The airline sector took off Monday following an analyst's upgrade on shares of American Airlines parent AMR ( AMR) and a dip in crude oil below $60 a barrel.

Citing capacity reductions that are likely to boost fares next year, Lehman Brothers analyst Gary Chase upped his rating on AMR to overweight from equal-weight. The analyst, whose firm does and seeks to do business with companies covered in its research reports, also said the fundamental outlook had improved for the entire sector.

In reaction, AMR shares jumped 59 cents, or 4.6%, to $13.47 on higher-than-normal volume of 5.2 million shares. Most other airline stocks followed in a broad rally that lifted the Amex Airline Index by 3.4%.

Alaska Air ( ALK) rose $1.24, or 4.1%, to $31.24, and Continental Airlines ( CAL) gained 84 cents, or 7%, to $12.93.

JetBlue Airways ( JBLU) increased 58 cents, or 3.2%, to $18.63, and Southwest Airlines ( LUV) advanced 12 cents, or 0.8%, to $15.87. US Airways ( LCC) added 80 cents, or 3.6%, to $24.70.

Also encouraging for investors was crude's decline below the psychologically important $60 level. The decline was attributed to milder Midwest temperatures and the belief the hurricane season is drawing to a close.

The airline industry remains in a crisis environment marked by bankruptcies and painful jet fuel costs. Hurricane Katrina knocked out key refining facilities around the Gulf Coast, increasing the incremental cost of refining crude oil into jet fuel.

Still, carriers are reporting improving revenue and fare trends as the industry cuts back on capacity on domestic routes. An overabundance of capacity in 2004 and earlier this year helped pressure fares.

As an example of improvements in revenue, United Airlines' parent UAL ( UALAQ) on Monday said third-quarter unit revenue , measured in revenue per available seat mile rose 11% in its mainline operations. That came as the company's average fares rose and capacity decreased.

UAL shares, which the carrier expects to render worthless on its planned emergence from bankruptcy protection early next year, rose a penny to 51 cents.

"Recent revenue trends have been very strong, and we expect those trends will gain momentum as capacity reductions accelerate into the end of the year," Lehman's Chase wrote Monday in a research note explaining his upgrade. "We continue to believe that AMR is and will continue to be one of the best-positioned network carriers. (Yes, that includes carriers who have availed themselves of the magic of bankruptcy.) With planned capacity reductions, cost savings initiatives, and company-specific drivers of revenue strength, we see improved fortunes for AMR in 2006."

AMR, the world's largest carrier by traffic, recently said its fourth-quarter mainline capacity would be flat from a year ago. That's down from previous expectations for 3% year-over-year growth.

Next year, AMR also plans to keep overall capacity essentially unchanged. But it will achieve that by paring domestic capacity 3% and raising capacity on more lucrative international routes by about 7%.

"When these capacity reductions are combined with expected economic growth, the domestic revenue picture for 2006 looks even better than what we are observing in 2005," writes Chase. "On this basis, we expect domestic revenue per available seat mile for 2006 to increase 8% to 10%."

Even as revenue trends improve, airlines face uncertainty about future fuel costs. When it reported third-quarter results earlier this month, AMR said it will incur a significant loss during the current quarter if fuel remains at current levels. The company also forecast an average jet fuel price of $2.17 a gallon for all of 2006. That's significantly more than the $1.88 a gallon it paid in the third quarter, when it lost $153 million.

With improving revenue trends, Chase believes AMR can turn a profit of 30 cents a share for all of next year, but adds that "small fuel changes" could easily wipe it out.

Other analysts are more bearish. The average estimate from Thomson First Call is for AMR to lose $1.92 a share next year.

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