By Michael Johnston of ETF Database

When Iceland's Eyjafjallajokull volcano erupted last week, few investors imagined that the ash spewing forth would cause fruit to wilt in Kenya, mozzarella to rot in Italy and flowerless weddings in New York City.

The ripples throughout the world from the most recent act of nature served as a reminder of the extent to which global economies are now intertwined.

But while companies in all corners of the global economy were affected by this most unexpected event, the biggest disruptions were felt closer to the volcano. It is estimated that the global airline industry lost more than $1 billion over the past week, the result of more than 60,000 flight cancellations as regulators refused to grant permission to fly anywhere near the potentially hazardous ash cloud. The prolonged service disruption presents yet another hurdle for an industry that has been at the brink of disaster multiple times in recent years.

The Claymore/NYSE Arca Airline ETF ( FAA) has been one of the best performing equity ETFs since markets bottomed last year, gaining more than 250% since March 2009 (see FAA's historical performance).

But the stubborn ash cloud from the Icelandic volcano spurred a sharp pullback. FAA, which tracks the NYSE Arca Global Airline Index, lost almost 5% between the first announcement of travel restrictions on Thursday and the end of trading on Tuesday. (Despite the turmoil caused by allegations of fraud at Goldman Sachs ( GS), the broad markets were generally flat over the same period). It's worth noting that FAA's largest holding, Southwest Airlines ( LUV), flies mostly domestic routes, and as such hasn't seen its operations affected significantly by the ash. LUV, which makes up about 15% of FAA's assets, was actually up about 1.5% during the recent slide in the ETF, meaning that the fund's other components experienced large declines.

The financial impact of the recent flight blackout on the airline industry was both material and adverse, a development that will likely be reflected in second-quarter earnings. But the idea that a a few days of canceled flights erased 5% of the airline industry's value is irrational. The beating taken by FAA over the last five days seems to be a bit overdone, especially when given the momentum airlines were carrying before the recent stumble.

52-Week Chart of Claymore/NYSE Arca Airline ETF

Reasons for Optimism

UAL Corp.'s ( UAUA) United Airlines has been active in pursuing a merger partner in recent weeks, flirting aggressively with US Airways ( LCC) before pulling back to consider a tie-up with Continental ( CAL). While a single merger wouldn't solve all of the industry's woes, it could signal a wave of consolidation that most analysts agree would be a positive development in an overcrowded space plagued by excess capacity.

Beyond merger rumors, some airlines are showing concrete signs of improved finances. Delta Air Lines ( DAL) recently announced a first-quarter loss of $256 million, a significant improvement over the prior quarter. Perhaps more importantly, however, Delta said it expects to turn a profit in the second quarter. "It appears that the economy has pretty good legs under it now," Delta CEO Richard Anderson said during a conference call. The outlook for smaller airlines is positive as well. Alaska Air ( ALK) is expected to report a first-quarter profit after both traffic and occupancy rose materially last month.

Long-Term Risks, Short-Term Opportunity

Volatility in fuel prices poses a threat to major airlines, a risk cited by Delta executives when explaining hesitance to project a full-year profit. Given the significant and omnipresent risks to the airline industries -- the volatility of fuel prices, persistent labor disputes, and dependence on business spending to name a few -- it's hard to recommend FAA as a long-term play or significant component of a retirement portfolio. But for bargain hunters looking for a good value and some short-term inefficiencies, the airline ETF presents an interesting option.

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At the time of publication, Johnston had no positions in equities mentioned.
Michael Johnston is the senior analyst and founder of ETF Database, a Web-based investment resource providing actionable ETF investment ideas and an ETF Screener for investors analyzing potential ETF investments. Johnston oversees ETF Database's free ETF Newsletter, one of the most popular sources for news and commentary focusing exclusively on the exchange-traded fund industry. Johnston also maintains and develops content for ETFdb Pro, a line of analyst reports and model portfolios designed to help investors utilize ETFs to meet their investment goals.

Johnston has completed the Chartered Financial Analyst (CFA) program, and obtained his bachelor's degree in finance from the University of Notre Dame. Prior to founding ETF Database, Michael worked in a private client service group performing valuations of companies operating in a wide range of industries.