Why the super spike in fuel prices may signal the end of super growth in air freight.

Transcription

1 Latest report in a multi-issue series covering value creation in transportation and logistics End of an era? Why the super spike in fuel prices may signal the end of super growth in air freight. BY MERGEGLOBAL VALUE CREATION INITIATIVE 32 AMERICAN SHIPPER: AUGUST 2008

2 Get advanced copies of MergeGlobal reports by visiting Two years ago, few air cargo industry executives or analysts foresaw that Asia s transformation into the world s manufacturing center could have a downside for the air transport industry. After all, Asia s booming exports have been a critical driver of global air freight growth since the early 980s with the expectation of even more growth, thanks to an anticipated boom in goods imported into Asia, driven by the hundreds of millions of relatively affluent consumers created by the reintegration of one-third of the world s population (China and India) into the global economy. The long distances separating Asia from its main trading partners in North America and Europe played to the speed advantage that aircraft enjoy over ships, and shortening product life cycles seemed to confer to aircraft a steadily rising share of global merchandise trade. Yet there is a downside to Asia s success: the soaring price of oil. In our view, the dramatic rise in oil prices since 2006 can be attributed mainly to the collision between inexorably rising Asian demand and fairly inelastic world supply, at least over the next five years. As of this writing in mid-2008, rising prices have resulted in slightly reduced oil consumption in the United States and other developed countries, but have not yet dented global demand growth because of the seemingly insatiable thirst for hydrocarbons in developing countries. Absent a global economic downturn, the outlook is for oil prices to remain high so the question is what impact permanently higher energy prices will have on the air freight industry? While almost all transportation modes depend on fossil fuels, air transport is particularly fuel intensive. For example, we estimate the fuel cost of moving a 40-foot ocean container from Shanghai to Atlanta via ocean is about 5 percent the fuel cost of moving the same goods via air freight. For those reasons we believe that high fuel prices will persist for the foreseeable future, though hopefully at somewhat lower levels than the $47/barrel prevailing at the time of this writing, and that they The MergeGlobal Value Creation Initiative comprises Brian Clancy, David Hoppin, John Moses and Jim Westphal. Clancy, Hoppin, Moses and Westphal are managing directors of MergeGlobal, a specialist firm that provides clients in the global travel, transport and logistics industries with services ranging from financial advisory to strategic consulting. This is the latest in a series of reports in which MergeGlobal will team with American Shipper for multi-issue coverage throughout will accelerate certain long-term trends that will substantially change the size and structure of the global air freight industry. Figure Door-to-door air freight value chain Origin S H IP P E R Origin terminal admin Cargo load Customerairport interface Integrated carrier Forwarder Source: MergeGlobal primary research. Airportto-airport (A-T-A) Airline Airportcustomer interface Forwarder Airport to airport value chain Aircraft prep and maintenance Integrated carrier Airportto-airport flying Airline ACMI provider Integrated carrier Aircraft prep and maintenance Destination Cargo unload C O N SI G N EE Destination terminal admin AMERICAN SHIPPER: AUGUST

3 Specifically, we expect high fuel prices to produce the following key developments over the next five years: Declining air freight market share. The decades-long trend of air freight capturing a rising share of global containerized trade flows will reverse as ocean carriers offer increasingly sophisticated and reliable time-definite products at a fraction of the fuel cost of aircraft. Tightening supply/demand balance. High fuel prices will force the early retirement of dozens of relatively fuelinefficient freighters, causing air freight supply to fall even faster than demand and giving the surviving airlines more pricing power than they have today at least until A380 and B787 deliveries begin in earnest, releasing B s and B s for passenger-to-freight conversions. Global integrated carriers becoming even stronger. DHL, FedEx and UPS are positioned to increase their share of the air freight pie and also to capture air freight traffic diverted to time-definite ocean services, thanks to their well-developed trucking networks in North America and Europe. On the following pages we will elaborate on our hypothesis and provide supporting evidence and analysis. Industry definitions Figure depicts the two basic business models in the air cargo industry: Integrated carriers own or exclusively control the assets, employees and information systems necessary to offer unbroken custodial control from the time a shipment Figure 2 Air cargo continuum Customer Shippers Forwarders Carriers Scheduled Customer has a need for capacity in payload size bracket Source: MergeGlobal primary research. Figure 3 Primary intercontinental air freight flows in 2007 Billions of laden FEU-kilometers leaves the shipper s facility to the time it arrives at the consignee s location. In contrast, non-integrated competitors primarily comprise freight forwarders who arrange door-to-door transportation, and rely on airlines to haul shipments from airport to airport. Figure 2 depicts the continuum of service types, shipment sizes and primary customer segments for each combination. The range of services covers scheduled door-to-door and airport-to-airport transportation, charter services and aircraft wet leasing. The shipment size spectrum includes transactions ranging from a few kilos moving as a small package up to a full airplane load. Shippers mainly purchase door-to-door services in kilo or pallet quantities. Forwarders purchase pallets and occasionally charter partial or full plane charters. Carriers are customers for ACMI (aircraft, crew, maintenance and insurance) wet leases of full aircraft. DHL, FedEx, TNT and UPS are the Big Four global integrators, which collectively control more than 80 percent of the global air package market using their integrated networks as a source of competitive advantage. This segment is concentrated because of the massive capital investment required to build a competitive network, as well as the economies of scale derived from flowing more and more volume over an existing network of aircraft, ground vehicles, sorting hubs and information systems. DHL s failed attempt to become the third force in the U.S. Payload size Pounds Pallets Part-airplane Full airplane Service type Charter Customer has little or no need for capacity in payload size bracket ACMI Asia. 3.0 North America Europe Africa 2.8 Middle East.5 Asia North America Latin America Total flows shown: 4.0 Intra-Asia Source: MergeGlobal world air freight supply and demand model. 34 AMERICAN SHIPPER: AUGUST 2008

4 Figure 4 Shipper industry share of directional air freight markets in 2007 Share of FEU-kilometers, billions of FEU-kilometers Billions of FEU-Km Refrigerated foods Non-refrigerated foods Consumer products Apparel, textiles, footwear High tech products Capital equipment Intermediate materials Primary products % % 5% % % 6% 7% 22% 25% 4% 9% 9% % 4% 28% % % 35% 9% 27% 32% 37% 36% 26% 32% 9% 24% 9% 5% 0% 0% 2% 2 % 2% 5% 4% 6% 4% 8% % 2% 6% 2% 0% 4% 4% World AS EU EU AS AS NA NA AS Intra-Asia EU NA NA EU LA NA NA LA 5% 6% 5% % 9% 2% 8% 5% 24% % % 8% % 5% 36% 00% 2% 0% 260 Source: MergeGlobal world air freight supply and demand model. domestic overnight market testifies to the industry s substantial entry barriers. As their volumes have grown, integrated carriers have enjoyed declining non-fuel cost per shipment thanks to increased network size and density. The integrators are invading the lower end of the heavy air freight segment largely by cherry-picking freight forwarder air freight shipments in markets where the integrators have excess capacity. Freight forwarders control 85 percent of the retail sales channel for heavy air freight shipments. The heavy freight market is less concentrated than the small package sector. The top 20 forwarders have 66 percent of the total intercontinental air freight tons, and the top 20 airlines transported 63 percent of total traffic in The rise in forwarder concentration has been driven by numerous cross-border mergers and acquisitions over the last five years, done under the assumption that larger forwarders are more attractive to customers because of greater geographic scope and increased ability to make investments in information technology. Carrier capacity concentration has also been increasing due to changes in passenger belly fleets towards smaller aircraft, reduction in flight frequencies and bankruptcies of all-cargo carriers due to high fuel prices. High fuel prices will accelerate certain long term trends that will substantially change the size and structure of the global air freight industry. The global air cargo industry transported 5.2 billion FEU-kilometers of traffic in intercontinental markets in 2007, of which 4 billion FEU-Kms moved in the major markets depicted in Figure 3. (A FEU-kilometer is one 40-foot container, containing an average.7 metric tons of goods, transported one kilometer.) Last year, the intercontinental air cargo market was only 2.5 percent of the size of the container shipping market, reflecting the reality that only a small fraction of shipments justify the cost of air transportation. The geographic distribution of air freight is similar to that of containerized ocean traffic. Asia is the single-largest origin market because it is the main manufacturing base for products that have a propensity to use air cargo services because their value, economic perishability and/or sheer distance from consumers in Europe and North America preclude sur- 36 AMERICAN SHIPPER: AUGUST 2008

5 face shipping. The transpacific market has a directional imbalance of almost 3-to- while the Asia-to-Europe market is less imbalanced where the front haul is nearly 2-to-. On an aggregate basis, north-south markets linking North America with South America, and Europe with Africa appear almost balanced, but in fact are imbalanced on a country-by-country basis, which requires carriers to operate triangular routing patterns to improve route trip load factors. Globally, the high tech industry was the single-largest end user segment of air package and freight services in 2007 with 27 percent share, followed by capital equipment and related spare parts with 9 percent, and apparel and footwear with 7 percent (Figure 4). The commodity mix varies considerably across air trade routes: Both the Asia-Europe and Asia-North America markets are dominated by high tech and apparel traffic. Flows into Asia from North America and Europe comprise mainly capital equipment to support Asia s manufacturing infrastructure, high tech components for final product assembly and intermediate material inventory to feed production lines. Fresh fruits, vegetables and seafood Figure 5 Total distribution cost concept Cost per year 00% surface, 0% air Surface captive commodities that can never bear the cost of air transport (i.e., grain, crude oil, etc.) Source: MergeGlobal. Value Creation in Air Express & Freight Minimum TDC Mixture of surface and air Transportation service Greater speed and reliability Total distribution cost (TDC)3 Transport-related cost Inventory-related cost 2 0% surface, 00% air Air captive commodities that cannot tolerate the transit time of surface transport (i.e. certain high-value perishables, hot-selling toys, etc.) Transport Related Costs reflect all costs associated with moving goods, including freight bills, documentation, customs brokerage, etc. 2 Inventory Related Costs include all other elements of logistics costs from storing and handling product to write-downs of obsolete or spoiled goods. 3 Total Distribution Cost = Transport-Related Cost + Inventory-Related Cost. AMERICAN SHIPPER: AUGUST

6 Figure 6 Transport mode share in eastbound transpacific market (Asia to Continental U.S.) Air percent; millions of FEU-kilometers, $ per kilogram A: Total air share of all commodities Air percent 4.% Sweaters 3.7% 3.8% 3.6% B: Example of seasonal commodity with high fuel price sensitivity 3.4% 3.4% Air FEU-Km 2,296 2,278 2,63 2,756 2,856 2,978 Air value % % 2.6% % 9.9% 8.9% 9.% 90.% 8.8% 7.6% 92.4% 9.2% 0.8% 4.2% 89.2% 85.8% Q 2Q 3Q 4Q Air value Ocean value Legend Millions of FEU-Km # x% x% Year Air value ($/kg) 24.3 Ocean value ($/kg) 6.0 Air share Ocean share C: Examples of commodities with declining unit values Video monitors and projectors % 24.% 9.7%.9% 8.6% 2.5% 88.% 9.4% 87.5% 75.8% 75.9% Air value Ocean value CDs and DVDs for music, movies and software % % 3.6% 2.0% 4.4% 86.4% 88.0% 85.6% 46.8% 6.7% 6.4% Air value Ocean value Non-digital Cameras % 5.6% % % % 94.7% % 74.5% Air value Ocean value Source: MergeGlobal world air freight demand model. are the primary commodities originating in Latin America to North America. Although not shown, market penetration of perishable goods is also high in the Latin America-to-Europe and Africa-to-Europe markets reflecting consumer demand for fresh produce, even during the Northern Hemisphere winter. Shipper modal choice decisions Historically, shippers have paid a premium to use air package and freight services, which can be 0 to 5 times more expensive than surface transportation because the speed and reliability of air transport more than offsets its high cost. Shippers arrive at this conclusion by explicitly or implicitly using some form of a total distribution cost framework as illustrated in Figure 38 AMERICAN SHIPPER: AUGUST The goal is to minimize total distribution costs by making trade-offs between transportation mode and inventory carrying costs. The decision is often not binary and requires determining the right mix of modes on a specific set of origins and destinations (O&Ds) that minimizes the total landed cost of the product mix being transported. There are two types of end user customers for air package and freight service: planned users and emergency users. Based on past shipper surveys, we estimate that split between planned and emergency users is 50/50. Specific reasons on why each segment uses are summarized below. Planned users: High value/weight ratios. Physical perishability. Economic perishability. Small shipment cost indivisibilities. Emergency users: Economic process impairment. Transportation service failure recovery. We estimate that products with high valueto-weight ratios make up 30 percent of total and 60 percent of planned use demand for air cargo services. These shippers can afford to use air cargo because its higher cost is offset by significantly lower inventory carrying costs relative to surface transportation. The complication is that the average value per kilo of high tech and apparel products continues to decline due to market maturity, technological advances and the progressive globalization of production. Consider the example of the eastbound

7 Figure 7 World intercontinental air freight traffic: Billions of FEU-kilometers % % Forecast % Legend 07-2 CAGR EB transpacific 6.0% WB transpacific 6.4% WB Asia-Europe 8.0% EB Asia-Europe 5. WB transatlantic 2.5% EB transatlantic 5.6% Intra-Asia 5.2% Other intercont l flows 5.7% x% 5-year CAGR transpacific market in Figure 6 from 2002 to While it is important to note that air penetration was helped by the 0-day port strike in 2002 on the West Coast, its annualized impact was not more than 20 basis points. In the aggregate, the rate of air penetration of total containerized trade has fallen by roughly one-sixth, from 4. percent in 2002 to 3.4 percent in The weighted average unit value of products being shipped by air has risen from $77 to $98 per kilo during the same time period, which provides further evidence that the bottom end of the demand curve has diverted to sea freight. The impact of higher oil prices is seen in the example of air penetration of sweaters in 2006 versus 2007 where sea freight took market share away from air in all four quarters as the spot price of jet fuel rose from $.86 per gallon in January 2006 to $2.64 per gallon in December Video monitors, DVDs and non-digital cameras made significant shifts from air to sea freight over the last five years as retail prices fell in response to competition that was enabled by lower production costs in Asia. The impact of generalized product price deflation will continue to depress the rate of air cargo growth regardless of the price of oil. However, its impact will be greater as the price of oil rises. Shippers of physical perishable products face an even more challenging supply chain cost problem because most of their products already have low unit values and they must use air cargo because of limited shelf life. Examples include strawberries, cherries, fresh seafood, and cut flowers. Three things will happen: 40 AMERICAN SHIPPER: AUGUST 2008 Figure 8 Intra-North America air freight traffic: Billions of FEU-kilometers % % Source (7 and 8): MergeGlobal world air freight supply & demand model. Legend 07-2 CAGR DPICJ 8.7% Intra-NA only 0. x% 5-year CAGR 0.9% DPICJ: Domestic Portion of Intercontinental Journey 3.0 Some shippers will stop exporting to certain markets due to high air freight costs. Others will attempt to pass on the costs with higher prices to retailers. The lucky few will take advantage of new refrigerated sea containers that are able to keep certain types of products fresh for long periods, thus enabling modal diversion from air to sea. Shippers that have used the reliability of Forecast air cargo to manage the economic perishability of their products due to short selling windows and high demand forecast error now have the option to use new time definite less-than-containerload and full-containerload sea freight services. The new ocean services are priced about 25 percent of air freight and have the same level of reliability (i.e., on-time delivery to the consignee, albeit with longer transit times. Small shipments, below 70 kilos, will

8 Emergencies will always occur but the definition of what constitutes an emergency will change with rising oil prices. continue to move almost entirely by air until the global integrators launch deferred intercontinental small-package products using time-definite ocean services. The emergency use segment is essentially price inelastic because the cost of impairing a broader economic process far exceeds the cost of air cargo. The most common emergency is when a broader economic process will be shut down, causing significant economic losses because a spare part or component inventory did not arrive on time. Examples of such emergency use include manufacturing line shutdowns due to lack of specific components, aircraft on ground awaiting replacement parts or an expensive advertising campaign ruined by not having key marketing collateral distributed in time for a big promotional event. Emergencies will always occur but the definition of what constitutes an emergency will change with rising oil prices. Overall, we expect traffic flows to continue a steady migration from air to ocean, led by the switching of planned air freight shipments to time-definite ocean service. Emergency shippers do not have a choice and will have to continue to use air cargo. 42 AMERICAN SHIPPER: AUGUST 2008 Figure 9 Intra-European air freight traffic: Billions of FEU-kilometers 2.2% Forecast 2.6% Source: MergeGlobal world air freight supply & demand model. DPICJ: Domestic Portion of Intercontinental Journey (extra-europe) Figure 0 Rising proportion of freighter lift Percentage of critical leg capacity between continents 00% 90% 27% 2% 8% 80% 70% 60% 50% 40% 7 79% 82% 30% 20% 0% 0% F Transpacific 37% Sources: MergeGlobal analysis; OAG SSIM. Asymmetric impact on air trade markets To be consistent with our container shipping demand forecast (July American Shipper, pages 68-85), we used the same GDP growth, exchange rate and oil price forecasts in our air cargo projections. Overall, we forecast that the rate of growth of FEU-kilometers in intercontinental markets will decline from 6.9 percent per year over the last five years to 6 percent for the next five years and slow to 4.6 percent from 203 to 207 (Figure 7). On the surface, the decline in the rate of growth does not seem drastic enough to be consistent with the structural changes discussed above. Our demand metric, FEU-kilometers, has three dimensions: originated weight, shipment density measured in cubic meters per ton and length of haul. Originated weight demand will grow slower averaging 5.4 percent per year over the next five years, but this will be offset by faster growth in volume of 5.8 percent due to declining shipment densities and an percent increase in average length of haul over the next five years. For the 0-year period from 2007 to 207, we forecast a 4.6 percent annual growth for combined intercontinental 6 58% 56% 42% 44% F Transatlantic Legend 07-2 CAGR DPICJ 8.4% Intra-Europe only -0.9% x% 5-year CAGR 2.9% 6% Legend Belly Main deck (freighter & combi) % 3 29% 67% 7% F Europe-Asia and inter-regional air cargo demand. In comparison to other widely tracked forecasts, such as those published by the airframe manufacturers themselves, MergeGlobal s forecasted growth rate is lower. Indeed, Airbus forecasts global air freight to grow by 5.8 percent annually from 2007 to 2026, and Boeing recently revised its 20-year forecast downward from 6. percent to 5.8 percent per year. MergeGlobal s air freight traffic forecast

9 takes a comprehensive view of global supply chain networks, which accounts for shippers increasing sophistication to cope with higher unit transportation costs, and the expansion of more reliable surface transport options. As detailed above, air freight growth will be impacted by shippers who have the knowledge and opportunity to lower their transport costs by shifting away from air freight to other, less costly alternatives. To appreciate the dynamics of the air cargo industry, it is interesting to compare growth rates on a directional trade route basis. The eastbound transpacific will grow at 6 percent per year reflecting a rebound in consumer spending in Westbound demand, heavily influenced by the cheap dollar, will grow faster, averaging 6.4 percent per year from 2007 to 202. Asia to Europe will grow the fastest at 8 percent per year and the backhaul market from Europe to Asia will grow slower, averaging 5.3 percent annually. The eastbound transatlantic will continue to benefit from a strong euro by generating 5.6 percent growth and imports from Europe to North America will grow at only 2.5 percent. Intra-Asia market growth, which is Figure Share of intercontinental air freight traffic: 2007 Billion FEU-kilometers, % Includes South America North America, Africa Europe and South America Europe. 2 Other intercontinental trade lanes that are not specified above connecting the following world regions: Europe, Middle East and Southwest Asia, North America, Asia, North West Africa, Oceania, South East Africa and South America; Does not include intra-asia. Value Creation in Air Express & Freight Freighters By belly % 32% Total air freight % 32% Transpacific 28% Asia-Europe 0% Transatlantic 8% Key South-North 7% 4% EU-Middle East & SE Asia NA-Oceania 2% Other 2 Traffic carried by larger freighters Sources: MergeGlobal freighter demand model; OAG SSIM. partially driven by final product demand shipment s journey (DPICJ). Intra-North in North America and Europe due to intermediate America will average 0.9 percent growth component flows, will average over the next five years with domestic 5.2 percent growth each year. traffic growing only slightly at 0.3 percent Intra-regional markets in North per year due to truck modal substitution. America and Europe are mature and will DPICJ will grow faster at 8.7 percent per derive all of their future growth from the year benefiting from continued emergency domestic portion of an intercontinental shipping in intercontinental markets and AMERICAN SHIPPER: AUGUST

10 Figure 2 Leading large freighter markets : October 2007 Aircraft units Rest of world World total large freighter fleet: 398 Non-integrated carriers 8 Integrated carriers Large freighters include: MD-Fs, B /300Fs, B F/BCFs 22 Legend Estimated number of large freighters operated by: # Non-integrated carriers # Integrated carriers Sources: JP Fleets; OAG SSIM; MergeGlobal analysis. the need to use at least one leg of the domestic air network to get to destination (Figure 8). The intra-europe air package market, due to its compact economic geography relative to the United States, will actually experience a contraction of 0.9 percent per year of intra-eu volumes as packages continue to shift to trucks. But overall DPICJ will grow at 8.4 percent 44 AMERICAN SHIPPER: AUGUST 2008 helping total intra-europe network traffic to average 2.6 percent over the next five years (Figure 9). New industry supply curve The latest spike in oil prices has caused jet fuel to become the largest component of a passenger or all-cargo airline s cost structure, averaging 35 percent to 40 percent of total costs on a fully allocated basis. This has caused several passenger and all-cargo airlines to ground their most fuel inefficient aircraft, shrink network capacity by as much as 5 percent, suspend or delay certain international routes and file for bankruptcy. The passenger capacity reductions will reduce available belly capacity in key intercontinental markets, causing belly supply to fall faster than market demand thus creating a shift in cargo traffic to freighters. Figure 0 shows belly capacity as a percent of total lift will fall in all three major markets due to these changes. Freighters will continue to be important to the global air cargo network because when measured on an FEU-kilometer basis, freighter aircraft transported 68 percent of total traffic in 2007 (Figure ). We estimate that 56 widebody large freighters were deployed in the major intercontinental markets in 2007 with 8 flown within an integrated carrier network and 398 operated by airlines (Figure 2). These aircraft have payload capacities above 80 metric tons as shown in the payload/range diagram in Figure 3. The complication is that 65 units were older /200/300Fs that have significantly higher fuel burns. To illustrate the impact of high fuel prices on freighter operating costs, we simulated a fly-off of old and new freighters on a non-stop route in the transpacific. As shown in Figure 4, at $3 per gallon the unit cost per ton transported on the simulated route ranged from $2,495 for the F classic to $2,230 for the production model F, a difference of 2 percent. At $5 per gallon the unit cost difference between the F and F jumps to 23

11 percent. The unit cost disadvantage grows to 40 percent when comparing a with the soon to be delivered F. In an industry when a freighter operator s EBIT margin is only 8 percent in a good year, the challenge of staying in business with older aircraft is obvious. Figure 5 summarizes the relative competitiveness of various freighter types on the simulated route. The x-axis is the average monthly utilization of the aircraft and the y-axis is the price of fuel per gallon. The lower left hand corner shows that the F is only viable when a market has low demand, when measured in monthly block hours, and with fuel prices below $3.25 per gallon. The logical replacement aircraft for low demand markets is the converted BCF freighter, which is competitive in a wide range of fuel prices and utilization levels. The clear winner is the F, which has the largest area of competitive advantage in terms of fuel prices and utilization combinations. This is a key reason why FedEx and DHL have elected to use the F as the backbone for their intercontinental line-haul networks over the next two decades. Our view is that the 747-8F is a special mission aircraft that requires very high utilization levels to be profitable, which means the aircraft will be deployed mainly in the transpacific and Asia/Europe markets. The trade-off between aircraft size on the front haul versus total trip cost minimization on the backhaul will take on increased importance when looking at the combined impact of growing directional imbalances, which puts a lower ceiling on round trip load factors, and cash expense of flying empty aircraft on the backhaul repositioning flight. We believe that these two factors will favor the F over 747-8F and BCF and the advantage could become even more pronounced if the air downgrade to sea freight accelerates. The accelerated retirements of older freighters, coupled with the constrained supply of both new-build and converted freighters should tighten the supply/demand balance in air cargo markets around the world, even if demand stagnates over the next several years. Figure 6 depicts our forecast of the global jet freighter supply/demand balance through 203. Note that total fleet size declines, both because of capacity reductions in the near term and the rise in average aircraft size over the longer term. Even with relatively modest demand growth, there will be a shortfall in aircraft required in the less-than-80 ton and 40 Figure 3 Freighters payload/range chart Maximum Maximum cargo net cargo capacity capacity (kilograms) (kg) 20,000 0,000 00,000 90,000 80,000 DC ,000 Medium A DC-0-0 freighter 60,000 (40-80 A metric ton 50,000 A DC-8-70 B capacity) 40,000 A A Small 30,000 20,000 B freighter (<40 B B757 metric ton capacity) 0,000 2,000 3,000 4,000 5,000 6,000 Range (nautical miles) Sources: Boeing Freighter Book; Airbus. to 80-ton payload segments because the production lines are essentially sold out for new build freighters while conversions are heavily constrained by the lack of feedstock as passenger carriers hold onto their B s and B s while awaiting much-delayed deliveries of new A380s and B787s. The bad news is that the market for small freighters, defined as less than 40 tons, is limited to replacing aging aircraft with no B MD- B B F Large freighter (>80 metric ton capacity) new growth. The reason is that 55 percent of all small freighters are operated within one of the big four integrated express networks, mainly within North America and Europe. For intra-regional markets, the integrators fleet strategy appears to be up-gauging aircraft size (e.g. from B747s to B757s) in order to drive down unit costs, even if doing so requires trimming the number of cities served by jets. Over time, the integrated carrier networks AMERICAN SHIPPER: AUGUST

12 will become less air intensive and deploy significantly fewer small freighters. Strategic implications Our view is that the integrated carriers are the big winners in three ways. They will: Further consolidate their market position in intercontinental small package. Divert the highest yield emergency air freight shipments away from airlines. Recapture downgraded air freight demand with their vast ground package and less-than-truckload networks in North America and Europe. Essentially, they are structurally hedged in the intercontinental market. Their challenge is how to manage the air to ground diversion within the largest regional networks. Freight forwarders will manage modal substitution of planned air freight users by recapturing pallet-sized shipments as LCL sea freight or consolidated FCL shipments. Net revenue margins per kilo will likely drift down forcing forwarders to explore new initiatives to reduce unit costs. They will continue to maintain some share of the emergency air freight market. Non-integrated airlines that operate belly capacity always have pricing flexibility due to the passenger revenue subsidy of flight costs. Carriers that survive the current downturn and upgrade to younger, more fuel-efficient aircraft should benefit from an industry with fewer competitors and therefore more pricing power than we see today. Freighter airlines, including ACMI carriers, that have relied on older aircraft in order to minimize capital investment, and who cannot afford to replace their fleets Figure 5 Lowest cost aircraft at different fuel prices and utilization levels: 200 Aircraft with lowest cost per ton transported $5.25 will be forced to exit the industry. For shippers, one obvious implication is that air freight will become more expensive as weaker carriers and excess capacity are squeezed out by high fuel prices. The Figure 4 Comparative ACMIFO cost per metric ton: 200 $ per metric ton 2 $5/gallon $4/gallon $3/gallon Insurance and other costs Maintenance Crew Aircraft Monthly block hours Tons transported $3 $4 $5 Fuel $2,752 $367 $367 $,02 $206 $563 B F $2,07 $2,385 $2, $2,768 $373 $373 $,8 $22 $568 B747-8F $2,023 $2,395 $2,768 price increases will drive more and more shippers to accept higher inventory levels in order to reduce emergency air freight shipments, and to make wider use of timedefinite ocean services. $3,23 $446 $446 $,339 ACMIFO Aircraft, Crew, Maintenance, Insurance, Fuel and Other costs excluding corporate overhead; comparison assumed similar monthly utilization for different new and old aircraft type; newer aircraft are usually capable of higher utilization due to lower maintenance requirements and higher speed relative to older aircraft. Route simulated is Tokyo Narita International/Los Angeles International/Tokyo Narita dollars. 3 Metric tons transported per rotation based on 94% of maximum net payload on front-haul and 46 metric tons on back-haul. 50 $2,230 $2,676 $3,23 $3,248 $494 $494 $, $2,259 $2,753 $3,248 $3,378 $500 $500 $, $2,378 $2,878 $3,378 $3,84 $673 $673 $2, $ $387 $ $528 $255 $234 $ B F B BCF MD- B $2,495 $3,68 $3,84 Fuel cost per gallon $5.00 $4.75 $4.50 $4.25 $4.00 $3.75 $3.50 $3.25 $ B BCF B /300F Assumptions Route simulated is NRT-LAX-NRT Front-haul payload is equal to 94% of max net payload Back-haul payload is set at 46 metric tons Cost to airline is simulated based on MergeGlobal estimate of wet lease providers cost + 5% markup Uniform discount applied to list prices of all new-build freighters B F B747-8F Source (4 and 5): MergeGlobal freighter fly-off model. 46 AMERICAN SHIPPER: AUGUST 2008 Monthly aircraft utilization (BHs)

13 Figure 6 Total freighter fleet forecast: Freighter fleet development forecast Aircraft units Value Creation in Air Express & Freight Freighter constrained demand forecast Aircraft units 2,00 2,000,900,800,700,600,500,400,300,200,00, Freighter demand line Freighter shortage Incremental production capacity Freighters delivered for replacement of retired fleet Retained fleet April Legend <40 MTs MTs >80 MTs +7% 2,74 2,04 2,05,935,984,859, April Source: MergeGlobal freighter supply and demand model. AMERICAN SHIPPER: AUGUST