Lower Fuel Prices: Why You Should Buy Delta, Short Union Pacific

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The transportation sector — everything from airlines to shipping to trucking to railways — move goods and people. So sure, revenue is determined by a multitude of factors (including a stronger economy), but historically, the bottom line has been a function of fuel prices.

Fuel accounts for approximately 34% of an airline’s operating costs. According to the Bureau of Transportation, U.S. airlines have consumed nearly 16.2 billion gallons of jet fuel in the 12 months ending September 2014. With jet fuel prices declining nearly 27% year-to-date, the saving for most of the airlines has been substantial.

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Jet fuel prices are likely to continue to face headwinds as robust supply offsets stable demand. Just last week, the Organization of the Petroleum Exporting Countries announced Thursday that they would keep their current production targets intact, which sent crude oil prices tumbling nearly $6 per barrel on Friday.

On the flip side, the decline in oil prices could negatively affect oil production in many regions of the U.S. The growth of shale-oil production could slow with crude in the $70-per-barrel range and will be eliminated in the $60 range, according to Burlington Northern Santa Fe Chairman Matt Rose. If fuel prices drop into the $50 range, output would decline. And Rose is certainly paying attention — rail freight has risen 4.5% in the first three quarters this year, but the recent rapid decline in prices could curtail oil production and consequently reduce rail traffic.

Additionally, the rails have benefited from traffic related to the increase in the volume of silica sand used in the hydro-fracking process. Producers in the Bakken shale region of North Dakota rely heavily on silica sand for fracking, which is moved to the region by rails. A decline in oil production could reduce the volume of silica sand needed for oil extraction, thereby reducing rail traffic.

Year-to-date the Dow Jones Transportation Index has notched up substantial gains, rising slightly more than 28%, while the Dow Jones Airline Index is up a whopping 74% year to date. Despite the disparity in these returns within the transportation sector, airlines should continue to outperform the rails if prices of energy continue to decline.

One of the best ways to take advantage of the outperformance of the airlines relative to the rails is a pair trade — you purchase an airline stock while simultaneously shorting a rail stock. This type of strategy focuses on the underlying relative performance of an airline relative to a rail and generally avoids producing returns based on the overall performance of the broader equity market.

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A pair trade that incorporates two very liquid transportation stocks is Delta Air Lines, Inc. (DAL) versus Union Pacific Corporation (UNP). The ratio between the two stocks is currently trading near 0.4 — for reference, the high point of the ratio since Delta exited bankruptcy in 2007 was 0.78 and the low has been 0.15.

Momentum on the spread between the two stocks has turned positive favoring Delta, as the moving average convergence divergence index (MACD) on the ratio generated a buy signal in late November. This occurs when the spread (the 12-week moving average minus the 26-week moving average) crosses above the nine-week moving average of the spread. Additionally, the Relative Strength Index (RSI), which is a momentum oscillator that measures overbought and oversold levels, moved higher with price action reflection accelerating positive momentum on the spread.

I would look to enter this pair trade by purchasing Delta and shorting Union Pacific.

For this trade to be successful, DAL will need to outperform UNP. If you decide to transact this pair trade, you could consider entering at a ratio near 0.4, stopping out of the trade if the ratio moved below 0.3 and taking profits when the ratio reaches 0.6.

As of this writing, David Becker did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2014/12/fuel-prices-dal-stock-unp/.

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