It's shaping up to be a cruel winter for the airlines, and that very likely means hefty fourth-quarter losses.

Airlines traditionally enter the fourth quarter with cash reserves bolstered by the busy summer travel season. This year, alas, the third quarter turned into an airline cash bonfire, with carriers forced to pay sky-high prices for jet fuel at the same time industry overcapacity and competition depressed prices.

The industry received a rare bit of bright news Tuesday, however, when

Continental Airlines

(CAL) - Get Report

reported results for October suggesting an improving price environment. Continental estimated mainline revenue per available seat mile, a key industry metric known as RASM, rose between 0.5% and 1.5% year over year, reversing declines in August and September.

Continental's October results constituted a "reasonable start to a tough quarter," wrote Jamie Baker, a J.P. Morgan analyst, in a research note. "Given recent leisure pricing traction, Continental's October results will likely represent the low point of its quarter, with less severe yield declines moving forward. If so, this suggests modest upside to the current

fourth-quarter Continental loss consensus of $2.83." (J.P. Morgan does and seeks to do business with companies covered in its research reports.) On average, analysts estimate Continental will bring in $2.38 billion in revenue during the quarter, according to Thomson First Call.

Modest improvements in Continental's yields aside, analysts say the fourth quarter will likely be grim overall. "While capacity is going to go down in 2005, it's still too high now, and oil prices are still high," said Jim Corridore, equity analyst at Standard & Poor's. "It's pretty obvious the industry is going to lose a lot of money in the fourth quarter." (Standard & Poor's does not do investment banking business with the companies its analysts cover, but its affiliates may provide other services to them.)

Oil prices have turned out to be a crucial variable the industry can't control, although airlines such as

Southwest

(LUV) - Get Report

and

JetBlue

(JBLU) - Get Report

presciently limited their exposure by hedging fuel costs.

If jet fuel had remained at year-ago levels, the 13 major U.S. airlines would have recorded combined third-quarter profits of $509 million, vs. their actual combined losses of $948 million, according to Merrill Lynch's Michael Linenberg. (Merrill Lynch does and seeks to do business with companies covered in its research reports.)

Crude oil may have retreated from its record high of more than $55 a barrel, but prices remain high. They're also more than $5 a barrel higher than when American Airlines parent

AMR

(AMR)

warned it would spend $1 billion more on fuel this year than last year.

Given the volatility of oil, Linenberg has fashioned what he calls a "bifurcated" view of airline stocks, meaning investment picks depend on what happens to crude prices.

"If oil prices decline to $35 barrel, the stocks that are most leveraged to a drop in oil prices are the ones that are unhedged, which, in most cases are the major network carriers," Linenberg wrote in a note Tuesday. "However, lack of a hedge can be disconcerting. Therefore, we recommend investors focus on the names that have the best liquidity positions. Our favorites are

Northwest Airlines

(NWAC)

and AMR, in that order." On average, Wall Street analysts expect Northwest to lose $3.35 a share on $2.77 billion in revenue, and AMR to lose $2.99 a share on $4.59 billion in revenue in the fourth quarter.

J.P. Morgan's Baker also looks at AMR and Northwest -- and adds Continental -- as good picks for investors seeking to exploit a potential decline in oil prices.

If oil prices remain at present levels or move higher, though, the picture changes. "We suggest investors focus on our most defensive names which happen to be the financially strongest low-cost carriers: Southwest and JetBlue, in that order," he wrote. "Higher oil prices would likely result in the withdrawal of more expensive capacity, providing further growth opportunities for both of these names."

The Wall Street fourth-quarter consensus is for Southwest to earn 9 cents a share on $1.68 billion in revenue and for JetBlue to lose 3 cents a share on $338.5 million in revenue.

Linenberg also recommends investors take a look at

Alaska Air Group

(ALK) - Get Report

should oil prices remain high; he notes the carrier has the second-best fuel hedge position in the industry after Southwest. On average, analysts expect Alaska to lose 75 cents a share on revenue of $649.5 million during the fourth quarter.