US Defense 2016 Outlook: Amid Middle East Oil Concerns And Stricter Congress, Industry Faces Uncertain Future

On a small stretch of the Margaret River in Norfolk, Virginia, where some of the U.S. Navy’s most celebrated warships have set sail over the last two centuries and where the Navy’s newest aircraft carrier, the USS Gerald Ford, recently launched from, U.S. military shipbuilders are facing an increasingly uncertain future.

An announcement last week by BAE Systems, one of the world’s biggest defense companies, that it would cut hundreds of jobs from its Norfolk ship repair yard in March is just one of many cost-cutting measures unfolding at all major defense contractors in America as the U.S. military continues its attempts to slim down after 15 years of intense warfare in the Middle East. While defense analysts claim that a rising U.S. military budget could help manufacturers rebound in 2017 after years of reduced orders and shrinking revenues, a financially shrewd Congress and increasingly unpredictable global oil market have raised questions about whether a recovery is on the horizon.

“Industry revenues coming from U.S. Department of Defense peaked five years ago, and since then we’ve seen a major glut of defense cuts, but I believe that 2016 is probably the bottom and then I think you’ll see small yet gradual increase in revenues in 2017,” said Andrew Hunter, an expert in international security and defense at the Center for Strategic and International Studies (CSIS), a Washington, D.C.-based think tank. “But the increase in U.S. defense spending will go up less rapidly than the [U.S.] defense budget is expected to in 2017.”

Jermaine Taylor, president of the Boilermakers Union in Norfolk, which represents the workers expected to lose their jobs in March at the BAE yard, said the proposed job losses of 530 people and similar cuts in late 2015 were largely because of “government cutbacks.” Taylor said he hoped the situation would change and his members' positions might be saved.

But any uptick in sales for the defense industry this year would require a change of policy among military leaders in Congress, who are adamant that future defense acquisitions and overall defense spending must be tightly controlled in the future. Big-ticket items from recent years, such as a $1.5 trillion F-35 jet project or a $30 billion littoral combat ship contract, which had both suffered from major cost overruns and delays from the main contractor, Lockheed Martin, appear to be a thing of the past, according to Sen. John McCain and Rep. Mac Thornberry, who serve as chairmen of the Senate and House Armed Services Committee, respectively. The fiscal conservatives both want an increase in the defense budget moving into 2017, but don’t necessarily want to increase acquisition costs.

The much maligned F-35 jet program, which is currently around $160 billion over budget and seven years late on delivery, was the Pentagon's biggest military procurement project in history when Lockheed Martin began production in 2006. McCain said last year that he accepted that unexpected expenses and delays had begun to stabilize since production began nearly 10 years ago, but was still concerned over “total cost, affordability and technological changes.” Moving forward, McCain said he and Congress would hold “individuals responsible” for continued failures on defense spending.

Years of across-the-board cuts to U.S. government spending, also known as sequestration, have forced budget planners to ask new and important questions about defense spending, said Todd Harrison, senior fellow at the Center for Strategic and Budgetary Assessments, a defense strategy think tank in Washington, D.C. He summed up the new attitude in Congress: “Are we spending it wisely? Are we spending it on the right things?”

A more prudent and streamlined U.S. military means defense manufacturers have to increasingly rely on sales from foreign governments to keep orders coming in and production lines open. Since late 2009, when U.S. spending on military acquisition started to fall, petro-economies in the Middle East began to spend huge sums on ships and aircraft using windfalls from oil prices that hovered just below $100 a barrel.

While Saudi Arabia led the way with big $30 billion deals for Boeing jets, Riyadh’s neighbors like Kuwait, Qatar and Oman also spent vast sums on defense items, including munitions and drones.

The outlook for future big defense purchases from the Middle East will continue to rely heavily on the price of oil, which has continued to plummet for more than 14 months. Since October 2014, oil has plunged from $100 per barrel to $29 by Tuesday morning, a fall that cuts billions from the government budgets of oil dependent Arab states in the Middle East and gives them less money to spend on defense.

Riyadh, for example, needs more than $100 a barrel to break even on its huge government budget, according to an International Monetary Fund report. The kingdom's leaders have decided to reduce spending by 15 percent, or nearly $100 billion, at the end of 2015, amid warnings from the IMF that it would be bankrupt within five years if it didn’t take immediate action.

Thousands of miles away on defense production lines all across the U.S., economic decisions being made in the once oil-rich capital cities of the Middle East are having a huge impact. Between 2009 and late 2015, Lockheed cut around 10,000 jobs from across all divisions, citing lower orders from abroad and domestically, according to CSIS’ Hunter, who said the company had “been the most public about their total number of cuts” but sensed “that workforce reductions have been pretty uniform across the whole industry."

Take Boeing’s F-18 manufacturing plant in St. Louis, Missouri. The plant is under threat from closure because the Navy will no longer order enough planes to justify keeping it open and plans to replace the F-18 with the F-35 in the coming years. This is where Kuwait, which had wanted to buy as many as 36 aircraft in response to a deteriorating security situation in the Middle East, would come in and save the production line. But falling oil revenues in the emirate have forced Kuwait to slash its budget and rethink the F-18 deal.

By current estimates, Boeing needs orders of around 24 a year to keep the production of the aircraft cost-effective. Secretary of the Navy Ray Mabus, whose branch has been the main buyer of the F-18, called on Congress to stop holding up the deal with Kuwait for the F-18 and push it through, sensing that the falling price of oil could force the Arab country to pull out and leave the Navy with the difficult decision on whether it will make purchases just to keep the production line open and save jobs. Once a production line is closed, it can cost billions to reopen and workers who are laid off or sent to different projects are hard to replace.

“It’s a frustrating process for all parties involved and it speaks to the need to do something about the whole process,” Mabus told reporters at the Surface Navy Association conference last week.

Until those changes are made or oil prices recover, experts said, the defense industry faces a losing battle to win new contracts and keep its workers busy.