What Was Behind Friday's Big Airline Rally?

Normally I don't let short-term movements have much of an influence over my investment. But when a sharp movement is caused by actual news, the underlying news deserves a look. With the entire airline industry rallying on Friday, it's important to know why investors are so much more bullish on airlines.

The rally
Shares of major airlines had strong showings at the end of last week, with Delta Air Lines (NYSE: DAL  ) and United Continental (NYSE: UAL  ) both up well over 5%, American Airlines Group (NASDAQ: AAL  ) up more than 4.5%, and Southwest Airlines (NYSE: LUV  ) up more than 2.5%. This rally looks to have multiple reasons behind it that are relevant for long-term airline investors.

Oil prices
With jet fuel being one of the largest expenses at major airlines, movements in the price of oil can swing airline stocks. Sometimes oil price movements are just the result of ordinary market movements and not really indicative of long-term oil prices. However, Friday's drop in oil prices had actual reasons behind it.

Part of the drop was attributed to rises in U.S. distillate and gasoline supplies. U.S. supplies had slipped through most of December, as refineries reduced supplies for more favorable tax treatment. However, oil markets recognized the tax angle on current supply levels and, based on the latest report, became more bearish on oil.

Supply concerns also weighed on oil prices as speculation surrounding Libyan oil production contributed to oil's losses. If Libya can bring more production on line, it could contribute to a longer-term period of less expensive oil, a major positive for the fuel-intensive airline industry.

Delta's numbers
Delta Air Lines helped give the entire industry a boost after reporting numbers that paint a positive picture of the holiday air travel season. The airline reported that passenger unit revenue increased 10% year over year, citing "strong demand and benefits from the timing of the Thanksgiving holiday." The position of Thanksgiving this year is not really something that would interest long-term investors, beyond its being an explanation for November's less impressive numbers.

But investors should take note of the "strong demand" note. Airlines have a large cyclical component, and passenger demand can make or break airline earnings. Delta's report continues to validate the bull thesis by showing an improving demand picture in the airline industry alongside the economic recovery seen in other industries.

Airline gains
With Friday's rally, airline shares are trading near their post-recession highs, reflecting the improving performance of the industry as a whole. Since there is no longer an airline ETF, investors looking for broad exposure to the industry have little choice but to create their own diversified basket of airline stocks.

While airlines still carry above-average risks going forward because of exposure to oil prices and high costs in both labor and equipment, I see those risks as being exaggerated by the market at this time. If airline earnings can continue to improve, not only should shares become more valuable on a fundamental basis, but increased investor confidence could also drive new buyers to the industry, increasing airline multiples.

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