Why High Oil Prices Could Be Good for Airlines: Analyst

April 4, 2017

It might seem logical at first to assume that as oil prices rise, airline stocks will fall. If companies have to spend more on jet fuel, the thinking goes, their bottom lines will suffer. But one analyst convincingly makes the case that not only are airlines resilient to rising costs, they’ve historically performed better in such a climate.

Hunter Keay, Managing Director of Airlines, Aerospace & Defense at Wolfe Research, recently appeared on CNBC to discuss the possible effects of rising fuel costs on airline industry performance.

His assessment? High prices are “good for airlines” because they encourage capacity discipline, which in turn makes the group more attractive to investors.

Here’s Keay speaking to CNBC’s Bill Griffeth and Michelle Caruso-Cabrera:

Multiples drive about 70 percent of the movement in stock prices. And multiples are dictated by the perception of pricing power, and pricing power is dictated by capacity control. Excess capacity drives pricing down… It’s not about profits, it’s about how they make the profits, about pricing power. Capacity discipline and fundamental behaviors are far more important than the amount of money they earn. It’s got nothing to do with estimates; it’s got nothing to do with margins; it’s got nothing to do with how much money or cash flow you’re making, it’s how you make it. Is it sustainable? High oil prices create that dynamic.

Simply put, when fuel costs were high in the past, airlines were forced to practice judicious capacity restraint to maintain a healthy supply-demand balance. This meant not only adding more seats to existing jets but also cutting unprofitable routes. All combined, these efforts made it less likely that carriers were operating with an excess of empty seats, which helped improve their pricing power.

In the chart below, you can see how U.S. airlines’ stock prices began to ascend even as fuel costs were nearly twice what they are today.

Analysts like Keay believe that when fuel suddenly becomes cheap, carriers might tend to boost capacity a bit too overzealously, often leading to a supply-demand imbalance.

But with prices now on the rise, carriers are again feeling the pressure to rein in capacity growth.

Among the U.S. carriers currently in the process of trimming capacity in anticipation of higher prices are American Airlines, Delta Air Lines, United Airlines and jetBlue Airways, according to the Centre for Aviation (CAPA).

Year-to-date, as of October 10, oil has risen a little over 30 percent. And with Russia, one of the world’s largest oil producers, announcing its plans to cooperate with the Organization of Petroleum Exporting Countries (OPEC) in limiting output, prices are expected to climb even more.

In 2015, the global airline industry logged a record net profit of more than $35 billion, and this year, they’re expected to beat that by about $5 billion. Cash flows have been strong. We can all agree that this is impressive, but as Hunter Keay points out, airline stock performance has less to do with profits and more to do with how those profits are made.

For more on the relationship between fuel costs and airline stocks, watch our informative video, embedded below.

Past performance does not guarantee future results.

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Passenger revenue per available seat mile (PRASM), often referred to as a measure of passenger “unit revenue,” is calculated by dividing passenger revenue by available seat miles. Typically, the measure is presented in terms of cents per mile.

Cash flow is a measure of the amount of cash generated by a company’s normal business operations.

A multiple measures some aspect of a company’s financial well-being, determined by dividing one metric by another metric. The metric in the numerator is typically larger than the one in the denominator.

Pricing power is an economic term referring to the effect that a change in a firm’s product price has on the quantity demanded of that product.

U.S. Global Investors is not affiliated with Wolfe Research.