As a growing number of economists and analysts believe crude oil prices appear poised for a major downward correction, the stock of major U.S. and European airlines could be set to soar.
Airlines have been hurting as crude has persistently crept to new all-time highs. As much as 30% of an airline's operating costs can come from jet fuel. Small adjustments to the price of crude, up or down, can have huge effects on an airline's income statement.
"We welcome falling oil prices like manna from heaven," says Bryan Baldwin, spokesman for
Airline stock prices reflect the impact of high crude prices. In a research note, Louis Capital Markets head of global research Robert Van Batenburg recently wrote that the airline sector has thus far underperformed the overall market in 2007. Year to date, the airline sector in Europe trailed the overall market by 6.5%, and U.S. airline stocks are off 16%.
Although Louis Capital Markets remains bullish on crude oil long-term, Van Batenburg says the momentum toward a short-term correction in the crude market seems to be gathering steam. He says that the price of crude doesn't appear to be supported by a complementary supply and demand function.
As of July 27 (the most recent figures available), there were 345 million barrels of crude oil in U.S. storage facilities, Van Batenburg says. This is 12% greater than the five-year average. That is a lot of crude oil saved for a rainy day or a supply shock, even as we enter the peak of hurricane season in the late summer.
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Conversely, inventories for motor gasoline, the main refined product during the spring and summer months, is only 2.2% below the five-year average. Also, demand for gasoline -- although slightly higher than it was last year -- hasn't been as alarming as some analysts were predicting earlier this year.
The last piece to this puzzle fell into place two weeks ago when the futures curve for crude oil went into "backwardation." Unlike a normal futures curve, a backward futures curve features near-month contracts that are more expensive than contracts further out. This eliminates the natural premium for inventory storage and inflation, and encourages holders of crude oil to sell their stores immediately for more money, thus flooding the market with oil and driving down near-term prices.
This appears to be what is happening now, according to an email from analysts at Louis Capital Markets. Crude has fallen from an all-time record above $78 reached last week, to almost $72 Monday. The spread between the September and October WTI contracts has tumbled from over $2 to about 20 cents. The extent of the futures curve's backwardation is down significantly.
The airlines that are least hedged against commodity price volatility would have the most to gain from a correction in crude prices. Ironically, these companies tend to be the companies with the large, well-known "legacy" carriers, according to Van Batenburg. These airlines have struggled through so much financial hardship that they've been unable to find counterparties to build hedge positions with.
Jet Blue, one of the bigger airlines that stand to benefit most from a correction in fuel prices, is hedged 51% in the third quarter and 35% in the fourth quarter, Baldwin says. A decline in oil prices would increase Jet Blue's profitability significantly, he says.
Smaller discount and regional carriers like
have had an easier time hedging, and thus have less to gain from falling crude oil prices. Southwest is 90% hedged in the third and fourth quarters, according to its second-quarter financial statement.
Other U.S. airlines that, like Jet Blue, are less dependent on hedging and poised to benefit most from falling prices are
( UAUA) and
, Van Batenburg says. European airlines that would be positively affected are Lufthansa and
It is these stocks that have the greatest earnings-per-share sensitivity to fluctuating oil prices, according to Van Batenburg. He says that they could have a minimum 20% upside if the price of oil drops 10% from current levels.
This same trend can be found during the 2006 oil cycle. Crude prices dropped from $77.05 a barrel on Aug. 7, 2006 to $55.59 on Nov. 17. Over essentially the same time period, shares of United Airlines climbed from $22.33 to $40.45.
A similar move by these same airline companies could easily occur again if crude prices were to correct to the extent that many economists are predicting.