The Impact Of Rising Oil On U.S. Airlines

Airlines may perform well despite oil prices edging higher, and the legacy and low-cost players such as Alaska Air Group, Inc. ALK, Delta Air Lines, Inc. DAL and Southwest Airlines Co LUV are likely to fare best, according to a report from Morgan Stanley.

Crude oil prices have been rising for the past few days, and are currently hovering around the $40 mark amid uncertainty on the outlook for global oil production. Data from American Petroleum Institute showed U.S. oil inventories rose 8.8 million barrels last week. Currently, crude oil for May delivery was down 1.21 percent at $40.95.

Macro Environment

"The macro backdrop matters most, thus rising oil could bode well. At the end of the day, the demand environment will determine the sustainability of profits and we believe that a rising fuel environment may coincide with comparable support for macro economic trends," analyst Rajeev Lalwani wrote in a note to clients.

Related Link: Airline ETF Endures Oil's Rise, Hedging Issues

The analyst said, "Supply additions may moderate [...] as weaker routes become less profitable and carriers adjust accordingly." Lalwani elaborated, "As fuel precipitously fell, 2015/2016 industry capacity growth nearly doubled from 2014 levels of about 2 percent. As fuel moves in the opposite direction, we expect capacity additions to decelerate."

Lalwani noted, "To the extent fuel rises, we believe carriers could pass-through incremental costs at similar proportions."

Oil And Airlines

Currently, Morgan Stanley sees oil prices a bit below market at about $40 per barrel, though consensus EPS still appears achievable even with the recent move up.

"Approached another way, assuming a more normalized level of oil at $60–65/bbl, derived from where E&P equities are trading, the group would be at what we consider an attractive ~10xP/E on 2017E or a peak multiple on a more mid-cycle profile, implying 20%+ upside," Lalwani said.

According to the note, legacy carriers are most attractive in the higher oil environment due to their relatively lower exposure to fuel as an operating expense. In addition, revenue potential is most pronounced "as their capacity levels are unlikely to change dramatically, while pricing upside emerges."

The analyst noted that disparity exists, as Delta Airlines fares better than American Airlines Group Inc AAL/United Continental Holdings Inc UAL, in part driven by the latter's lower margins and the former's more variablized cost structure.

On the low-cost/leisure front, EPS sensitivity looks somewhat similar, though Southwest Airlines stands out because it is well-hedged (about 65 percent in 2017) and Alaska Air's strong margins create support. However, Hawaiian Holdings, Inc. HA "may be challenged given its lower margins," the note highlighted.

EPS Impact

• American Airlines and United Continental: 2017 EPS to deteriorate by about 40 percent
• Delta: $60–65/bbl oil should pressure EPS by about 15 percent
• Alaska Air: Earnings decline of about 25 percent with$60-65/bbl oil
• Hawaiian Holdings: To experience about 40 percent EPS decline in a $60–65/bbl environment
• JetBlue Airways Corporation JBLU: Should see about 40 percent of earnings drop in 2017
• Southwest: Earnings could hit only about 20 percent
• Virgin America Inc VA: EPS may hit by about 40 percent
• Allegiant Travel Company ALGT: 35 percent EPS deterioration
• Spirit Airlines Incorporated SAVE: 2017 EPS to decline by nearly about 50 percent in the higher-fuel environment

• American Airlines and United Continental: 2017 EPS to deteriorate by about 40 percent
• Delta: $60–65/bbl oil should pressure EPS by about 15 percent
• Alaska Air: Earnings decline of about 25 percent with$60-65/bbl oil
• Hawaiian Holdings: To experience about 40 percent EPS decline in a $60–65/bbl environment
• JetBlue Airways Corporation JBLU: Should see about 40 percent of earnings drop in 2017
• Southwest: Earnings could hit only about 20 percent
• Virgin America Inc VA: EPS may hit by about 40 percent
• Allegiant Travel Company ALGT: 35 percent EPS deterioration
• Spirit Airlines Incorporated SAVE: 2017 EPS to decline by nearly about 50 percent in the higher-fuel environment