Option Investor

Airline Suffering Rises

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The airlines are feeling the pain of $100 oil along and they know it is not going to get better. USA Today had a great article last week on the problems airlines are facing with rising fuel prices. This was the teaser on the article:

Record prices for both crude oil and refined jet fuel are threatening to send U.S. carriers spiraling toward deep losses, drastic service cutbacks, job cuts and, perhaps by year's end, an industry wide cash crunch.

I will warn you now. If you don't want bad news then skip this section. You have seen blurbs in the paper and on TV about service cutbacks, retiring of older planes, canceling of orders or reductions in quantities of planes on order. Ticket costs are rising almost weekly and there is nothing the airlines can do to stop the bleeding. Two weeks ago United added $50 to the round-trip price of domestic tickets. Other airlines have followed suit although some to a lesser degree. On Friday Northwest joined several other carriers who had already made the move by announcing a $25 charge for a second checked bag. More bags equal more weight and higher fuel costs. Airlines are cutting jobs, cutting services, eliminating marginal routes and watching their cash like a spinster on social security.

The problem is simply the record prices for jet fuel. Three years ago the price of jet fuel was in the $1.50 per gallon range. In 2007 carriers paid an average of $2.10 per gallon. In the last three weeks the price rose to a high of $3.40 a gallon. To put this in perspective it is higher than the $3.13 high at the post Katrina peak of supply disruptions. $2.10 per gallon equates to about $72 per barrel of crude. Most carriers had budgeted for crude to be in the $85-$90 range for 2008 and we have already been to $111. Analysts everywhere are raising their estimates for crude to well over $100 for the full year and many are saying we could reach $125 or higher if the recession fails to appear or is brief.

Northwest Airlines CEO Doug Steenland said $105 oil was a budget breaker. An average oil price of only $100 would add $1.7 billion to Northwest's fuel bill in 2008. That is more than double its 2007 pretax profit of $764 million.

United currently spends $173,000 in fuel to fly from Chicago to Hong Kong. That equates to $500 per seat for each of the 347 seats in the 747. Other expenses like planes, employees, maintenance come on top of that.

American Airlines said its annual fuel bill rises $33 million for every penny rise in a gallon of jet fuel. In 2007 its average cost was $2.12 per gallon. Compare that to the $3.40 price in March. In January American said it expected to pay $1.5 billion more for fuel in 2008. Last week American said it now expects to pay an average of $2.98 per gallon, a rise of $2.6 billion in costs to $9.3 billion for fuel alone. To put this in perspective American only made a profit of $504 million in 2007. A $2.6 billion fuel increase is five times its 2007 profit.

At the transportation conference last week Delta, United, JetBlue and US Airways said they were grounding 70 planes to cut expenses. American, Northwest and Southwest strongly hinted they would also be cutting back on planes.

Frontier spokesman, Joe Hodas, said "None of us can sustain $110 oil in the long term." I am going to paraphrase the rest of his comments. You will see either consolidation or shrinking of capacity as prices go higher. Fares will have to go a lot higher and fuel surcharges now in place on most international tickets must be "adopted domestically as part of the pricing system." This is already happening with seven successful major fare increases already in 2008.

In February Merrill Lynch analyst Michael Linenberg analyzed what would happen to profits at various oil prices. At $75 all would be profitable. At $95 only five would post minor profits. At $110 only two airlines would make money, Southwest and Allegiant, and the entire group would lose $3.3 billion.

Airlines have been in cost cutting mode ever since 9/11. With reduced traffic in the 9/11 aftermath they were forced to cut to the bone to survive. Now that oil prices have doubled or tripled costs there is nowhere left to turn. Companies are contracting maintenance to lower cost firms, eliminated frills like meals and pillows and gained concessions from unions under the threat of bankruptcy. All extraneous assets were sold to raise cash. Actual jet fuel demand has fallen for the last three years as airlines cut routes and planes to cope with higher prices. This is not a factoid you see in the daily press.

The following table came from Merrill Lynch Airline Research and shows the impact of oil prices on profits for the various companies. Note that Southwest, which runs a very strong hedging program would change very little while the others are swimming in red ink.

For those of us that believe the peak oil story we know how this airline problem ends. Oil will undoubtedly move over $110 for prolonged periods in 2008. By 2009 they could be wishing for $110 oil as it moves into the $125-$150 range according to Goldman. When peak oil finally arrives in 2010-2011 that number will quickly rise to $200 per barrel and half the carriers on that list will be gone and the other half will be nationalized or government supported. The number of destinations will shrink significantly and the ticket prices will rise so high that most will not be able to afford air travel. If you want to be a world traveler you need to do it soon.

Oil Inventory Report

It was an interesting week in the inventory report. Oil inventories have been absolutely flat for two consecutive weeks. Supply has exactly equaled refining production. Refinery utilization has fallen drastically to the lowest level since Katrina knocks many out of commission. It is at the lowest level of utilization in 16 years. The crack spread was negative last week, which means refiners were losing money on every barrel they produced. With gasoline inventories at a 15-year high and demand slowing there is simply no reason for refiners to turn oil into gasoline just so they can lose money. The lack of refining over the last two weeks has produced the first weekly drops in gasoline inventories since Nov-2nd.

Inventory Table

This gasoline glut is causing another problem in the refining sector. With little refining in progress there is less demand for imported oil and that causes imports to shrink. Fewer incoming barrels pushes the oil inventories lower, currently -4.6% below last years levels. Lower inventory levels will eventually push crude prices higher and reduce the crack spreads even further. Eventually the trend will reverse but not until demand begins to improve. Over the last four weeks U.S. crude consumption has fallen -2.2% below the same period in 2007. Gasoline usage fell -0.3% and distillates (diesel and heating oil) fell -4.0%.

Distillates are the higher margin products for a refiner. 45% of a barrel of oil goes into zero profit gasoline today and 20% is refined into high margin distillates like diesel. Diesel is selling at a 65 cent per gallon premium to the cost of light sweet crude. There is a global shortage of diesel driven in part by European nations paying incentives to consumers that buy diesel cars rather than gasoline vehicles. The switch to low sulfur grades of diesel also took some of the refiners out of the diesel business rather than pay the extremely high cost to convert old processes to produce the new grade.

If you are a refiner and 45% of your output was being produced at a loss last week and only 20% at high margins what do you do? Most are already taking this slack time to perform maintenance and switch over to the summer fuels process. Do you rush back into production or take your time and wait for prices to correct? Do you continue to stock up on oil at $105 and face the potential for prices to drop and leave you with billions in high cost inventory? The consensus believes that refiners coming off a maintenance cycle are waiting for conditions to improve before ramping up production. They are buying the minimum amount of oil needed and are running the plants at a snails pace just to keep the process moving. Analysts believe many are expecting this scenario to eventually correct sharply to the downside and they are currently reducing inventories in order to take advantage of lower prices when they appear.

It will drive you crazy if you try and calculate all the possible scenarios only to have a pipeline bombing in Iraq cause a $5 spike in crude and foil your plans. That pipeline is back in production now but it shows you how skittish the oil market can be. The declines in consumption we are seeing now are called demand destruction due to high prices. This is a normal cycle that is accentuated somewhat this time by the U.S. recession fears and the drop in housing values. Consumers are being forced to drive less simply because they can't afford to pay for fuel.

The fear of a price correction in crude is depressing the energy sector and the refiner blahs are not helping. Of course expecting an imminent correction has been fruitless for the last two months. That does not make our job of picking stocks any easier. If you read my OptionInvestor commentary this weekend you know I am concerned about a potential return to the lows on the S&P if not lower. This is not a market where we want to be jumping into every setup we see. We need to be patient and let the entries come to us. Fortunately AAPL and RIMM have finally recovered and appear on their path back to prosperity.

Jim Brown

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