Editor's note: This was originally published on RealMoney earlier this month. With the Delta-Northwest merger back in the news, it is being republished as a bonus for TheStreet.com readers.

Airline executives are popping champagne corks this week. They knew that a powerful direct hit by Gustav would have decimated the industry. Simply put, the financial position of many of the carriers is extremely tenuous, and oil prices above $140 or even $150 surely would have triggered faster cash burn rates and closed the doors to badly needed balance-sheet fixes.

Gustav showed more bark than bite, and the airlines are heaving a collective sigh. The stocks of the major carriers all rose more than 15% on Monday.

But investors are missing a key point: $140 oil is lethal for these carriers, but $100 oil is no panacea. At that level, most carriers would still bleed red ink. The carriers would need to see oil at $80 and the economy on the mend if they are to keep their planes full and profit margins in the black.

Although the airline sector has pushed through a range of price increases, oil prices have risen even faster. As a result, the five major carriers are on track to lose more than $3 billion in 2008.

The carriers have been slow to respond to the changing market, and actually added an aggregate 1% in new available seats this year, compared to a year ago. That net increase and the slowing market has led to many planes that are less than full, typically with about 79% of seats filled.

In years past, an occupancy rate above 70% ensured a profitable flight. Nowadays, with fuel oil priced far higher than in the past, that figure is closer to 85%.

To fill more seats, airlines have just begun a post-Labor Day process of taking many flights out of commission. The hope is that fewer planes (and seats) will lead to greater pricing power. But the industry has never hit 85% occupancy before, so it is unclear whether the capacity cuts will be enough to meet that figure, especially in the face of slowing demand.

Carriers are expected to take 3% to 6% of their planes out of commission in coming weeks, and a similar round of cuts may take place in 2009 as well.

Of added concern, airline demand is quite elastic. The carriers' price increases appear to be triggering consumer fatigue. The summer ended on a down note for the carriers, as they served 1 million fewer passengers (-6%) over the last week, compared to a year ago, according to the Air Transport Association.

Bookings have started to slump for the coming months as well, and we may yet see another set of price wars if airlines fear that their planes will have too many empty seats.

A Minor Boost Abroad

The major carriers have been able to offset some of the domestic economic weakness by shifting planes to international routes, and a weak dollar enabled them to push fares higher. The average international fare rose 11% in the second quarter to $1,980, according to American Express. In contrast, the typical domestic fare averages $260.

But the rising prices for international fares are already beginning to crimp demand -- advance bookings for international flights have slowed in recent weeks. And the recent strengthening of the dollar could start to reduce the number of Europeans traveling to the U.S., a scenario that appears increasingly likely now that the continental economy has slowed sharply in recent months.

A Range of Options

The major carriers are facing these challenges without much excess cash to work with, so they are pursuing a variety of options to stay afloat.

For example, more airlines are likely to raise capital by selling shares, following U.S. Airways' ( LCC) sale of $155 million of stock in mid-August. AMR ( AMR) recently announced plans to sell $300 million in new stock to pay down some debt and buy new aircraft.

As will be discussed in a companion piece to this analysis, AMR's financial distress is especially acute, with $1 billion in debt and lease payments coming due this year. ($380 million had been paid off by the end of June, according to the company). Those figures do not include the expected repurchase of a $225 million convertible note that comes due on Sept. 23.

Other carriers are looking to merge to shed redundant routes and older, inefficient planes, and achieve better scale economies. Delta ( DAL) is expected to complete its merger with Northwest ( NWA) by the end of the year, which would vaunt the third- and sixth-largest carriers into the first spot, surpassing AMR's American Airlines. Update: " Delta, Northwest Holders to Vote on Merger"

In a bid to shave costs and fill more seats, many American carriers are also trying to forge close links with European counterparts. Foreign carriers are still forbidden from making outright acquisitions of domestic carriers (ostensibly for national security reasons), but as Lufthansa's 2007 acquisition of a 19% stake in JetBlue ( JBLU) shows, smaller deals can be arranged.

AMR has been lobbying Congress to grant antitrust immunity to a proposed code-sharing agreement among American Air, British Airways and Spain's Iberia. That request was denied 10 years ago, but the current industry distress makes it more likely that the alliance will be granted a waiver. Merrill Lynch believes that such an arrangement could yield $400 million to $800 million in synergies for AMR.

Capitalizing on the Weakness

Even as the carriers retrench, they need to watch their flanks. Better-capitalized competitors might look to simply fill in the route gaps that the major carriers expose. For example, Southwest Airlines ( LUV) is looking at beefing up capacity in markets where other carriers have sharply pulled back. Southwest can move aggressively thanks to its strong balance sheet and hedged fuel prices.

In a similar vein, Amtrak is increasingly seen as a viable alternative now that airfares are quickly rising. Total ridership is up 11% from a year ago, and many popular trains are selling out. Amtrak is now debating ordering new trains, especially for its high-speed Acela service.

I highlighted Amtrak's opportunities a few months back. If the government finally accedes to Amtrak's wish for greater funding, rail can take even more market share from the airlines.

Hope Springs Eternal

In the second part of this series, I will look more closely at the specific financial strengths or weaknesses of the carriers. But investors should note that many industry analysts are often quick to sound the "all clear" on this sector, despite the fact that the industry has consumed untold billions of investor cash and has little to show for it. For example, Lehman Brothers issued a very bullish report Friday, noting that its analysts now "expect the industry to be profitable on an accounting basis in 2010, if not sooner."

The realistic view: If the industry inches back to health in 2009 or 2010, carriers will resort to their old fare-cutting ways, showing the usual lack of restraint that you would expect to see in an oligopoly.

This was originally published on RealMoney on September 3, 2008. For more information about subscribing to RealMoney, please click here.

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  • David Sterman has been an equity analyst and financial journalist for 15 years, most recently serving as Director of Research at Jesup & Lamont Securities.

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