5 Airline Buys And 1 Sell Based On Wednesday's Oil Spike

by: Adam Levine-Weinberg

Mr. Market was not kind to airline stocks Wednesday. All four network carriers, Delta (NYSE:DAL), United Continental (NYSE:UAL), American (AMR), and US Airways (LCC) closed down 5-6% on the day. Alaska Airlines (NYSE:ALK) and Southwest Airlines (NYSE:LUV) were each down a more modest 2%. (All data from Yahoo Finance.) In part, this decline can be attributed to continuing worries about the European debt crisis, which could negatively impact the network carriers. Alaska and Southwest do not fly to Europe and thus have less exposure to the situation there.

However, an equally important cause of the declines seems to have been a "spike" in oil prices. NYMEX crude oil for December delivery closed at $102.59, up more than 3%. The major cause of this move was Enbridge's announcement that it will reverse the Seaway pipeline so that it can carry oil from the overcrowded Cushing terminal in Oklahoma to the Gulf Coast. The market seems to have misunderstood this development, which has created a huge buying opportunity in airline stocks.

Over the past year, NYMEX crude oil prices (commonly quoted in the United States) have become disconnected from Brent crude oil prices (commonly quoted in Europe). The reason is that NYMEX quotes prices at the land-locked Cushing terminal, where there has been an ongoing glut of oil (thus depressing prices). However, market petroleum product prices in the U.S. are largely driven by Brent crude, which can be transported by sea. In the past few months, Brent crude has traded as much as $28/barrel higher than NYMEX crude oil, but the spread is now down to single digits. The result is that while NYMEX crude oil prices are rising, petroleum products like jet fuel are becoming cheaper. The New York heating oil contract, which typically trades within a few pennies of Gulf Coast jet fuel, closed the day down more than 1% at $3.1346/gallon.

As the so-called "crack spread" between NYMEX oil prices and jet fuel prices narrows, airlines will reap a substantial windfall. Wednesday's news alone narrowed the crack spread by about 11 cents/gallon. To put that in perspective, Delta and United would save about $400 million each on an annual basis if jet fuel costs dropped by 11 cents/gallon. The Seaway pipeline news is thus a big win for the airlines (and consumers, for that matter) but airline stocks headed south. As people realize the likely effect of the pipeline news, airline shares are likely to move higher.

The sell candidate here is fairly obvious. American Airlines parent AMR is simply a hapless company these days. Its work groups (particularly the pilots) seem determined to make the company "share the wealth", which is somewhat ironic, considering the company is essentially broke. Barring a complete about-face by the APA union, which represents American's pilots, AMR will almost certainly be forced to file bankruptcy in the next year or so. It's not necessarily a short sale candidate, though, simply because the price is already so low. The upside risk (if the company manages to avoid bankruptcy through a big pick-up in demand, lower oil prices, and/or better labor agreements) outweighs the additional downside for AMR.

All five other airline stocks are buy candidates. They are all trading at or near their 52-week lows with the exception of Alaska. Alaska and Southwest are the safest bets in the sector, due to their long demonstrated records of profitability. However, I think the network carriers (United, Delta, and US Airways) have much more near-term (i.e. six months or less) upside. They trade at very low earnings multiples and have done an admirable job of maintaining profitability in spite of high fuel costs and a weak economy.

As for the one major airline I left out of the above analysis, I think JetBlue (NASDAQ:JBLU) is fairly attractive at current prices (the stock actually trades below book value). However, the shares could continue to see near-term pressure as last month's snowstorm saga plays out. I doubt the DOT will come down hard on JetBlue because so much was out of the company's hands, but there could be significant customer backlash regardless.

My favorite pick in the airline sector is United Continental. As I mentioned last week, the company has the best balance sheet of the network carriers, an absurdly low P/E ratio, and is well-positioned to benefit from AMR's troubles. I also like US Airways, which now trades at its 52-week lows (I opened a small position in the afternoon at $4.51). I think US Airways is poised to benefit from its upcoming LaGuardia/Reagan National slot swap with Delta and Southwest's cutbacks in Philadelphia, where US Airways maintains a hub.

Bottom line: there are lots of good buy candidates here. Just stay away from AMR!

Disclosure: I am long UAL, LCC.