The high price of oil has disrupted the airline industry's return to profitability, with Wall Street brokerages dropping earnings estimates and warning that more could come.

In 2004, the price of oil soared from about $32.50 a barrel to well above $36 a barrel, as demand remained strong and OPEC pushed a plan to limit supply. In response, Morgan Stanley lowered earnings estimates on the entire airline industry on Tuesday morning, while Raymond James dropped estimates for a pair of low-cost carriers.

With the average price of oil at $34 a barrel in 2004, Morgan Stanley analyst William Greene ditched an assumption that oil would average $30 a barrel, telling investors that at current levels, none of the network carriers would be profitable for the year. On average, Wall Street analysts currently predict that Continental Airlines ( CAL) and AMR ( AMR), parent of American Airlines, will be profitable.

"It should come as little surprise that those airlines with the largest hedged positions will see the most limited earnings impact from oil price changes," said Greene in his note. "If oil averages $34 a barrel, none of the U.S. major network airlines is likely to be profitable, though all of the low-cost airlines should remain in the black."

High Oil, Deeper Losses

Instead of seeing American earn $1 a share in 2004, Greene expects it to lose 70 cents a share. His 2004 loss estimates for Continental, Delta Air Lines ( DAL) and Northwest Airlines ( NWAC) were also cut, falling below current Wall Street expectations.

Profits at low-cost carriers, which have done a better job hedging fuel costs, will be hurt, but less so, with Greene dropping estimates for AirTran ( AAI), Frontier ( FRNT), JetBlue ( JBLU) and Southwest ( LUV). Elsewhere, Raymond James dropped earnings estimates for AirTran and JetBlue, assuming oil would stay at $35 a barrel for the first half of the year.

This could be the beginning of a trend. As the recent estimate changes indicate, if oil remains above $34 a barrel, brokerages may feel compelled to lower expectations, and that could put even more pressure on airline shares. After gaining nearly 60% in 2003, the Amex Airline Index has slumped 3.4% in 2004.

"It may be naive on our part to assume $34 a barrel for 2004, but other sell-side analysts have not yet incorporated oil prices anywhere close to current levels," said Greene. "As the models are updated, we expect airline estimates to come down across the board."

An Unhedged Bet

Network carriers will be hit the hardest by high oil prices. As a rule, low-cost carriers have hedged much of their oil needs, while network carriers have limited hedges, at best. Of all the airlines, Southwest is the best-positioned for fiscal 2004, with 80% of its fuel needs hedged at $24 a barrel. In comparison, Northwest has no fuel needs hedged for fiscal 2004.

Over the last few years, network carriers left oil unhedged for strategic and economic reasons, betting that the price of oil will drop and being unwilling to use weak balance sheets to pay for hedges if oil doesn't. This is quite a reversal from just five years ago, when the network carriers' ability to hedge was an advantage over smaller rivals.

"In the post-Sept. 11 period, as the big network airlines had big capacity cuts, they found themselves with excess pre-purchased fuel," said Stuart Klaskin, founding partner at KKC Aviation Consulting. "So they got shy on fuel hedging and are cash-constrained now."

Many economists felt that the price of oil, which hit a low of $25.22 a barrel at the end of April 2003, would be closer to $30 a barrel in 2004. Since 1984, oil had only been above $36 a barrel three times. The first two times, in September 1990 and March 2003, were the direct result of conflicts with Iraq.

Betting on the historical trend, the network names left their oil needs largely unhedged, while low-cost carriers played it safe, in part because they could afford to.

"There's a real competitive risk to locking yourself in to certain price levels when prices are expected to decline," said David Swierenga, economist at Aeroecon, an aviation consultancy. "And there's another, maybe even more important factor, and that is that hedging is expensive. In this case, carriers simply went with the advice of many oil experts who guessed wrong."

And according to Swierenga, who had expected oil to dip to $28 a barrel in 2004, the wrong guess may have added $1 billion in extra expenses to the airlines in the first quarter.

"Oil is above $35 a barrel, and that is $7 a barrel difference from my expectations. And $7 a barrel translates into 21 cents per gallon in jet fuel," he said. "That sounds like a small number, but the airlines consume about 18 billion gallons of jet fuel a year, and each penny adds $180 million to expenses. So if we're looking at 21 cents, that's $3.8 billion in added costs."

Because of the differences in hedging, oil affects each airline in different ways, but it has a powerful effect on earnings at network carriers and a negligible effect on the low-cost competition. Roughly speaking, using Morgan Stanley estimates, when oil moves by $1 a barrel, American's EPS moves by 50 cents. In contrast, when oil moves by $1 a barrel, Southwest's EPS moves by less than a penny.

Fewer Cheap Seats?

Ultimately, the rising cost of oil only highlights the industry's inability to offset it with higher ticket prices. On Feb. 27, Continental hiked round-trip fares by $10, calling oil prices "the highest we've ever seen." The move was matched by Delta, American and Northwest, but only in select markets. On Mar. 1, the fare hike was rescinded because the rest of the industry didn't match it.

"The industry is marked by lemming-like behavior, especially at network carriers. The industry has become dominated, especially on the domestic side, by smaller low-cost carriers who are really the driving force these days in pricing," said Klaskin. "None of the network carriers have got the fortitude to stick with it. As soon as they perceive they are turning passengers away, they wave a white flag in defeat."

Indeed, low-cost carriers seem to set prices on domestic routes -- the only price hike to stick so far this year appears to be one proposed by ATA Airlines ( ATAH) on March 4. ATA hiked round-trip fares by $10 and was matched by Northwest.

There could be a silver lining, however. Despite the industry's continued failure to raise ticket prices -- there were at least 10 failed attempts in 2003 -- Morgan Stanley believes the high price of oil could force airlines to raise ticket prices or run the risk of extinction.

"To compensate for a sustained high oil price, we believe there will be a gradual increase in airfares," said Greene. "We are not suggesting airlines suddenly have pricing power, but over time, higher fuel prices will eventually work their way into airfares."

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