for the next 20 years need to consider the implications that larger and higher capacity narrowbodies brings particularly in terms of production rates. The number of aircraft being produced may continue to rise but only as a consequence of needing to replace existing smaller and less efficient aircraft. Airbus and easyJet have recently announced a joint venture to examine the use of electric powerplants on short haul aircraft as have ATR and Air New Zealand; the UK government has invested millions of dollars in converting a BN Islander to electric powerplant. Residual Cascade will therefore likely act as an accelerant to the process of change thereby making it necessary to assess the effect on residuals in ten rather than twenty years time. Modelling the effects of Residual Cascade has become ever more sophisticated with future values reflecting different probability levels thereby providing a greater insight into the risks associated with an accelerated change to the product lineup.

 

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