3 Airline Stocks to Consider, Despite Rising Oil Fears

Includes: CPA, FAA, JBLU, LTM
by: Ian Bezek

"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it." -- Warren Buffett

If you believe the market correction we've had this week does not mark the beginning of the end of this bull market, then you ought to be buying airline stocks hand-over-fist. And yes, I am aware of oil's mercurial rise on the back of sweeping unrest across North Africa. Airlines are obviously extremely vulnerable to $100 per barrel or higher crude. Despite airlines' complex hedging strategies to protect against price spikes, they are still hurting from this sudden price surge. The recent trend of rising profits across the industry will likely be reversed in upcoming quarters.

So what's there to like about airline stocks? The market is simply overreacting to the geopolitical news we've had so far. Egypt is not a first-tier oil producer, and even though Libya is a significant player, it is not among the world's top-10 producers. And not all of Libya's production has been shut down at this point. The market is pricing in much more unrest than there currently is. This baked-in uncertainty includes a fairly-high probability that the political contagion will spread to Saudi Arabia when in fact there is little evidence of this worst-case outcome is about to happen.

There's no shortage of oil around the world presently. There's actually a glut of supply in the Americas, with the discrepancy between the price of the UK's Brent crude and the United States' NYMEX crude (more than $10 a barrel presently) reaching the widest level in many years. While Libya's partial shutdown of production will reduce inventories, particularly in Europe, it will have little to no impact in the near-term in the Western hemisphere. Commentators are comparing the potential loss of Libya's production capacity to a hurricane surging through the Gulf of Mexico. This comparison is useless, as Gulf of Mexico oil production immediately goes into domestic refineries and is relied upon to ensure domestic gasoline supplies. A powerful Gulf hurricane can cause American gas stations to run dry as happened with 2008's Hurricane Ike; this is not at all the case with Libya, where their oil takes awhile to cross the Atlantic, if it does so at all blunting any impact of production cuts.

The fundamental bullish case for crude remains flimsy. The World in 2011, the Economist's annual prediction issue of their magazine, forecast that Brent crude would fall to $76 per barrel this year (it's $110 now), and that OPEC would maintain "a disciplined production ceiling" to support prices. The risk to oil prices was supposed to be to the downside, due to excess supply, in 2011. And the world's economic situation, if anything, has softened a bit since that issue of the Economist went to print. In addition, other geopolitical risks have not played out. For example, the split-up of Sudan was surprisingly peaceful and its oil production is now set to dramatically rise. If the geopolitical risks go away, oil is clearly going lower.

There are two roads we can go down. Either the geopolitical pressures keep growing and Iran, Kuwait, Saudi Arabia or another major oil producer is engulfed. Nomura Securities' call for $220/barrel oil plays out and the economy collapses under the weight of $6 a gallon gas. In this case it won't matter what stocks you own if you're a bull as the only stocks holding up will be energy names. In a crack-up oil boom, the S&P 500 will enter a sickeningly vicious bear market.

The other road is that things cool off overseas, the NYMEX oil market gets held down by significant price resistance just above the $100/barrel level, and the economic recovery and bull market carry on. In this case, the transportation sector will be a focal point the rebound and airlines will lead the charge. As the airline sector is a high beta sector with strongly inverse correlation to oil prices, it stands to make huge gains if the geopolitical fires diminish.

With the NYSE Airline Index (^XAL) trading down 18% off its recent peak (just shy of the 20% threshold to establish a bear market) and also sitting on strong support from last year, the airlines must bounce here and now or they will enter a bear market than threatens to take down the rest of the transportation sector. Market bears have long noted that when the Dow Jones Transportation Average (^DJT) goes into a bearish trend, the rest of the market often tumbles like a pile of bricks shortly thereafter. The current broad bull market has entered a correction and the airline sector will provide the litmus test to see whether this is a "buy-the-dip" opportunity or the prelude to a top in equities. If you are still a bull on U.S. equities, you should be holding your nose, overcoming your fear, and buying airlines hand-over-fist.

Since there is no good airline ETF (the Guggenheim Airline ETF (NYSEARCA:FAA) has little trading volume), here are some quick picks:

LAN Airlines S.A. (LFL) and TAM S.A. (NYSE:TAM):
These two are Chile's and Brazil's largest airlines. They are supposed to be merging later this year, but a Chilean court decision held up the deal in January. Assuming the merger succeeds, as I think it will, the combined Latam will be a top-10 world carrier in a fast-growing market that will have high margins for its industry after duplicated functions are cut in the combined company.

Copa Holdings (NYSE:CPA): This Panama-based airline has remarkably high margins for it industry due to the low levels of competition it faces on many routes. Its operating margin is 18% versus single-digit readings at most U.S. airlines. Here is Seeking Alpha contributor Rash Menaria's detailed article laying out the bull case for Copa. It's worth noting that Copa maintains a smaller oil-hedging book than many other competitors, making it an even more leveraged to the price of crude than the industry as a whole.

Jetblue (NASDAQ:JBLU): Jetblue remains one of the best-run American airlines. It deftly managed its operations during the bitter dual punch of economic crunch and oil spike in 2008 that wiped out many industry players. Jetblue is now expanding and appears to be building a stronger brand that is successfully stealing market share while remaining consistently profitable. Jetblue shares have fallen much more quickly than the airline sector as a whole in the past months and now represent a good relative value.

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