Conventional wisdom states that high oil prices are bad for airline stocks. Historically, profit margins have tended to be slim in the airline industry, and cutthroat competition made it hard to raise fares enough to offset big cost increases.
By contrast, airline analyst Rajeev Lalwani of Morgan Stanley recently told clients that rising oil prices could be good for airline stocks like American Airlines (NASDAQ:AAL), Delta Air Lines (NYSE:DAL), and United Continental (NYSE:UAL). He argues that higher oil prices will encourage airlines to be more disciplined about their capacity growth and spending and that multiple expansion will outweigh the impact of lower earnings.
This line of argument seemed plausible a year or two ago. However, airlines haven't changed their capacity plans very much in response to higher oil prices. Without a common commitment to capacity discipline among American, Delta, and United (at the very least), higher oil prices will put pressure on earnings -- and undercut most airline stocks.
We've seen this argument before
The idea that higher oil prices might be good for airline stocks isn't new. Two years ago, Wolfe Research analyst Hunter Keay asserted that rising oil prices would cause airlines to reduce capacity (to protect profits) -- leading to strong unit revenue growth. He argued that this would drive multiple expansion by giving investors more confidence in the sustainability of airlines' profits.
Lalwani's analysis is similar. Whereas he was worried about airlines adding too much capacity due to low oil prices in the spring of 2017, he sees the recent run-up in oil prices as a stabilizing force that will promote capacity and pricing discipline.
Additionally, Lalwani expects the margin pressure from rising fuel prices to encourage airlines to find other cost savings opportunities. Lastly, like Keay (the Wolfe Research analyst), he expects airlines' earnings multiples to rise substantially as investors start to look forward to an eventual margin recovery.
The facts say otherwise
Airline stocks performed strongly in the face of high oil prices during 2013 and 2014, lending some support to the argument that airline investors should prefer higher oil prices. But over the past two years, a ton of evidence to the contrary has emerged.
First, shares of American Airlines, Delta Air Lines, and United Continental have dramatically underperformed the broader market since the beginning of 2016. Among the top three airlines, United has posted the best stock performance, but its total return has been just half that of the S&P 500. Empirically, airline stocks haven't flourished during the last two-plus years of rising oil prices.
Second, airlines have not cut back on capacity growth in response to skyrocketing oil prices. If anything, industry capacity growth has accelerated somewhat this year relative to 2017.
United Continental is leading the way, as it attempts to build up its hubs and recover lost market share. It is planning 4% to 6% annual capacity growth for the next three years, far exceeding the rate of GDP growth. American and Delta are being a little more conservative, but they are still targeting GDP-like capacity growth as they try to fend off the threat from United.
Despite this rapid capacity growth, all three legacy carriers have been able to grow unit revenue this year. However, unit revenue is recovering from a low base -- and it's not rising fast enough to offset the increase in jet fuel prices.
Indeed, rising fuel prices helped drive pre-tax margin declines of 3.5 percentage points at American Airlines and 3.8 percentage points at United Continental in 2017. Both carriers' forecasts imply that they will suffer additional pre-tax margin erosion in 2018.
Be careful what you wish for
There's a decent chance that airlines' pre-tax margins could start expanding again once oil prices start to stabilize, sparking a rally in airline stocks. That said, rising oil prices aren't the only potential threat to airlines' bottom lines. A recession would also pinch profits for the sector.
If the recent oil price surge continues, it could actually bring the next recession closer, by driving up inflation and forcing the Federal Reserve to raise interest rates faster. (Rapid increases in interest rates have a tendency to tip the economy into recession.)
Business travel often dries up during recessions, which would have a severe negative impact on unit revenue at American, Delta, and United. Meanwhile, all three -- but especially American and United -- have experienced margin erosion over the past two years, leaving them less of a cushion to absorb a revenue shock.
Fortunately, with U.S. oil production rising rapidly, there's a decent chance that oil prices will cool off later this year. That would be a welcome relief to airline investors.