Analysis: Jetmakers’ inflation shield no match for soaring costs

Tokyo Century

12/05/2022 16:02

* Jet prices linked to US cost and labour indices
    * High inflation pushes adjustments into highest band -
sources
    * High inflation partly absorbed by planemakers - sources

    By Tim Hepher
    DUBLIN, May 12 (Reuters) - Inflation clauses that determine
how much airlines pay for new jets have jumped into a
"hyper-escalation" band, pushing up aircraft prices but still
leaving manufacturers unable to fully pass on their soaring
costs, industry executives told Reuters.
    The hike to the top inflationary band is a rare move in the
industry, potentially triggering a rise in airfares by airlines
while manufacturers will also be left out of pocket, experts
warned during major gatherings over the past week in Dublin, the
centre of the global aviation finance industry.
    Airlines buy jets at a basic price agreed in confidential
negotiations but the final price includes adjustments for
inflation during long production waiting times, based on U.S.
factory input and labour costs, wherever the planes are built.
    For years, these "escalation" clauses discreetly swelled the
profits of planemakers as price revisions exceeded their
long-term purchasing costs, people familiar with the contracts
say.
    Now, with key U.S. cost indices rising by the largest amount
in over a decade, the price adjustments are steeper and the
cushion between escalation and real costs has vanished.
    "It's always been a windfall game for the (manufacturers) so
long as they're efficient enough to make sure their own costs
don't grow as fast as the escalation," AerCap  AER.N  Chief
Executive Aengus Kelly told the Airline Economics conference.
    The rapid spike means some manufacturers may be left out of
pocket as the clauses were negotiated during an era when
inflation fears were low. 
    Yet leasing companies who secured limits to their exposure
during that decades-long lull in inflation will be in a more
comfortable position than some competitors, Kelly said.
    "It's certainly something that we're watching carefully...
We're seeing very strong inflation pressures in the United
States," said Steven C. Udvar-Hazy, senior vice-president at
Tokyo Century  8439.T  leasing unit Aviation Capital Group.
    "The inflationary environment in the United States is of
concern to us because that can have knock-on effects on
escalation in the broader supply chain," he told the Airfinance
Journal conference.
    
    SHARED RISK
    Inflation is a double-edged sword for aircraft leasing
companies that own half the world's fleet.
    They benefit from the impact of inflation on the value of
aircraft they own. But they must also contend with rising
purchase prices, prompting some to insist on escalation caps.
    Exact terms depend on the buyer. But in one common type of
structure, the lowest escalation band is paid entirely by the
airline or leasing buyer and tends to be capped at rates
averaging around 3%, sources familiar with the process said.
    After that, there may be a second band up to around 5% where
manufacturers carry all the additional risk.
    When inflation kicks into the highest tier of all,
triggering so-called "hyper-escalation" clauses, the two sides
typically agree to split the extra burden, they said.
    "That is where we are now, in the hyperinflation band, and
this is causing a lot of pain for everyone," a senior industry
source told Reuters.
    In rare cases, preferred clients may have a get-out clause
allowing both sides to walk away from the deal entirely if
inflation shoots beyond an extreme level, one source said.
    Airbus  AIR.PA , Boeing  BA.N  and Embraer  EMBR3.SA 
declined comment on contractual matters. All are said to face
tough negotiations over price clauses on future airplane deals.
    "We don't see the current high levels of inflation very
often but the impact of what is happening is huge. Escalation is
going to be a big topic going forward," Embraer Commercial
Aviation Chief Executive Arjan Meijer told Reuters.

 (Reporting by Tim Hepher;Editing by Elaine Hardcastle)
 ((tim.hepher@thomsonreuters.com; +33 1 49 49 54 52; Reuters
Messaging: tim.hepher.thomsonreuters@reuters.net))