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Analysis-Jetmakers’ inflation shield no match for soaring costs -Breaking

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© Reuters. FILE PHOTO A Airbus A321 being assembled at the Airbus U.S. Manufacturing Facility, Mobile, Alabama on September 13, 2015. REUTERS/Michael Sooneybarger/File Photograph

By Tim Hepher

DUBLIN, (Reuters) – Inflation clauses, which determine the price airlines will pay to buy new aircraft, have jumped into a hyper-escalation band. This has caused an increase in aircraft prices, but left manufacturers unable pass on their soaring cost, according to industry executives.

A rare step in the aviation industry is the hike to the top inflation band. It could cause a rise of airfares for airlines, while manufacturers may be left in the dust. Experts have warned at large gatherings in Dublin this week that such a move would not only affect the financial sector but also impact the quality of life.

Airline pilots purchase jets for a price they agree to in secret negotiations. The final price, however, includes inflation adjustment during long production delays, which are based on U.S. inputs and labour costs.

These “escalation clauses” have quietly inflated the profits for planemakers over years as long-term price increases exceeded the aircraftmakers’ purchasing costs. This is according to people who are familiar with the contracts.

With key U.S. cost indexes increasing by the greatest amount in more than a decade now, price adjustments have become steeper, and there is no cushion between real and escalating costs.

Aengus Kelly from AerCap stated that “it’s been a profitable game for the manufacturers so long as their own costs aren’t growing as fast as the escalated.”

This rapid rise could mean that some manufacturers are out of pocket, as clauses were not negotiated in an era where inflation worries were low.

Kelly stated that leasing companies will still be more secure if they have secured limits on their inflation exposure over the decades.

Steven C. Udvar–Hazy is senior vice president at Tokyo Century’s leasing unit Aviation Capital Group.

According to him, the Airfinance Journal conference was concerned by the US’s inflationary environment. This could have knock-on consequences for escalation in the wider supply chain.

SHARED RISK

For aircraft leasing firms that hold half of the fleet worldwide, inflation is a dual-edged sword.

They are able to take advantage of the inflation’s effect on their aircraft values. They also have to contend with increasing purchase prices. Some insist on escalation limits.

Buyers will decide the terms. Sources familiar with the matter said that the most common structure is the one where the leasing buyer or airline pays the entire escalation rate. This usually caps at rates of around 3%.

There may be an additional band of risk, up to 5% for manufacturers.

The two parties usually agree to divide the added burden when inflation reaches the highest level, the so-called “hyperescalation” clauses.

According to Reuters, a senior source in the industry said that “that is where we are right now, in hyperinflation”

A few cases may be rare, but preferred clients could have a “get-out” clause, which allows the parties to end their agreement completely if inflation reaches an extreme high, according to one source.

Embraer and Boeing (NYSE;) declined to comment about contractual matters. All three companies are expected to engage in difficult negotiations regarding future aircraft deals.

While we don’t notice current inflation at such high levels often, the effect of it is significant. Arjan Meijer, Embraer Commercial Aviation Chief Executive, said that escalation was going to be a hot topic moving forward.

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