Time to Fuel Up on Airline Stocks With LEAPS

Includes: AAL, DAL, JBLU, LUV, UAL
by: Simon Monger

Airline stocks could be poised for a rebound amid jet fuel price declines and traffic and capacity increases. While prices are still 39.4% higher than a year ago, prices are down 8.5% on the month and 10.9% on the week, according to IATA’s Jet Fuel Price Monitor. Meanwhile, many airlines are seeing increased traffic as they move to expand capacity amid a broad economic recovery.

Fuel Prices Fall, Fare Prices Rise

Many airlines have benefited from the combination of falling fuel prices and rising fare prices that have helped to boost profit margins. In a recent Wall Street Journal article, High Frequency Economics economist Ian Shepherdson found that airfares have been rising more quickly than crude oil prices, while capacity is down and competition has been limited by the United-Continental merger.

While fares have showed no signs of slowing, jet fuel prices are trading down 10.9% this week alone, according to IATA. These trends could help boost the sector’s profitability over the long-term, assuming customers continue to pay the higher fares. And, this is why many analysts are now recommending buying some exposure to the recently shunned sector.

J.P. Morgan Recommends the Sector

J.P. Morgan analysts also upgraded the sector before the opening bell today to reflect the recent decline in jet fuel prices. According to its estimates, the 30 cent a gallon drop since April 29th could represent an overall annualized benefit of $3.5 billion (net of slightly softer revenues). But yet, analyst estimates on the sector have not been modified at all, suggesting that it may outperform.

Estimates for the remainder of 2011 are also moving lower. $100 oil and a $23 crack spread are now assumed over the prior $110 oil and $24 crack spread assumptions. Crack spread is a term used in the oil industry to represent the difference between the price of crude oil and petroleum products extracted from it, such as jet fuel, or the profit margin that a refinery makes from “cracking” crude oil.

Recovery Economics Could be at Play

In addition to the many cost savings factors at play, the industry also appears to be benefiting from a recovery in demand. For instance, AMR Corporation (AMR) – the third largest airline in the world – recently reported that its April traffic increased 12.2% year-over-year as it expanded its capacity by 12.4%, with a load factor of around 72.4%.

Meanwhile, the world’s largest carrier, Delta Airlines (NYSE:DAL), reported that its April traffic increased 2.6% on a 5.3% increase in capacity, with a load factor of 80.8%. In the end, the increase in traffic may represent higher demand from customers, while the increase in capacity could represent a prudent bet on a further recovery by the airlines.

Prudently Buy Into Airlines with LEAPS

Investors looking for broad exposure without risking a lot of capital may want to consider LEAPS – or long-term equity anticipation securities. These long-term stocks options involve less volatility than shorter-term stock options, but less up-front capital investment than straight equity. As a result, they can be used a stock substitute by investors.

Currently, AMR Corporation (AMR) 7.50 Jan ’13 calls are trading at $1.60 per contract, meaning that investors can purchase the right to buy 100 shares of AMR at $7.50 per share anytime between now and January 18, 2013 for a total investment of $160. Meanwhile, here are a few other option plays in the sector that may be of interest:

  • JetBlue Airways Corporation (NASDAQ:JBLU) – 7.50 Jan ’13 @ $0.70/Contract
  • Delta Air Lines Inc. (DAL) – 12.50 Jan ’13 @ $2.25/Contract
  • Southwest Airlines Co (NYSE:LUV) – 12.50 Jan ’13 @ $2.05/Contract
  • United Continental Holdings Inc. (NYSE:UAL) – 25 Jan ’13 @ $7.50/Contract

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.