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Like the rest of the airline industry,


(AMR) - Get Free Report

American Airlines


Continental Airlines

(CAL) - Get Free Report

face a gloomy winter, with sky-high fuel prices and the normal seasonal travel slowdown.

However, J.P. Morgan analyst Jamie Baker believes next year is starting to look bright for the two carriers -- the only so-called legacy airlines able to avoid bankruptcy in the wake of the Sept. 11, 2001, terrorist attacks.

Baker, whose firm does and seeks to do business with companies covered in its research reports, raised his ratings on both stocks to overweight Tuesday.

His investment call lifted AMR 25 cents, or 2%, to $13.01, and Continental 29 cents, or 2.5%, to $12.14. Baker contends that high oil prices are at long last having a salutary effect on the industry by forcing excess capacity from the system and allowing carriers to boost unit revenue.

"Ex-fuel margins are reaching new highs," Baker writes in a research note. "By our account, a model that was supposedly 'not built for $40 oil' appears poised to function at $60, though you wouldn't guess it looking at how certain equities have performed as of late. Not surprisingly, we feel better about the industry's near-term fundamental prospects and equity potential upside than at any time this decade."

In 2006, rising unit revenue should help AMR record a profit of $1.60 a share and Continental EPS of $1.15, Baker writes, adding that his forecasts are based on crude oil averaging $62 a barrel next year and crack spreads -- which measure the additional cost of refining that oil into jet kerosene -- averaging $12 a barrel.

Judging by what his peers predict, the J.P. Morgan analyst is sticking out his neck. The average estimates of Wall Street analysts surveyed by Thomson First Call are for AMR to lose $2.22 a share next year and Continental to lose 79 cents a share.

Even if next year turns out better for the industry, airlines must still make it through the winter, a time when carriers typically tend to burn cash. The season will be all the more difficult if the cost of filling a plane remains near recent levels.

Jet kerosene prices have been crushingly high in the wake of hurricanes Katrina and Rita, which knocked out refining facilities around the Gulf Coast. One pilot at a major airline said his company paid $2.54 a gallon to fill its planes on the East Coast on Monday.

To put that cost into perspective, it's almost 50 cents a gallon more than the $2.05-a-gallon average Continental is predicting for the fourth quarter, and the Houston-based airline expects a significant loss for the period. That recent fuel price is also 35% higher than the $1.88 AMR paid for a gallon of fuel in the third quarter, when it lost $153 million, or 93 cents a share.

AMR, based in Fort Worth, Texas, still has a sizable cash hoard -- $3.9 billion at the end of the third quarter -- but Continental expects its cash to fall to about $1.6 billion at the end of the year from around $1.92 billion at the end of the third quarter.

Continental expects that amount to be sufficient to make it through 2006 without a liquidity crisis, but has noted that further delays in restarting Gulf Coast refineries or added significant increases in crude oil prices would hurt its liquidity.

Also Tuesday, Baker lowered his ratings on discount airlines


( AAI) and

Southwest Airlines

(LUV) - Get Free Report

to neutral from overweight, citing recent gains in the stocks.

"While our desire for a balanced ratings spectrum regrettably pushes AirTran and Southwest down a notch, our enthusiasm for these names (particularly the latter) is not reduced in absolute," Baker writes.

AirTran plans to report its third quarter before the bell Thursday. Its shares fell 55 cents, or 3.9%, to $13.71. Shares of Southwest, which reported a better-than-expected quarter last week, fell 29 cents, or 1.8%, to $15.61.