The past few days have brought a lot of angst amongst airline investors, as the Fed's decision to initiate QE3 last Thursday drove airline shares down even while boosting the broader market. Shares of the largest airlines [Delta (DAL), United (UAL), Southwest (LUV), and US Airways (LCC)] all underperformed the market on Thursday and Friday. The primary worry is that quantitative easing will increase oil prices, along with other commodity prices. If the dollar weakens substantially, the dollar-denominated price of oil would naturally rise. Seeking Alpha author Sammy Pollack recently recommended shorting airline stocks based on this logic.
Last week, I disputed the notion that QE3 will automatically drive oil prices higher through the rest of 2012. As I noted in my earlier post, oil prices declined rapidly during the first round of quantitative easing, due to a very weak demand environment. The return to high oil prices over the past two years has been driven more by increases in demand and concerns about potential geopolitically-caused supply shortages. In contrast, natural gas prices have continued to drop in spite of the Fed's "easy money" policy because of abundant supply. In short, supply and demand fundamentals ultimately outweigh the direct effects of monetary policy.
The primary reason why I think airline shares are attractively valued at current levels is that the fundamentals of the oil market look very bearish to me. Traders may bid up oil prices in the short term and increase volatility, but ultimately, someone has to take physical delivery of the oil. Oil supply is likely to outstrip demand by a substantial margin this fall; when the market recognizes this, it will quickly drive prices down. Last week, the EIA reported that oil and petroleum product stocks increased by 2.4 million barrels in the week ending 9/7. This occurred despite the fact that domestic production was depressed by more than 500,000 bpd of shut-in production relating to Hurricane Isaac. Additionally, that week included the traditionally travel-heavy Labor Day weekend.
By contrast, oil demand is likely to be much lower now that we are entering the fall and people are getting back to school and work. Furthermore, the Wall Street Journal reported on Wednesday that only 4% of Gulf oil production was still shut-in. In the coming weeks, increasing supply and falling demand will likely drive weekly inventory gains of 10 million barrels of more. Barring a major supply disruption in the Middle East (plausible, but still unlikely), the imbalance between supply and demand will send oil prices down by at least $15/barrel (and as much as $30/barrel) by November.
If oil is indeed posed to drop this fall, as I argue, then the recent weakness in airline shares represents a buying opportunity. One of the best plays in the sector is Hawaiian Holdings (HA). Hawaiian has been increasing its international exposure and is adding new routes this fall to Sapporo, Japan and Brisbane, Australia. If QE3 weakens the US dollar, Hawaii vacations will be cheaper for travelers originating in Japan and Australia (the yen and Australian dollar have been strong currencies in recent years). This will boost demand for Hawaiian's international routes. With a dirt cheap P/E near 4, Hawaiian is an excellent buy candidate right now.
I have also written positively about Delta Airlines recently. Thus far, Delta's decision to purchase a refinery to hedge against refining premiums seems very prescient. A combination of lower crude oil prices and lower refining costs would vastly improve Delta's profitability in the seasonally weaker Q4 and Q1 periods. I think Delta has upside as far as $15 over the next six months, as investors become more comfortable with the refinery operation.
I expect other airline stocks to do well this fall, but Hawaiian and Delta provide the most upside with relatively contained risk. US Airways, which does not hedge fuel costs, has the most to gain if prices fall, but would suffer the most if (for whatever reason) oil prices remain elevated. United and Southwest are both in the process of ongoing merger integrations. This creates some long-term upside as synergies materialize, but could impact results in the near term (as we have seen at United this year). I am therefore most bullish about Hawaiian and Delta.