Airlines (AAL, DAL, LUV, UAL, ALK, VA, SAVE) - historically - have been a dangerous investment, but we might be hurricane free for the next few years if oil prices can stay low and we avoid recessions, and mostly if we avoid the combination of high oil prices and a recession.
In this article, I want to show some historic background into why airlines in general are trading on cheap multiples. It would be interesting to see how airlines have fared during recessions and during high and low oil prices. In the following chart, I plotted in the average yearly oil price, recession years and number of airline bankruptcies. The number of bankruptcies is a proxy that airlines have done badly whereas an absence of bankruptcies is an indication that airlines did well.
When you look at this chart, it becomes clear that the deadly cocktail of high oil prices and an economic downturn historically has been too much for many airlines (1980-82, 2007-08), whereas years with 'only' a recession (1990-91, 2001-02) or 'only' high oil prices (1979, 2011-2014) have been more manageable, and as a result we see fewer bankruptcies. These results are hardly surprising as high fuel prices impact negatively on airlines' bottom lines while recessions decrease demand for air fares.
However, it still worth noticing that the harshest environment is a combination of high fuel costs and declining demand for airline services, whereas one without the other is way more manageable for airlines.
Since the summer of 2014, oil prices - as everyone knows - have been trending downwards, and it seems like we are in a period, regarding oil prices, that looks like 1986-2003. If this is true, it is very positive for the airline industry in general.
Many analysts think that oil prices will stay lower for longer because of OPEC's weakened power, the Saudis' apparent unwillingness to adjust their output and the dynamics of the US shale production with many small producers that will start production as soon as the marginal price hits the marginal cost.
Oil prices, however, are very volatile and very susceptible to changes in output due to geopolitical risks (such as wars and trade embargos). That being said, it seems most likely that it will be many years before we see 3-digit oil prices again.
Most economists don't see a US recession around the corner, although there are serious risks in the world economy, e.g. huge build-up of corporate debt in emerging economies, China is slowing down and the biggest risk of all might be that many central banks - already having brought interest rates way down - will be unable to respond adequately to a sharp downturn in demand. Albeit, an economic downturn would likely decrease demand for oil hence keeping prices low.
Therefore, it seems unlikely that we will see the killer combo of high oil prices and a recession at the same time in the next few years, which indicates that airlines - for now - are safer than history otherwise indicates.
Safe buying and flying
With the low 1-digit P/E ratios many airlines are trading for, it could seem like that the market is being way too worried about the risks. As this analysis shows, the most dangerous situation for airlines in general is the combination of an economic downturn and high oil prices. Each - on their own - seems unlikely for the foreseeable future, and a (killer) combination of them seems even more unlikely.
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Disclosure: I am/we are long AAL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.