Editor's note: This was originally published on RealMoney earlier this month. With the Delta-Northwest merger back in the news, it is being republished as a bonus for TheStreet.com readers.

When crude oil was trading at $140, it was fair to wonder how many airlines might have to seek bankruptcy. If we see a fresh spike, that question will move back to the front burner.

But with oil quickly moving toward the $100 mark, investors are increasingly wondering which share prices are positioned to move up. To my mind, it is far too early to sound the all-clear on this group, because even with $100 oil and all the recent massive cost cuts, serious hurdles remain:

  • Distressed consumers are becoming increasingly price-sensitive to steadily rising airfares.
  • For some carriers, aging, inefficient fleets will need to be upgraded.
  • The strengthening dollar is reducing demand from foreign travelers.
  • Increasingly constrained corporate spenders are seeking to rein in travel expenses.

In the current environment, you want to stick with the best operators, such as

Southwest Air

(LUV) - Get Report

, while avoiding carriers that have old fleets and overextended route networks.

AMR

(AMR)

, parent of American Airlines, comes to mind in that regard.

More aggressive investors may want to give a fresh look at

JetBlue

(JBLU) - Get Report

, which has established very strong brand equity and a low-cost structure, even though the carrier is now experiencing significant growing pains.

Showing Fliers Some LUV

In a perverse way, Southwest would have greatly benefited from high oil prices. That's because the carrier has the financial muscle to expand into markets that others are fleeing. That may still happen, but even at $100 oil, Southwest is a "safe" way to play the sector's upside ("safe" being a relative term when it comes to the airline industry).

As was noted before, Southwest aggressively hedged fuel costs and has been able to make money on routes where others could not. (The company has hedged 70% of its fuel requirements at $50 per barrel for 2008, and 55% at $51 in 2009.) Those hedges will steadily erode over the next two years, but Southwest still has the second-lowest costs (in terms of seat miles) in the industry after

Airtran

(AAI)

.

Moreover, Southwest's reliance on just one type of plane (Boeing 737) has reduced costs in terms of maintenance and training. These low costs enable Southwest to generate strong profits at $90-$100 oil and to operate near break-even when oil is moving past $140.

That strong profit profile, coupled with nearly $3 billion in cash to play with, enables Southwest to contemplate a major move. The carrier could finally ramp up a meaningful international presence. Or it could look to buy up assets and gate slots from distressed competitors such as Airtran. Southwest could also look to simply enter into code-sharing arrangements with other carriers as a way to build connections into foreign markets such as Canada and Mexico.

The knock on Southwest is that the company's impressive year-over-year growth metrics, which rose quickly in the 1990s, have been steadily cooling in recent years. This explains why shares have barely budged over the last five years.

So what happens next? I can identify three scenarios:

    Oil falls to $80 per barrel, and the economy starts to rebound, leading per-share profits to exceed $1 in 2010.

    Oil stays at $110, the economy remains mired in slow growth, competitors keep retrenching, and Southwest continues to expand in markets to fill the void. As Credit Suisse's Daniel McKenzie notes, "Legacy carriers are broadly capitulating to LUV in its largest markets."

    Oil spikes back to $140-$150, the major carriers shrink even faster to preserve scarce capital, and Southwest holds course, operating near break-even. (This would be great news for the long term, as the company will face materially weaker competitors when the economy rebounds.)

    I am a big believer that tough times can yield major market-share gains for the strongest players, (as we are likely to see in the banking sector). That makes Southwest a strong hand to play, regardless of where oil prices settle.

    Playing the Weakest Hand

    As I noted in my second piece of this series, AMR is saddled with an aging fleet, an unwieldy route network, sagging morale and an emerging slowdown in international travel. Yet shares of AMR have spiked 150% this summer as investors no longer see a bankruptcy risk.

    In fact, some analysts have turned quite bullish. But they overlook the high operating costs that are keeping AMR from being profitable.

    When oil was trading at $140 a few months back, analysts predicted that AMR would lose nearly $7 a share in 2009. Even as oil prices are now close to $100, analysts still say per-share losses will exceed $4 next year. Simply put, the ongoing cash burn, coupled with the need to replace the old gas-guzzling fleet of planes, could very well erode the cash cushion that AMR has built for itself.

    Swinging for the Fences

    I continue to be a believer in JetBlue, despite the obvious headwinds in place right now. I

    wrote about JetBlue in the spring, and my thesis remains largely intact.

    Simply put, the low-cost carrier has built a very strong brand, serves high-traffic routes, maintains a relatively young fleet of planes (averaging 3.1 years), has a very strong presence in the all-important New York market (which will be augmented by a snazzy new terminal at JFK in coming weeks) and has secured an intriguing relationship with Lufthansa that could soon bear fruit.

    JetBlue will hold its analyst day on Wednesday, Sept. 10, at which time investors will get a sense of the new management team's vision. Although the initial euphoria over JetBlue has clearly passed, the carriers' second act could be equally impressive.

    This was originally published on

    RealMoney

    on September 9, 2008. For more information about subscribing to

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    David Sterman has been an equity analyst and financial journalist for 15 years, most recently serving as Director of Research at Jesup & Lamont Securities.