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Jetmakers’ inflation shield no match for soaring costs

Kitco News

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
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