U.S. Airline Industry Overreacts To Higher Fuel Costs

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Includes: AAL, DAL, LUV, UAL
by: David Barbalas
Summary

News of increased fuel costs resulted in a 3-4% drop in major US airline stocks.

While fuel costs are a major fraction of operating costs for airlines, growing demand and increased passenger yields will minimize impact on profit.

United and Delta have good positioning due to international demand and options for increasing passenger yield.

As crude oil prices have past $80/barrel for the first time in 4 years, US Airline stocks suffered a commensurate drop. United (UAL), Southwest (LUV) and American Airlines (AAL) are down 3% at time of writing, and Delta Air Lines (DAL) is down nearly 4%. Just last week however, US Airline companies dodged legislation slated to mandate “reasonable” baggage and other fees.

In response to the drop in airline stock prices, I believe that major airlines will be able to recoup higher operating costs through additional fees and increased ticket prices. The ability for airlines to maintain baggage fees will allow for the impact of higher fuel costs to be lessened, and I expect that increased costs for customers will not dramatically shift airline demand, and hence airline revenues should suffer only a minimal decrease.

Fig. 1: Revenue from various airline fees per quarter (All figures from Oliver Wyman Airline Economic Analysis 2017-2018, Source).

Fig. 2: Cost per average seat mile (ASM) against average stage length for network carriers (Delta, American, United) and value carriers (Southwest, JetBlue, Spirit, etc) (Source).

Of major domestic carriers, Southwest maintains the lowest cost per ASM due to its business model. Of the rest, Delta is the most susceptible to the increased oil prices, as its strategy for operating older aircraft, including nearly 150 McDonnel Douglas DC-9 and MD-80/90s, was dependent on low oil prices. The average fuel cost per seat for operating a 737-800 compared to a MD-90 is approximately 10% lower. This is reflected in Delta’s highest cost per available seat mile, 15% higher per passenger mile compared to American and United. However, Delta owns a jet fuel refinery that insulates its operations from higher prices; any competitive advantage derived from it will depend on how much fuel costs have increased.

Fig. 3: Breakdown of cost per average seat mile (CASM) for different carriers. (Source)

While Southwest has the advantage over the other three major carriers, it suffers from its short-haul flights, as fuel costs for narrow-body planes can approach 50% of operating costs. For Southwest’s airline fleet entirely composed of 737s, this should act as an equalizing factor with respect to exposure to increased fuel costs.

To offset impacts of higher fuel costs, airlines must rely on robust levels of demand to meet expectations. Capacity growth has been the leading driver of increased revenues for airlines with passenger yield a close second. It will critical for airlines to look for yield improvements, especially in the face of increased costs. As it stands, airlines have become quite profitable, and efficiency in maintaining capacity while minimizing operating costs will allow the impact of higher costs to be minimized. Airlines with the greatest exposure to international markets will be best positioned to reap the benefit of increased demand. As United and Delta have partners in the two largest airline network, their exposure to growth internationally should help offset increased operating costs.

Fig. 4: World capacity change from 2016-2017, commensurate to demand. Note that Asia/Oceania and North America compose nearly 60% of global capacity (Source).

Fig. 4: Revenue per average seat mile (RASM) and cost per average seat mile for different US airlines (Source).

In conclusion, I believe that the price drops across major US airline stocks represent a timely entrance point for investors. Domestic and international demand for air travel will continue to increase, and margins are at an all-time high for airlines. In the face of lowered profit outlook, airlines will be able to rely on optimizing passenger yields and maintaining capacity to ensure continued profitability.

While Southwest seems to be the best positioned of the largest US carriers due to its low-cost model, I believe that Delta and United are still top choices based on their ability to generate profits from delivering additional services to their customers and strong domestic and international demand for their long-haul flights. While the domestic market will likely suffer greater impact due to higher fuel costs, long-haul international flights will benefit from growing demand in Asia, which United and Delta are perfectly positioned for. Increased fuel costs will likely hurt the revenue growth the airline sector has seen over the last few years, but airlines should be able to mitigate major impacts to profitability by passing on costs to customers and through greater efficiency.

Disclosure: I am/we are long UAL. 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.