After surviving Covid-19 lockdowns, American Airlines Group (NASDAQ:AAL) and the airline sector in general were set up for a full recovery of passenger traffic this summer. The Russian invasion of Ukraine and the ensuing surging oil prices are set to disrupt this recovery for the time being. My investment thesis remains Bullish on the stock, as the market vastly overplays the downside risk of higher oil prices.
As sanctions ratchet up against Russia, crude oil prices are soaring to heights not seen in nearly a decade. With jet fuel being the second largest cost to airlines after employee costs, the markets are naturally worried about the financial position of American Airlines.
First and foremost, fuel is a cost passed onto fares passengers pay, but the costs take up to six months to be fully reflected in current fares. Second, American Airlines has the youngest and most fuel efficient fleet amongst the major airlines potentially providing a cushion on the oil shock.
Oil prices are up at $120/bbl and jet fuel has soared to $3.62 per gallon. Jet fuel prices are up over 50% since the start of 2022 and have soared from just $2.68 per gallon on February 25 right as the Russian invasion of Ukraine started.
The biggest question impacting airlines is where oil prices end up and how long prices remain at elevated levels. Jet fuel prices haven't been this high since prior to 2014 and averaged around $1.88 per gallon in 2019 pre-Covid when the airlines were highly profitable.
In 2019, American Airlines spent $9.4 billion on jet fuel costs, or ~22% of revenues of $45.8 billion. The airline only paid close to $2 per gallon, so clearly the costs in 2022 will vastly top those levels based on the current oil prices. The numbers just wasn't dramatically different outside of this recent oil spike due to Russia invading Ukraine.
American Airlines had guided Q1'22 average fuel prices to over $2.40 per gallon based on the consumption of 934 million gallons. The airline was already factoring in higher jet fuel prices due mainly to higher oil prices to start January when the airline reported Q4'21 numbers.
Clearly, the airline is set to spend billions more on fuel this year than back in 2019 when American Airlines was last very profitable. If jet fuel prices were to stay at $3/gallon, the airline could spend somewhere around $5.0 billion annually in additional fuel costs without any assumptions for improved fuel efficiency since 2019. Though, the question is the long-term impact to the airlines and whether oil would stay as high as $100 for a full year with the shift to EVs.
In the last decade, the airlines have better tied fuel costs to fare prices. For this reason, American Airlines doesn't necessarily benefit when fuel prices fall because fares dip as well.
Delta Air Lines (DAL) suggested fuel prices take up to 6 months to fully funnel into fares. Back on the Q3'21 earnings call, the airline forecast up to 4% fuel efficiency from 2019 levels with confirmation of fuel prices and revenue correlating again as follows:
While fuel is a near-term headwind for our results, we expect to recapture higher fuel in the medium to long run as we return to a more historical correlation between fuel prices and revenue.
And well, I think it might be difficult in the very short run despite the fact that the booking curve has moved in a bit, that I would estimate that 4 to 6 months is about right because we believe that demand and capacity will fall back into very good equilibrium by next spring, which would put you inside that window.
Cowen analyst Helane Baker suggested the fuel impact takes only 4 months to fully work into fares. The biggest question is whether higher fares are elastic enough, if oil tops $125 or more.
American Airlines had already forecasted the airline being profitable by March and demand is probably exceeding forecasts here. The last prediction was in January when the Omicron variant was full speed ahead and Covid fears were still rampant. Now, most mask and vaccine mandates are gone in addition to cruises fully starting up leading to more demand for travel. TSA traffic has stated early March off at nearly 90% of 2019 levels.
The company ended the year with liquidity of $15.8 billion. American Airlines does have net debt of $25.6 billion, so any scenario of extended jet fuel prices is far from ideal.
Analysts at Wolfe Research suggested American Airlines could burn up to $4.4 billion in cash for the year, but the amount doesn't address the losses beyond the January/February months where traditionally weaker traffic and Omicron held back the traffic recovery. The amounts aren't so dire considering the cash burn going forward isn't so great based on $100 oil after a short period of normalization.
The big question is whether oil comes back down to $100, or oil jumps to $150 or more. Considering European nations such as Germany don't appear willing to sanction Russian oil and China and India appear willing buyers, oil prices could actually plunge with an Iranian deal bringing a flood of new oil onto the market.
The key investor takeaway is that the long-term impact of higher oil prices on the airlines is vastly overstated. No doubt, American Airlines would be hit with higher losses in the short term, but oil prices aren't likely to stay at elevated prices due to global needs to consume Russian oil until alternatives are developed.
Investors should continue to use another irrational fear to build a long-term position in airlines such as American Airlines.
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Disclosure: I/we have a beneficial long position in the shares of AAL either through stock ownership, options, or other derivatives. 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.
Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock, you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.