Higher oil prices continue to weigh heavily on airline stocks as new forecasts predict increased fuel costs will drive down profits by as much as 46% in 2011. On Wednesday,the International Air Transport Association revised its industry profit downward to $8.6 billion, a significant drop from the $9.1 billion it estimated less than three months ago – and just more than half the $16 billion the industry earned in 2010.
The airline industry is a capital-intensive and competitive business — that $16 billion profit in 201 came on $565 billion in total revenue, which is a razor-thin 2.7% net profit margin. This updated forecast for 2011 expects margins to be driven even deeper into the bleeding edge at 1.4%.
“We are constantly walking on a tight rope of very thin margins,” IATA Director General Giovanni Bisignani said on Wednesday. “And there is no buffer against shocks. So everything that hits us has the potential to knock us over. The oil price situation this time is somewhat buffered by strong economies. But even a 1.5% fall in revenues could change the situation completely. So we have an industry that stumbles from crisis to shock with the margins of a charity association.”
On Wednesday, airline stocks were showing some lift as oil prices showed some moderation. Shares of U.S. Air (NYSE:LCC) were up 4.3%. Still, the sector as a whole is trading at five-and-a-half-month lows.
To their credit, North American airlines have done a better job of trimming capacity – a practice which, when combined with a comparatively stronger U.S. economy, IATA believes will offset higher fuel costs. And a Federal Reserve survey released on Wednesday reported that the economy grew at a “modest to moderate pace” in all 12 of the Fed regions, with retail sales growth reported in every region except Atlanta and Richmond.
But even though U.S. carriers are better off than many of their counterparts around the world, here are three reasons airline shares still could be in for a bumpy ride this year:
Oil Price/Supply Worries. IATA’s new profit expectations for 2011 are based on average oil prices rising from December’s estimated $84/barrel to $96/barrel. But the political turmoil spreading like wildfire across the Middle East has already pushed the price of a barrel of oil over $100. New uncertainty over who’s actually in control of Libya’s massive oil reserves, coupled with escalating protests in Oman and Iran have revived fears that recent $200/barrel worst-case numbers tossed out by Nomura Capital and Deutsche Bank could be spot on if the region continues to melt down. Iran’s warning to the U.S. and its allies on Wednesday not to meddle militarily in Libya and the Middle East potentially injects further risk into an already volatile fuel supply situation.
Airlines Are Backing Off Fare Increases. Since fuel costs now eat up some 40% of airline operating costs, there are three ways carriers can make up for lost earnings: fuel hedging, cuts in capacity and fare and fee increases. Since airlines have been proactive in capacity cuts and hedging will continue to get more expensive by mid-year, fare increases have become a logical way for carriers to salvage their profits. But after five rounds of fare increases this year alone, low-cost carriers Southwest, JetBlue (Nasdaq:JBLU), AirTran (NYSE:AAI) and Republic (Nasdaq:RJET) unit Frontier Airlines flashed their competitive colors, beating back a new industry price hike. Delta, United and American tried to boost round-trip ticket prices by $20 last weekend, but their rivals held the line. When the dust settled, all of the airlines had cut their planned fare increases in half to $10. In this economy, any price war among carriers is bound to further clip airline earnings and cause shares to slide.
Economic Impact of Higher Oil. Just on its own, triple-digit oil prices can stall the fragile economic recovery, potentially taking a big bite out of U.S. airlines’ most profitable source of income: business travel. The IATA believes that strong corporate reporting at the end of 2010 and expanding world trade will continue to drive business travel in 2011, albeit at a slower pace than last year. But petroleum demand is already up over last year and the U.S. government reported Wednesday that oil and gasoline supplies both fell unexpectedly last week. If high oil prices trigger inflation, companies likely will cut back on travel and buy cheaper tickets when they do have to fly.
