Podcast: Putin’s War And Commercial Aviation

Bank of America’s Ron Epstein joins our experts to assess the industry’s reliance on Russian metals and whether lessors could lose hundreds of aircraft.

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Rush Transcript:

Joe Anselmo:

Welcome to this week's Check 6 Podcast. I'm Joe Anselmo, Aviation Week's Editorial Director. Russia's brutal invasion of Ukraine triggered a global backlash that surprised nearly everyone with its speed and severity. Nearly overnight, large segments of the Russian economy were unplugged from the global economy and banking system. Even nonaligned nations, such as Finland, Sweden, Switzerland and Singapore, joined in.

            The question now is what does this mean for commercial airplane lessors, builders and their suppliers? How big of an impact will all this have on global aircraft markets? Do aerospace companies have adequate backup plans for the titanium and other critical metals that they sourced from Russia? And what happens to the hundreds of airplanes owned by Western lessors that are still parked in Russia?

            Here to help us understand that, is a special guest, Bank of America's longtime U.S. Aerospace and Defense Analyst, Ron Epstein. Also weighing in is Jens Flottau, Aviation Week's Executive Editor for Commercial Aviation. And rounding out the discussion is Daniel Williams, a Manager of Fleet, Flight and Forecast Data at Aviation Week. Ron, let's start with you, what's your assessment of the impact of all this on our industry and what has your most concerned?

Ron Epstein:

I think there's a couple things you have to think about, Joe, and maybe you just kind of run the gamut real quick. I think the first thing is there's a fleet of airplanes in Russia. And we can talk about that and what that all means, but you've got Western-built airplanes that are financed by organizations outside Russia that are stuck there. In the end, what does that mean? And then, the implications of what does that mean for the Cape Town Treaty and aircraft financed in other markets that are emerging markets that are maybe not as friendly to the U.S. or NATO or our allies, and does that have some kind of implication there? So that's one thing.

            I'd say the other thing is traffic. When you look at air traffic, the Russian economy is less than 2% of global GDP. So just as a rule thumb that probably implies their air traffic's less than 2% of global air traffic. From a traffic perspective, it's not that big a deal. It's inconvenient from, call it an air-routed point of view, if you want to go from Western Europe to Asia, not flying over Russia is a bit of a pain. If you want to fly from North America to Asia, particularly from the East Coast, the polar routes, you can't really do those without flying over Russia. So that has some implications on airline operations.

            I think probably the most important thing, or one of the most important things, is the impact on raw materials and supply chains. One of the topics that's come up in investor conversations, and I think has gone across industry, is Russia is an important source of both titanium aponge, so the upstream titanium, and then also through VSMPO titanium forgings and processed titanium. The things you hear out there are, I think there was a report from the Department of Commerce that stated Boeing gets about 35% of their titanium product from VSMPO, a lot of that through a JV they've got with VSMPO there's a bureau of Boeing manufacturing, UBM, and I believe Airbus gets about half of their Titanium there.

            Also, and I think people seem to forget about this, it's not just the airframers. Titanium is used in the engine supply chain and in other areas in the supply chain. So when you start peeling back the impact here, you have to demarcate between what's going to the airframers, what's going to the engine guys, and what's going to other suppliers. What you hear is Boeing's got a lot of titanium. Boeing's been in the open market trying to actually sell some titanium, but that's different than what's being sourced for the engine suppliers and so on and so forth.

            And the various engine suppliers have different dependencies on it. So one of the key things, I think, we're going to have to keep an eye on is that, and then another very important thing is titanium forgings. So having raw titanium is one thing, having the ability to forge it into big near final form parts. Something that immediately comes to mind is the landing gear for wide body aircraft. Landing gear on, I think most, if not all wide body aircraft are titanium. On narrow bodies, they're landing gear steel. So it's a different problem for narrow bodies and widebodies. VSMPO has in their structure over there, a 50,000-ton certified press, where you can do these giant near final form forges. That's offline, which I guess technically it is right now.

            That's capacity that would be very, very difficult to start up someplace else, not impossible, but it would take time, 18 to 24 months, something like that. I think there is ample room for some meaningful disruptions in the supply chain in terms of parts and so on and so forth. So that's, I think, something we have to keep a close eye on. I think on the good news side, can we get access to titanium sponge through places like Japan? We get a lot of titanium sponge from Japan today. Yeah, probably. Is there the capability to start up some titanium sponge processing again in the U.S.?

            The final plant to do that was a facility that shut down during COVID. Theoretically, could they start that back up again, if there was an economic reason to do so? They probably could. Allegheny Technologies made a humongous investment in Raleigh, Utah in a Greenfield site for titanium sponge that got shut down several years ago. Potentially, could that restart? It could, but all this takes time and it's disruptive and it's just another headwind for the recovery.

And then maybe one final point, the one place where you could see, even the disruption really matters is in narrowbodies versus widebodies. It's been this K-shaped recovery where the narrowbody market's doing fine, widebody market, not so much. This whole thing going on just suggests that the widebody recovery is going to take even longer to play out. So this bifurcation between the two markets between narrowbodies and widebodies, it just doesn't give you the warm and fuzzies about widebody's getting better any quicker.

Jens Flottau:

Ron, just to come in behind you to fully support this view about widebodies in my conversations this week with people like you and others, that's been the one major conclusion, narrowbody production rates may not be that much affected after all. But this puts additional pressure on widebodies. The A350 in particular, don't forget, Aeroflot has 13 on order. And I think eight of them were supposed to come this year and next year. So there's an immediate problem there for Airbus. More importantly A350 is ultra long haul, Europe to Asia in parts, and ultra long haul also suffers the most when fuel is expensive. So there are several factors that will do what you describe, put more pressure on the wide bodymarket and thus potentially, slow the rebuilding of production rates.

Joe Anselmo:

Jens, Ron had alluded to all those Western-owned airplanes that are still in Russia. How do the lessors get those airplanes back?

Jens Flottau:

I guess the short answer is they won't get them back. That seems to be the conclusion that most of them have made, at least privately. They won't talk about this officially, of course, because that's not a position you can have as in this situation right now, but many people assume that the Russian government will not allow the state-owned airlines and the private Russian airlines to return the aircraft post March 28th, which is the deadline set by the European Union sanctions. How many aircraft? It's about 600. The numbers vary by source a little bit, but that's about the ballpark number here. And if you look at who's leased aircraft to the Russian airlines, it's basically everyone. AerCap is the most exposed by absolute numbers, but there's a lot of Chinese lessors in there, a lot of American lessors.

            And if you just take a big picture view on Russia, this is a market that has only opened up 30 years ago, and it's grown significantly. At the end of last year, the domestic market was 22% above 2019 levels… Worldwide domestic markets were still 20% below 2019 levels. So it's been a market that has done well in terms of growth. It's also done well for Western OEMs and lessors because there was a huge replacement demand, replacing all the Soviet era aircraft over many years. So, lessors have generally done well in Russia. They've also not complained about business practices. People have generally paid the lease rates on time, but now of course the crisis is big and the value of the fleet in Russia is a double digit billion dollar value. So the big question is now what's happening next?

I've heard that many lessors will go to their insurers and claim a total loss of the aircraft affected. That of course will put a lot of pressure on the insurance companies, which will have this wave of claims coming in at the same time, more than $10 billion in value. Will they accept this just like that? Probably not. My assumption and the assumption of many that I've talked to is that there will be litigation going on for years, claims, write offs. In short, it's going to be really messy.

Joe Anselmo:

Dan Williams, you have been crunching the numbers, the fleet data for the last couple of weeks. What are your key takeaways to the impact of all these current events?

Daniel Williams :

Yeah, there's so many moving parts to this. I'm going to start by jumping on what Jens has just said, and 95%, thereabouts of Russian operated Airbus and Boeings are leased, of which only there are handful that are outside of Russia right now. So those handful outside of Russia maybe could be reposessed even though the timeframe is quite tight, because there is less than three weeks before this deadline kicks in. So that's one thing.

           Even if then all the others are nationalized -- they can't be reposessed because Russia intervenes -- then that poses other problems for Russia because there are already sanctions on them taking parts, extra supplies that will keep these aircraft going. So yes, they could use some of these aircraft and cannibalize them to keep the remainder of the fleet going, which we'll see them through a period of time, depending on how long the invasion carries on for and how long more importantly, post invasion, these sanctions carry on.

            This could knock back the Russian economy by a decade almost regardless of how long this goes on for. The longer it goes on for, the more impact it will have. We see that the Russian utilization, the Russian operators utilization recently, is generally split about 70% domestic and 30% international. Now, obviously back to Ron's point before, in terms of what the Russian operators bring to the global total, it's a relatively small number. So we won't be impacted too much holistically. However, the Russian operators will lose 30% of their operations straight away, pretty much, other than Belarus and a few other select countries that they do still fly to and from. But also, that only leaves them with 70%.

Now, back to Jens was saying before, their domestic market was doing really well. It had recovered super fast. And by June, July, of 2021, it was back at pre-COVID levels and surging. Now, the problem is with the Russian economy the way it is and the Russian ruble and the interest rates doubling, then actually the general public and the population in Russia won't have the cash available to afford to fly. So, this is going to impact their domestic market as well. Their indigenous manufacturing is not what it once was and those that it does make still relies heavily on Western parts. So no matter how we look at this, it's going to be very difficult for the Russian aviation industry as a whole be it an airline, be it an OEM is going to be very, very difficult.

            And then, there's knock on implications for you and I, and everybody else. The price of oil is gone up, which will lead to cost increases, and the closure of Russian air space to most foreign airlines increases flight length, which also poses other challenges. We're seeing reduced schedules between places because airlines can't operate that longer flight that often,so they've reduced the number of frequencies. So whilst it is a huge headache for the Russian aviation industry, there are certain knock-on effects to the wider commercially aviation industry as a whole. Now the defense industry, and that's not for us to talk about here, it is almost the opposite. So it's give and take in equal measure almost.

Joe Anselmo:

Ron, Russia wants to develop its own narrowbody airplane and jointly develop a widebody with China. What does all this do to those efforts?

Ron Epstein:

Clearly it makes that more complicated, right? Because they're cut off from the usual supply chain. So, if you look at any of the Russian projects right now, they're dependent on some non-Russian suppliers for avionics and engines and so on and so forth. So that all goes away. So the MC-21, correct me, if I'm wrong, it's got geared turbofan engines on it. Well, not anymore. Right.

            So, they got to figure that out. And then, if you look at the Sino-Russian widebody, the 929, I mean, that gets exceedingly complicated now. I mean, where are you going to sell these things? How's it going to go? I mean, it's an open debate right now in geopolitical circles. Who's China's friend here, right? China typically --  not to get political, but I will for a moment -- is going to back the winner. So is the winner of this going to be Russia, or is the winner of this going to be those who are not Russia? So, we'll see ultimately where it all plays out, but it makes the outlook for both the Russian programs and the Sino-Russian program much more complicated. Far, far more complicated.

Jens Flottau:

So the MC-21 received some form of preliminary certification late last year, which was kind of politically driven and was expected to be delivered for the first time towards the middle of this year. Obviously, that remains to be seen because as Ron says, there's a lot of Western parts. The Russianized version with Russian engines will not be available until 2024. So, there's a big gap. And even then, if you're thinking about could Russia replace Western aircraft? Obviously, the production rates will be very, very, very low. So, there's no way they can even think about replacing a significant part of the current narrowbody fleet.

            With the [Sukhoi] Superjet, it's a similar story, but actually this week, just this weel the Russian government ordered the industry to speed up the development of what they call the Superjet-neq, which is also the Russianized version of the Superjet. And now it's supposed to be ready within 12 to 14 months. I'm not sure how that goes, but anyway, there's clearly an understanding that something needs to be done and quickly,

Ron Epstein:

Even if we assume that they can pull off the Superjet new, and even if we assume MC-21 with Russian engines works, I guess Russian engines have had sort of a spotty history of reliability over the years, but let's assume they can pull that off. The Russian economy is smaller than the economy of the state of New York. So, can the state of New York support an airplane program? No, they can't. Right. So if they're cut off from the rest of the world, those programs will be extraordinarily limited in volume and scope, period.

Joe Anselmo:

We're starting to run down on time, but Dan Williams, let's give you the final word. What's next? What are you looking for in this?

Daniel Williams :

Well, this is going to have knock-on effects throughout the industry. Something that I've been looking at is what's going to happen. We talked about the delayed "recovery" and I'm using air quotes when I say recovery, in the widebody sector in the long-haul market. And obviously this is going to have a further knock-on effect. Are we at this tipping point now? Because as it stands today, there are approximately 600 passenger Boeings and Airbuses that were stored in 2020 that are still stored today.

            Now, some of those aircraft, yes, will come back to the in-service fleet. However, it looks ever more increasingly likely the whatever hope for some of those aircraft means that they probably now become more appealing for tear-downs, especially with possible raw material issues that are coming because they could be a source of raw materials as they are recycled and titanium. And again, going back to Ron's point before, just because Boeing's got plenty of titanium, doesn't mean to say that all their suppliers have either. So, the longer, this goes on the more headaches it's going to cause the industry, as we move into 2022, '23 and beyond.

Joe Anselmo:

Ron. Final question for you. You and I are the old guys on this podcast. We're about the same age, old enough to remember Ronald Reagan and the Cold War. Are we entering a new paradigm? I mean, is this the beginning of a complete decoupling of Russia from the aerospace ecosystem? Or is it going to blow over at some point?

Ron Epstein:

Honestly, I wish I knew. I mean, if you look at what's gone on, depending on how long this takes to play out, right? So if this is a protracted issue, it's a decoupling, right? I mean, you really saw, I think, the potential for a complete reordering of kind of the geopolitical environment a couple weeks ago, right? It's not pivot to defense for just a moment to have the German government come out and essentially double their defense budget over a weekend. That's a big deal. Moving to saying 2% isn't the target, but 2% of GDP is now the floor in defense spending. That's a big deal, right?

            So I think there's a very high potential for this to be a complete decoupling from Russia. Now, if this all blows over in a couple weeks, maybe not, and that would be the best case, and I think that's what we're all hoping for, but it seems like the probability of that happening is actually quite low, sadly.

Joe Anselmo:

Okay. Well, Ron, we thank you for taking the time to join us and share your wisdom with our listeners. Dan Williams, thanks for joining us. Jens Flottau, thanks to you as always. I know you have to get back to writing your big features for the week. But that is a wrap for this week's Check 6 podcast. You can subscribe to Check 6 in Apple podcast, Google podcast, Amazon, Audible and Spotify. Special thanks to our podcast editor in London, Guy Ferneyhough. Join us again next week and stay safe.