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32 AMERICAN SHIPPER: AUGUST 2008

Latest report in a multi-issue series coveringvalue creation in transportation and logistics

End of an era?End of an era?Why the ‘super spike’ in fuel prices may signalthe end of ‘super growth’ in air freight.

BY MERGEGLOBAL VALUE CREATION INITIATIVE

http://www.mergeglobal.com

Get advanced copies of MergeGlobal reports by visiting www.americanshipper.com/TF2008

The MergeGlobal Value Creation Ini-tiative comprises Brian Clancy, Da-vid 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 2008.

AMERICAN SHIPPER: AUGUST 2008 33

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 1980s — 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 shorten-ing product life cycles seemed to confer to aircraft a steadily rising share of global merchandise trade. Yet there is a downside to Asia’s suc-cess: 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 devel-oping 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 $147/barrel prevail-ing at the time of this writing, and that they

will accelerate certain long-term trends that will substantially change the size and structure of the global air freight industry.

Source: MergeGlobal primary research.

Figure 1

Door-to-door air freight value chain

Airport to airport value chain

Integrated carrier

Origin

Customer-airport

interface

Airport-to-airport (A-T-A)

Airport-customer interface Destination

Airline ForwarderForwarder

SHIPPER

CONSIGNEE

Airline

ACMIprovider

Originterminaladmin

Cargoload

Cargounload

Airport- to-airport

flying

Aircraft prep and

maintenance

Destinationterminaladmin

Aircraft prep and

maintenance

Integrated carrier

Integrated carrier


http://www.americanshipper.com/tf2008

Value Creation in Air Express & Freight


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 contain-erized 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 bal-ance. High fuel prices will force the early retirement of dozens of relatively fuel-inefficient 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 B747-400s and B767-300s for passenger-to-freight conversions.

• Global integrated carriers becom-ing 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-devel-oped 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 1 depicts the two basic business models in the air cargo industry:

• Integrated carriers own or exclusively control the assets, employees and informa-tion systems necessary to offer unbroken custodial control from the time a shipment

leaves the shipper’s facility to the time it arrives at the consignee’s location.

• In contrast, non-integrated competi-tors 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, char-ter services and aircraft wet leasing. The shipment size spectrum includes transac-tions 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. For-

warders purchase pallets and occasionally charter partial or full plane charters. Carri-ers 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 advan-tage. 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 flow-ing 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.

Customer has a need for capacityin payload size bracket

Source: MergeGlobal primary research.

Figure 2

Air cargo continuum

Cus

tom

er

ScheduledCharter

ACMI

Shippers

Forwarders

Carriers

Payload size

Service type

Pounds Pallets Part-airplane Full airplane

Customer has little or no need for capacity in payload size bracket

Figure 3

Primary intercontinental air freight flows in 2007Billions of laden FEU-kilometers

Source: MergeGlobal world air freight supply and demand model.

North America

Asia

Total flows shown: 14.0

Latin America

North America

Intra-Asia

AsiaMiddle

East

Africa

Europe

0.7

0.5

0.1

0.4

0.4

0.8

3.0

1.1

0.4

0.3

0.20.2

2.8

1.5

1.6

3.0

1.1




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 2007. 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 invest-ments in information technology. Carrier capacity concentration has also been increas-ing 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.

The global air cargo industry transported 15.2 billion FEU-kilometers of traffic in intercontinental markets in 2007, of which 14 billion FEU-Kms moved in the major markets depicted in Figure 3. (A FEU-ki-lometer is one 40-foot container, contain-ing an average 11.7 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 be-cause their value, economic perishability and/or sheer distance from consumers in Europe and North America preclude sur-

Source: MergeGlobal world air freight supply and demand model.

Figure 4

Shipper industry share of directional air freight markets in 2007Share of FEU-kilometers, billions of FEU-kilometers

World AS–EU EU–AS AS–NA NA–AS Intra-Asia EU–NA NA–EU LA–NA NA–LA

Billions of FEU-Km

Refrigerated foods Non-refrigerated foods Consumer products

Apparel, textiles, footwear

High tech products

Capital equipment

Intermediate materials

Primary products

0.390.420.670.801.132.98 1.601.532.7915.24

16%

5%

260

100%

36%

3%3%

24%

14%

41%

8%

15%

27%

2%0%

1%3%3%

24%

23%

3%

19%

9%

10%

3%4%

6%

19%

32%

18%

14%

1%

12%

2%

16%

15%

35%

11%

15%

5%1%

4%

13%

26%

4%

28%

21%

3%

6%

15%

36%

31%

11%

1%

0%3%

14%

37%

3%

19%

15%

22%

10%

32%

8%

1%

25%

2%

16%

19%

27%

12%

17%

5%1% 1%

9%

High fuel prices will accelerate certain long

term trends that will substantially change the size and structure of the

global air freight industry.



Value Creation in Air Express & Freightface shipping. The transpacific market has a directional imbalance of almost 3-to-1 while the Asia-to-Europe market is less imbalanced where the front haul is nearly 2-to-1. 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 19 percent, and apparel and footwear with 17 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 equip-ment to support Asia’s manufacturing in-frastructure, high tech components for final product assembly and intermediate material inventory to feed production lines.

• Fresh fruits, vegetables and seafood

“Surface captive”commodities that can never bear the costof air transport (i.e., grain, crude oil, etc.)

100% surface, 0% air

Source: MergeGlobal.

Figure 5

Total distribution cost concept

1 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.

Co

st p

er y

ear Minimum TDC

Total distribution cost (TDC)3

Transport-related co

st1

Inventory-related cost 2

0% surface, 100% airMixture of surface and air

Transportation serviceGreater speed and reliability

“Air captive” commodities that cannot tolerate thetransit time of surfacetransport (i.e. certain

high-value perishables, hot-selling toys, etc.)




are the primary commodities originating in Latin America to North America. Al-though 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 premi-um to use air package and freight services, which can be 10 to 15 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

5. The goal is to minimize total distribu-tion costs by making trade-offs between transportation mode and inventory carry-ing 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 seg-ment 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 re-

covery. We estimate that products with high value-to-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

Video monitors and projectors

Figure 6

Transport mode share in eastbound transpacific market (Asia to Continental U.S.)Air percent; millions of FEU-kilometers, $ per kilogram

Source: MergeGlobal world air freight demand model.

A: Total air share of all commodities

-17.2%

Air percent 4.1%

3.7% 3.8%3.6%

3.4% 3.4%

Sweaters

B: Example of seasonal commodity with high fuel price sensitivity

2006 2007 2006 2007 2006 2007 2006 2007

118.3 148.9 149.0 170.0 334.1 354.6 249.9 256.1

1Q 2Q 3Q 4Q

Air value 24.3 24.2 23.7 22.7 18.5 19.4 19.0 20.9

Ocean value 16.0 16.5 14.0 14.5 12.9 13.3 14.0 14.7

12.6%

87.4%

9.7%

90.3%

9.9%

90.1%

8.9%

91.1%

8.8%

91.2%

7.6%

92.4%

14.2%

85.8%

10.8%

89.2%

2002 2003 2004 2005 2006 2007

Air FEU-Km 2,296 2,278 2,631 2,756 2,856 2,978

Air value 77.3 83.1 85.4 91.5 98.8 97.9

Legend Millions ofFEU-Km

Air share

Ocean sharex%

x%#

Air value ($/kg) 24.3

Ocean value ($/kg) 16.0

Year

C: Examples of commodities with declining unit values

2002 2003 2004 2005 2006 2007

Air value 149.6 114.2 119.6 115.9 120.5 119.5

Ocean value 35.7 40.1 41.8 42.4 36.4 40.0

35.9 56.8 80.1 101.7 124.6 77.8

24.2% 24.1%

75.8% 75.9%

19.7%

80.3%

11.9%

88.1%

8.6%

91.4%

12.5%

87.5%

CDs and DVDs for music, movies and software

2002 2003 2004 2005 2006 2007

Air value 35.7 35.3 27.4 35.3 47.8 45.1

Ocean value 11.8 11.0 8.6 6.6 5.6 5.9

8.8 9.7 10.4 20.9 19.4 14.5

53.2%38.3%

46.8%61.7%

38.6%

61.4%

13.6%

86.4%

12.0%

88.0%

14.4%

85.6%

Non-digital Cameras

2002 2003 2004 2005 2006 2007

Air value 111.5 102.6 88.4 113.7 109.1 87.2

Ocean value 26.6 23.7 21.4 17.8 14.9 13.7

28.7 36.3 34.4 29.6 16.8 11.4

25.5%

13.3%

74.5%86.7%

8.7%

91.3%

5.6%

94.4%

5.3%

94.7%

5.7%

94.3%




Source (7 and 8): MergeGlobal world air freight supply & demand model.

Figure 8

Intra-North America air freight traffic: 2002-2017Billions of FEU-kilometers

’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17

0.9%0.8%

Legend ’07-’12 CAGR

DPICJ 1 8.7% Intra-NA only 0.3%

0.9%

3.2

x% 5-year CAGR

0.2 0.3

3.0

0.4

3.1

3.53.5

3.0

3.23.13.23.13.13.2 3.3 3.3 3.3 3.3 3.4 3.4 3.4

1 DPICJ: Domestic Portion of Intercontinental Journey

Forecast

Figure 7

World intercontinental air freight traffic: 2002-2017Billions of FEU-kilometers

’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17

6.0%

6.9%

10.9


EB transpacific 6.0%

WB transpacific 6.4%

WB Asia-Europe 8.0%

EB Asia-Europe 5.3%

WB transatlantic 2.5%

EB transatlantic 5.6%

Intra-Asia 5.2%

Other intercont’l flows 5.7%

4.6%

11.412.8 13.3

14.215.2

16.217.2

18.419.3

20.421.2

22.223.2

24.425.5

Forecast

x% 5-year CAGR

2.3

1.7

1.2

1.2

2.6

3.0

2.8

1.5

1.1

0.80.7

1.6

3.7

1.5

4.1

2.00.9

2.1

4.9

4.9

5.2

2.6

1.0

2.6

6.2

4.02.0

0.9

1.10.8

0.70.5

transpacific market in Figure 6 from 2002 to 2007. While it is important to note that air penetration was helped by the 10-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 4.1 percent in 2002 to 3.4 percent in 2007. The weighted average unit value of products be-ing 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 $1.86 per gallon in January 2006 to $2.64 per gallon in December 2007. 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:

• 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

air cargo to manage the economic perish-ability 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-contain-erload 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




Source: MergeGlobal world air freight supply & demand model.

Figure 9

Intra-European air freight traffic: 2002-2017Billions of FEU-kilometers

’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17

2.6%

2.2%


DPICJ 1 8.4% Intra-Europe only -0.9%

2.9%

0.2

x% 5-year CAGR

0.10.1

0.1

0.1

0.1

0.30.3

0.1

0.20.20.20.20.2

0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

1 DPICJ: Domestic Portion of Intercontinental Journey (extra-Europe)

Forecast

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 essen-tially 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, caus-ing 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 adver-tising 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 f lows 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.

Asymmetric impacton 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 2013 to 2017 (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 mea-

sured 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 0.2 percent increase in average length of haul over the next five years. For the 10-year period from 2007 to 2017, we forecast a 4.6 percent annual growth for combined intercontinental

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 6.1 percent to 5.8 percent per year. MergeGlobal’s air freight traffic forecast

Sources: MergeGlobal analysis; OAG SSIM.

Figure 10

Rising proportion of freighter liftPercentage of “critical leg” capacity between continents

79%

21%

73%82%

37% 42% 44%

61% 67% 71%

27%18%

63% 58% 56%

39% 33% 29%

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%2000 2007 2012F

Transpacifi c2000 2007 2012F

Transatlantic2000 2007 2012F

Europe-Asia

Legend Belly Main deck (freighter & combi)

Emergencies will always occur but the definition

of what constitutesan emergency will change with rising

oil prices.




Sources: MergeGlobal freighter demand model; OAG SSIM.

Figure 11

Share ofintercontinental air freight traffic: 2007Billion FEU-kilometers, %

1 Includes South America–North America, Africa–Europe and South America–Europe.2 Other intercontinental trade lanes that are not specified above con-necting 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.

13.6

28%

9.3100%

32%

10%

8%

7%4%

12%

Asia-Europe

Transpacific

Transatlantic

Key South-North 1

EU-Middle East & SE AsiaNA-Oceania

Other 2

68%

32%

Frei

gh

ters

By

bel

ly

Traffic carried by larger freighters

Total air freight

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 al-ternatives. 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 2009. Westbound demand, heavily influenced by the cheap dollar, will grow faster, averaging 6.4 percent per year from 2007 to 2012. 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 con-tinue 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

partially driven by final product demand in North America and Europe due to in-termediate component flows, will average 5.2 percent growth each year. Int ra-regional markets in Nor th America and Europe are mature and will derive all of their future growth from the domestic portion of an intercontinental

shipment’s journey (DPICJ). Intra-North America will average 0.9 percent growth over the next five years with domestic traffic growing only slightly at 0.3 percent per year due to truck modal substitution. DPICJ will grow faster at 8.7 percent per year benefiting from continued emergency shipping in intercontinental markets and




Figure 12

Leading large freighter markets1: October 2007Aircraft units

Legend

Sources: JP Fleets; OAG SSIM; MergeGlobal analysis.

1 Large freighters include: MD-11Fs, B747-200/300Fs, B747-400F/BCFs

World total large freighter fleet: Non-integrated carriers Integrated carriers

12121

374

10

60 2

0

291

11457

277

72

013 23

12

90

398118

221

Rest of world

Estimated number of largefreighters operated by: Non-integrated carriers Integrated carriers##

the need to use at least one leg of the do-mestic 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

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 15 percent, suspend or delay certain international routes and file for bankruptcy. The passenger capac-ity 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 10 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 11). We estimate that 516 widebody large freighters were deployed in the major intercontinental markets in 2007 with 118 flown within an integrated carrier network and 398 operated by airlines (Figure 12). These aircraft have payload capacities above 80 metric tons as shown in the payload/range diagram in Figure 13. The complication is that 165 units were older 747-100/200/300Fs that have sig-nificantly 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 14, at $3 per gallon the unit cost per ton transported on the simulated route ranged from $2,495 for the 747-200F clas-sic to $2,230 for the production model 747-400F, a difference of 12 percent. At $5 per gallon the unit cost difference between the 747-200F and 747-400F jumps to 23



Value Creation in Air Express & Freightpercent. The unit cost disadvantage grows to 40 percent when comparing a 747-200 with the soon to be delivered 777-200F. 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 15 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 747-200F 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 747-400BCF freighter, which is competitive in a wide range of fuel prices and utilization levels. The clear winner is the 777-200F, which has the largest area of competitive advan-tage in terms of fuel prices and utilization combinations. This is a key reason why FedEx and DHL have elected to use the 777-200F as the backbone for their inter-continental 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/Eu-rope 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 777-200F over 747-8F and 747-400BCF 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/de-mand balance in air cargo markets around the world, even if demand stagnates over the next several years. Figure 16 depicts our forecast of the global jet freighter supply/demand bal-ance through 2013. 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

to 80-ton payload segments because the production lines are essentially sold out for new build freighters while conver-sions are heavily constrained by the lack of feedstock as passenger carriers hold onto their B747-400s and B767-300s 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

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’ f leet 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 trim-ming the number of cities served by jets. Over time, the integrated carrier networks

Ma

xim

um

ca

rgo

ca

pa

cit

y (k

ilog

ram

s)

Sources: Boeing Freighter Book; Airbus.

Figure 13

Freighters payload/range chart120,000

110,000

100,000

90,000

80,000

70,000

60,000

50,000

40,000

30,000

20,000

Largefreighter(>80metric ton capacity)

Mediumfreighter(40-80 metric ton capacity)

Smallfreighter(<40metric ton capacity)

0 1,000 2,000 3,000 4,000 5,000 6,000

Range (nautical miles)

B777-200

B747-400F

MD-11

B747-200

DC-10-30

A-330-200

A-340-300

A-310-300

B757

B767-300

B767-200

DC-10-10

A-310-200

B727-200

DC-8-70

A-300-600

Max

imum

net

car

go

cap

acit

y (k

g)




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 posi-tion 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

Source (14 and 15): MergeGlobal freighter fly-off model.

Figure 15

Lowest cost aircraft at different fuel prices and utilization levels: 2010Aircraft with lowest cost per ton transported

$5.25

$5.00

$4.75

$4.50

$4.25

$4.00

$3.75

$3.50

$3.25

$3.00

Fue

l co

st p

er

ga

llon

Monthly aircraft utilization (BHs)

497

489

481

473

465

457

449

441

433

425

417

409

401

393

385

377

369

361

353

345

337

329

321

313

305

297

289

281

273

265

257

249

241

233

225

217

209

201

B747-400-BCF B777-200FB747-8F

B747-200/300F

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 + 15% markup

• Uniform discount applied to list prices of all new-build freighters

Figure 14

Comparative ACMIFO1 cost per metric ton: 2010$ per metric ton2

Fuel @ $5/gallon

Fuel @ $4/gallon

Fuel @ $3/gallon

Insurance and other costs Maintenance Crew Aircraft

1 ACMIFO – Aircraft, Crew, Maintenance, Insurance, Fuel and Other costs excluding corporate overhead; comparison assumed similar monthly utilization for different newand 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.2 2007 dollars.3 Metric tons transported per rotation — based on 94% of maximum net payload on front-haul and 46 metric tons on back-haul.

Monthly block hours

Tons transported3

@ $3 Fuel

@ $4 Fuel

@ $5 Fuel

350

128

425

148

425

150

425

171144

425

$2,378

$2,878

$3,378

$2,259

$2,753

$3,248

$2,230

$2,676

$3,123

$2,023

$2,395

$2,768$2,752

$2,385

$2,017

350

147

$2,495

$3,168

$3,841

MD-11B747-400BCF

B747-400F

B747-8F

B777-200F

B-747-200

$3,841

$673

$673

$2,020

$255

$3,378

$500

$500

$1,500

$387

$298

$3,248

$494

$494

$1,483

$385

$234

$3,123

$446

$446

$1,339

$226

$528

$2,768

$373

$373

$1,118

$212

$568

$2,752

$367

$367

$1,102

$206

$563

115

31

94

31

107

31

119

38

145

47

63120

37

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

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 time-definite ocean services. ■




Freighter demand line

Source: MergeGlobal freighter supply and demand model.

Figure 16

Total freighter fleet forecast: 2008-2013

2,174

Freighter fleet development forecastAircraft units

Freighter constrained demand forecastAircraft units

2,1002,0001,9001,8001,7001,6001,5001,4001,3001,2001,1001,000

900800700600500400300200100

0April ’08 2008 2009 2010 2011 2012 2013

Freighter shortage

Incremental production capacity

Freighters delivered for replacement

of retired fleet

Retained fleet

April ’08 2008 2009 2010 2011 2012 2013

Legend <40 MTs 40-80 MTs >80 MTs

+17%

662

693

819

2,105

653

662

790

2,041

647

633

761

1,984

647

604

733

1,935

653

574

708

1,906

679

543

684

1,859

684

516

659


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