When it comes to the U.S. airline industry, many investors borrow their wisdom from Warren Buffett. For years, the Berkshire Hathaway CEO has stuck to his conviction that investing in airlines is like “pouring money into a bottomless pit.” His reasoning, partly drawn from an inopportune trade for US Airways stock that he made in 1989, is that airlines tend to earn thin profit margins despite requiring heavy capital investment up front. Buffett’s stance on airlines certainly proved correct last decade as the recession, bankruptcies at four major carriers, and rising fuel prices led to billions of dollars in losses.
But after years of bumpy rides, airlines are finally flying high, with three powerful dynamics acting in their favor. First, the U.S. economic recovery is gaining steam, boosting consumer demand. Second, the consolidation of American Airlines and US Airways, which closed last December and was announced in February, capped off a series of major mergers that have helped airlines eliminate money-losing routes and fill more seats. Third, the icing on the cake: the price of Brent crude has plummeted to $77 per barrel from $115 per barrel in June. That means cheaper fuel, which drives down costs and increases profit, especially since 30 percent of U.S. airlines’ operating expenses go towards fuel purchases.
The industry is fortunate to have largely avoided a major potential snag: losses from fuel hedges. Carriers often enter into hedge contracts that allow them to obtain fuel at a fixed cost in order to guard against future price increases. But the strategy works both ways: contracts purchased before oil started falling in June have obligated airlines to buy fuel at above-market rates since. Because most U.S. airlines didn’t engage heavily in hedging this year, the five largest airlines are still capturing an average of 80 percent of the savings from lower fuel costs, according to Yates. The most fortunate has been American, which sold all its remaining fuel hedges after it merged with US Airways, an airline that had a policy to refrain from hedging. Delta and United do have hedging contracts that Credit Suisse expects will lead to losses of around $100 million each in the fourth quarter, but savings from the cheaper fuel they buy in the spot market will more than make up for the losses.
The savings on fuel is a main reason most of the majors should report strong earnings in the fourth quarter. American Airlines, for example, expects to pay around $2.60 per gallon for fuel during this quarter, down from $2.98 in the third quarter and $3.06 in the fourth quarter of last year. Delta, United and Southwest are expecting to pay around $2.75 per gallon in the fourth quarter. The 15 cents per gallon that American will save compared to its competitors translates to $200 million in operating income, according to Julie Yates, an equity research analyst covering U.S. airlines at Credit Suisse. “The benefits of cheaper fuel are starting to accrue for airlines in the fourth quarter, with unhedged American recognizing the most significant tailwind,” Yates says.
One key question is whether airlines will pass their lower operating costs onto consumers in the form of cheaper fares. So far, they’ve gone in the opposite direction: Expedia reported last month that Thanksgiving flights were 17 percent more expensive this year than in 2013. Yates doesn’t expect the upward move in prices to end because she says airlines tend to set their fares based on demand rather than fuel costs. In the past, when airlines have reduced fares amid falling oil prices, it’s been at times when the economy was also slowing and ticket sales were sluggish. This time, however, the economy is improving and traffic is up. As a result, Yates doesn’t even expect carriers to scale back bag fees and change fees that were implemented in the wake of the 2008 financial crisis. “As long as demand is strong, they’re not going to take pricing down,” she says.
With airlines holding onto the extra cash, they’ll be able to pay off more debt and give more back to shareholders in the form of dividends. In other words, the upside to investors is clear, especially since oil prices show no sign of rising anytime soon. The positive outlook for airlines may even be enough to rebuff Buffett’s famous pessimism. Credit Suisse already has. “This is now an investable industry,” Yates says. “And falling fuel is a nice tailwind.”