AS OIL PRICES FALL, NEW AIRCRAFT LOSE COMPETITIVE EDGE

Aviation, Aerospace & Defense AS OIL PRICES FALL, NEW AIRCRAFT LOSE COMPETITIVE EDGE AUTHORS Tim Hoyland, Partner Andrew Medland, Principal

The decline in jet fuel prices could stymie the airline industry s deliberate march toward a new generation of narrow-body aircraft. Aircraft manufacturers developed new planes and engines, and airlines ordered them, to reduce fuel consumption at a time when oil prices seemed stuck at historic highs (with the added benefits of reducing emissions and noise). However, as airlines wait to receive their new 737 MAXs, Airbus neos, and other efficient and innovative aircraft, fuel prices have dropped. This dramatic shift offsets the operating cost advantage highly utilized new aircraft would hold against older models in an environment of higher fuel prices and low interest rates. According to an Oliver Wyman analysis, jet fuel prices at $2.4 a gallon or less would make older aircraft increasingly competitive with new planes, particularly in lower utilization networks or as spares. This price point will vary by airline based on the business models employed for maintaining aging fleets. This could lead to overcapacity in the North American aviation industry, following strict capacity discipline during the last couple of years. Low fuel prices spur airlines to keep their current planes in operation while adding new fixed orders to their fleets. Considering current profitability, investors might seize this opportunity to start new airlines with older aircraft. After a decade of rising fuel costs, prices declined during the past year, with year-over-year jet fuel prices down 3 percent at $1.48 a gallon as of January 15. Other than a few short months during the recession in 29, the last time fuel was this low was in 25. According to the Energy Information Administration, The November price decline reflects continued growth in US tight oil production along with weakening outlooks for the global economy and oil demand growth. The decision by the Organization of Petroleum Exporting Countries to leave its production target unchanged has further weighed on prices. Copyright 215 Oliver Wyman 2

FUEL BURN As fuel prices decline, older aircraft become more profitable to operate at higher utilizations than new aircraft that are about to be delivered. The inflection point for any airline can be plotted on the curve based on the intended utilization of the airline s new and aging fleets. Exhibit 1: Aircraft generational profitability curve: Where is your fleet s inflection point? Exhibit 2: Jet-A fuel price at a four-year low JET-A PRICE US$ 3. New-generation aircraft are more profitable than the current generation. Oct 213 $2.89 US$ 4.5 Airlines make purchasing decisions about new-generation aircraft. 2. Fuel prices drop 3. Non-recession jet-a prices have not been consistently below $2.1 since 25. Linear trend line (inflation adjusted to 214) 1. New generation aircraft are less profitable than current generation. 2, 2,4 2,8 3,2 3,6 4, 4,4 4,8 Utilization in hours Jan 215 $1.48 1.5 2 27 214 Inflationadjusted price to 214) Spot price Exhibit 3: Global crude oil production: 2-22 (projected) BARRELS BILLION 4 Exhibit 4: Global crude oil consumption BARRELS BILLION 35 35 214 rate of crude oil production: 33.56 billion barrels per year 3 3 25 2 22 24 26 28 21 212 214 216 218 22 25 212 213 214 215 Assumptions and methodology Estimated actual lease payments in US dollars, assuming a six-year term, with maintenance reserves included, for a 215 build. Includes inflation. Assumes you start a new six-year lease every six years. Fuel burn includes 2 minutes of APU fuel. Sources BLS.gov, indexmundi.com, EIA, Aircraft Value Analysis Company, Aircraft Value Reference 212 report, using standard specification and maintenance condition assumptions; Aircraft performance degradation May 29, Airbus; Aircraft performance statements issued by Airbus and Boeing. Copyright 215 Oliver Wyman 3

Exhibit 5: Benefits of new planes extend beyond fuel efficiency CO2 EMISSIONS KG PER SEAT KM.25 NOISE EMISSIONS EFFECTIVE PERCEIVED NOISE IN DECIBELS 1.2 8.15 6.1 4.5 2 A32 A32neo 737-8 737 MAX Airbus Boeing A32 A32neo 737-8 737 MAX Airbus Boeing Sources Boeing, Airbus, Atmosfair, FAA. The volatility in fuel and other costs in the past decade prompted airlines to evaluate their total cost of ownership models. Almost every airline ordering new aircraft has a finely tuned total cost of ownership model based on many things, including purchase price, crew costs, landing fees, financing costs of the aircraft, inventory, utilization, specific maintenance agreements, and expected fuel costs. Prior to making a purchasing decision and with some diligence, an airline can exercise control over all variables in the model, except for some future financing costs and the future cost of fuel. Manufacturers listened, pouring billions of dollars into technology to reduce emissions, improve on-wing life, curtail noise, and increase fuel efficiency. Boeing, Airbus, Embraer, Mitsubishi, and Bombardier now offer planes with these sought-after benefits. GE and Pratt developed engines to boost the cost benefits. Combined, these efforts produced aircraft that, according to manufacturers marketing materials, improve fuel consumption by at least 2 percent. Further, updated seats and better airflow systems make the ride more comfortable for passengers. Exhibit 6: Airbus A32neo vs. Boeing 737 MAX firm orders by year (all variants) 1,25 1, 75 5 25 21 211 212 213 214 Sources Airbus, Boeing. Boeing 737 MAX Airbus A32neo Copyright 215 Oliver Wyman 4

Airlines opened their wallets, ordering an unprecedented number of aircraft. Now, after years of allowing their fleets to age as they waited for a new total cost paradigm, some airlines are planning to replace their fleets in the next few years. The new planes promise to reduce fuel burn and the cost of maintenance, although financing costs are higher. This trade-off looked like a boon when oil prices were high. But if low fuel prices continue, as financing costs rise, it could spoil the party for the supposed winners of the new generation of aircraft: the owners and manufacturers of the innovative planes. Instead, if fuel prices remain low, the winners could be the airlines flying older aircraft at lower utilization; maintenance, repair, and overhaul companies; and maintenance mechanics, as older aircraft need repairs and updates. Some airlines could keep low-cost spares available to improve on-time performance. The market could watch the reaction of lessors, which represent large order books, as a leading indicator of a shift in new-generation aircraft economics. If lessors expect low fuel prices for the long term and rising interest rates, they might sell, cancel, or delay orders and rebalance their portfolios toward aircraft currently in operation. Exhibit 7: Net new deliveries will substantially increase active-service aircraft by 22 Retirements Deliveries AIRCRAFT DELIVERIES (RETIREMENTS) # OF AIRCRAFT (BY REGION) 2, 1,5 1, 5-5 -1, TOTAL ACTIVE-SERVICE AIRCRAFT # OF AIRCRAFT (BY REGION) 3, 25, 2, 15, 1, 5, Asia: Adding 2,8+ aircraft Europe: Adding 1,4+ aircraft North America: Adding 1,6+ aircraft Net change North America Europe Asia Pacific South America Middle East Africa 213 214 215 216 217 218 219 22 213 214 215 216 217 218 219 22 Sources Airline Monitor, ICF, ACAS, Airbus, Boeing, Oliver Wyman analysis. Copyright 215 Oliver Wyman 5

If they aren t getting the profit boost they expected out of the new aircraft, airlines, too, could start eyeing the older planes as quick revenue generators and add capacity. While that might be a rational decision for individual carriers, for the industry, more capacity could bring the North American airline industry back to earth. The risk of adding too much capacity is acute. North American airlines have recently achieved their best margins in a decade and seem to have finally lifted themselves out of a boom-and-bust cycle. Industry yield has grown steadily since 22. A flood of capacity could unravel those gains. THREE ROUTES INTO THE FUTURE Given the uncertainty of jet fuel prices, three scenarios could unfold, each with a different set of winners and losers across the industry. SCENARIOS WINNERS LOSERS 1. Jet fuel enters an extended period below $2.4 a gallon. 2. Jet fuel prices enter a period of volatility for the next three years or so, with broad fluctuations and return above $3 a gallon. 3. Jet fuel prices quickly snap back above $3 in 215. All airlines benefit, as fuel is 3 percent of their costs. In particular, airlines with access to older aircraft and any start-up carriers that use current aircraft can add capacity cheaply. MROs benefit as older aircraft remain in service, increasing total shop hours. OEMs with aftermarket capabilities win. Lessors with portfolios weighted with current and older aircraft win. All airlines win, if orders get canceled and production declines as capacity is constrained on the supply side. Airlines with hedges enjoy price certainty. Airlines with young fleets would immediately win from the dip in fuel prices, then benefit more as oil prices rise just as new aircraft are delivered. With only a short-term dip in prices, those airlines and lessors that are poised to take on new aircraft with better fuel efficiency win. OEMs win as order books remain unchanged. Lessors with portfolios weighted with orders for new aircraft win. All airlines lose, as capacity expansion will cut into pricing and margins. In particular, airlines switching to new fleets without the older aircraft mix and airlines with fuel hedging programs through 215 are affected. OEMs lose if orders are delayed or canceled. Lessors with portfolios weighted with orders for new aircraft lose. Airlines that made long-term bets on older aircraft and airlines that delay orders for new aircraft lose. Airlines with older aircraft lose, including any start-up using older fleets. MROs lose as the influx of new aircraft will decrease total shop time in coming years. Lessors with portfolios weighted with current and older aircraft lose. Copyright 215 Oliver Wyman 6

ABOUT OLIVER WYMAN Oliver Wyman is a global leader in management consulting. With offices in 5+ cities across 25 countries, Oliver Wyman combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. The firm s 3, professionals help clients optimize their business, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies [NYSE: MMC], a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy and human capital. With over 53, employees worldwide and annual revenue exceeding $11 billion, Marsh & McLennan Companies is also the parent company of Marsh, a global leader in insurance broking and risk management; Guy Carpenter, a global leader in providing risk and reinsurance intermediary services; and Mercer, a global leader in talent, health, retirement and investment consulting. For more information, visit www.oliverwyman.com. Follow Oliver Wyman on Twitter @OliverWyman. ABOUT OUR AVIATION, AEROSPACE & DEFENSE PRACTICE Oliver Wyman s global Aviation, Aerospace & Defense practice helps passenger and cargo carriers, OEM and parts manufacturers, aerospace and defense companies, airports, MROs, and other service providers develop growth strategies, improve operations, and maximize organizational effectiveness. Our deep industry expertise and our specialized capabilities make us a leader in serving the needs of the industry. Also, Oliver Wyman offers a powerful suite of industry data and analytical tools to drive key business insights through www.planestats.com. For more information on this report, please contact: TIM HOYLAND Partner tim.hoyland@oliverwyman.com ANDREW MEDLAND Principal andrew.medland@oliverwyman.com Elizabeth Souder edited this report. www.oliverwyman.com Copyright 215 Oliver Wyman All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisors. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. The report is not an offer to buy or sell securities or a solicitation of an offer to buy or sell securities. This report may not be sold without the written consent of Oliver Wyman.