The last few years have been great for aircraft lessors. High oil prices and strong emerging markets propelled the industry forward. Demand was booming as airlines required new fuel-efficient planes while growth in expanding markets such as China and Brazil also added to the strong demand.

The aircraft leasing business involves leasing aircrafts to airlines that don't want to buy new planes. They would rather not take on the financial burden of a purchase, so they lease instead. The lessor provides the plane and the financing.

With demand growing fast, the leasing industry expanded its inventories and fattened operations. Lessors purchased a lot of planes. More planes meant more leases and more money.

But the lessors weren't thinking about the possibility of oil prices collapsing and emerging markets slowing down, which is exactly what's happening now. The trend reversal caused airplane demand to fall off a cliff. This is bad news for an industry that stocked up on so many planes, thinking the heavy demand would continue. The lessors will now be stuck paying for idle, expensive inventory, and their profits will take a hit as a result.

The Operator Community located two specific short-selling targets to play this theme. Both AerCap (AER) - Get Report and Air Lease (AL) - Get Report have great setups for short trades. But before jumping into the technicals, let's review the fundamental story further.

As mentioned, high oil prices were a big driver of airplane demand. More expensive oil meant higher fuel costs. This made it cheaper for airlines to buy or lease new planes instead of trying to operate the gas-guzzling older models.

For example, a new Boeing 787 Dreamliner is 16% cheaper to fly than a B767 from 1982. Other newer planes such as the Boeing 737 Max and Airbus A320neo were saving up to three bucks a gallon on flights. Savings like this made the purchase or lease of these new planes more economical.

But this was only the case when oil cost more than $90 a barrel. With the current cheaper oil prices, the cost savings from new planes have disappeared. The costs actually reverse. Older planes become cheaper to operate.

The current conditions make airliners with old fleets less likely to upgrade to newer planes. And if they do have to upgrade for other reasons, they don't have to buy new fuel-efficient planes. Low oil prices mean fuel costs aren't as big an issue. They can buy used planes that have similar fuel consumption rates as their old ones. This ends up being much cheaper.

For example, DeltaAir Linesrecently purchased a used 777 jetliner for $7.7 million. That's only 3% of the $277.3 million list price for a new 777. That's a huge difference. No wonder airlines are resorting to used planes.

The story is no better when it comes to emerging markets. Wealth management firm Canaccord Genuity recently warned that the United Arab Emirates' Etihad Airways and Russia's Aeroflot are likely to defer new plane orders due to poor economic conditions.

As Aircastle (AYR) - Get Report (another aircraft lessor) CEO Ron Wainshal explained: "The demand for planes is a concurrent economic indicator. Economic activity and airplane travel tend to go together."

Struggling emerging markets mean less aircraft demand. This turns out to be a big problem because emerging markets have been the primary driver for growth in the aviation markets. For example, Air Lease has seen a revenue growth rate of more than 40% from just China. But now China, along with the rest of the emerging markets, is slowing, and it doesn't look like things will improve anytime soon.

The recent Singapore Airshow was a big signal of the slowdown. This is one of the world's largest airshows and Asia's biggest. There are usually many deals made and planes sold, but this year was different. Total deals came to only $12.3 billion, 62% less than at the last Singapore Airshow, which was held in 2014. As Shukor Yusof of the aviation consultancy Endau Analytics explained: 

"This airshow [was] the most quiet and most muted in terms of sales and buzz. There are far too many aircraft orders already from the region, so we [saw] airlines do the sensible thing and not [get] carried away by placing more orders."

Many airlines around the world have reported a higher capacity, but an inability to fill their seats. This is causing revenue to decline. JetBlue, American Airlines and United Airlines all expect unit revenue to fall 6%-8% year over year in the first quarter, and Delta Air Lines expects unit revenue to drop up to 4.5%.

Due to oversupply, Boeing recently announced cuts to its production of the 747 and 777 models. This is the first step to correcting the glut that has built up over the years, but more action will be required.

Lower demand and less revenue are a problem because these lessors have a lot of debt they need to service. Check out the debt-to-capitalization ratios below, according to YCharts:

  • Aercap: 78%
  • Air Lease: 72%
  • Aircastle: 69%

If things get bad enough, servicing this debt will become an issue. Investors see this coming. Aircraft leasing companies' bonds have taken a hit recently. Investors are selling them due to the potential risk they see in the future.

Meanwhile, aircraft lessors have faced a slew of new competition from China. With the massive growth in emerging markets, Chinese firms saw an opportunity to jump into the market. The Chinese domestic share of the lessor market shot up from 7% in 2007 to 40% today. Chinese regulators helped make this happen by relaxing lending rules in 2013 and 2014. Nearly 500 new companies were created by the government's move.

Another reason this growth was possible is because the Chinese government guarantees all these companies' bonds. A guarantee like this will flood the market. With all these Chinese firms, competition and supply will both increase, pushing profits even lower.

Complacent aircraft lessors are not ready for an environment of cheap oil and weak emerging markets. Their inability to adapt will cause a significant correction in their share prices.

The best way to invest in this situation is to sell short the shares of Aercap and Air Lease. From a technical perspective, these stocks have broken down from multiyear topping patterns. Both had recent retracements that brought their prices to a resistance level. This is a great area to initiate a short position. But investors need to be careful when shorting. Bear markets are tricky and volatile. Be sure to take profits quicker than otherwise.

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Courtesy of TradingView

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Courtesy of TradingView

These stocks ran up because of excess in the aircraft leasing industry. As the glut corrects itself, we plan to profit heavily to the short side.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.