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Oil Pummels Airline Profits

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Surging fuel prices could clip the wings of airlines in 2011.

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The airline industry will earn almost 50% less this year than in 2010, as fast-rising oil prices pummel the sector's profitability.

The International Air Transport Association has now downgraded its airline industry outlook for this year to $8.6 billion from the $9.1 billion it estimated in December. This is a 46% drop in net profits compared to the $16 billion earned by the industry last year.

IATA raised its 2011 average oil price forecast to $96 per barrel for Brent crude, up from $84 in December. This will increase the industry fuel bill by $10 billion to a total of $166 billion.

"There is very little buffer for the industry to keep its balance as it absorbs shocks," said Giovanni Bisignani, IATA's CEO in a statement. "Today oil is the biggest risk. If its rise stalls the global economic expansion, the outlook will deteriorate very quickly."

The price of oil has surged as global financial markets react to the violent civil unrest sweeping through the Middle East and North Africa. Brent crude -- the benchmark for oil prices in Europe, Africa and the Middle East -- ripped through $100 on January 31 and has continued to move higher in recent days. It's at $116.55 as of this afternoon. Fuel is now estimated to represent 29% of total operating costs for airlines in 2011, up from 26% in 2010.

IATA says that growing economies give airlines opportunity to recover some of these added costs with additional revenues. The trade group estimates revenue of $594 billion for the industry this year, for a profit margin of 1.4%. However, higher revenues aren't expected to be sufficient to prevent the rise in oil prices from causing profits to shrink.

Still, a recovering global economy does bode well for continuing strong demand for air transport, said the IATA, which revised its passenger demand growth forecast to 5.6% from 5.2% and its cargo growth forecast to 6.1% from 5.5%.

By region, Asian-Pacific carriers are expected to deliver the largest collective profit of $3.7 billion and the highest operating margins of 4.6%. North American carriers will deliver $3.2 billion profit, which is down from the $4.7 billion profit raked in last year. European carriers are expected to make a $500 million profit, which is up from the $100 million previously forecast, but still well below the $1.4 billion profit generated in 2010. European carriers remain the least profitable among the major regions.

Read a full copy of the IATA report here.

Airline stocks gained altitude in 2010, with the Amex Airline Index rocketing up 39%. However, investors have since parachuted out of these positions: the index, year-to-date, has now nose-dived 10%, with some analysts predicting more challenges ahead for investors putting money to work in this struggling industry.

Basili Alukos, an equity analyst at Morningstar who covers the airlines, notes that these companies have adjusted to rising oil prices by increasing fares, raising fees and hedging fuel purchases. However, he argues that the industry is highly price sensitive and can't pass on prices without substantially hurting demand.

"Last year was certainly a banner year," Alukos says. "But there are now a lot of cost pressures looming," adding that every $1 per barrel increase in the price of oil adds between $415 million and $450 million of fuel costs on an annualized basis.

By his estimate, the analyst says that the current price surge equals between $3.2 billion and $3.4 billion in added expenses for the industry. Although carriers have hedges in place for between 30% and 50% of their 2011 consumption, he emphasizes, the increase will nevertheless still have a negative impact on their financial results.

As such, he's told clients that he's placed Delta (DAL), AMR (AMR), US Airways (LCC), and United Continental Holdings (UAL) under review as he now revisits his fuel and yield assumptions.

Others remain more cautiously optimistic about the industry's prospects. David Tyerman, an analyst with Canaccord Genuity, says that the sell-off in the airline stocks might represent a window of buying opportunity for investors. His argument is that the strength of the economy, coupled with a limited supply of flights but strong passenger demand for seats, should allow airlines to continue increasing prices.

Also, he argues, rising energy costs might not necessarily pinch the profits of these airlines as much as some analysts and investors fear. "Higher oil prices don't necessarily mean worse profitability or share prices for the industry," he says. "Since the start of 2009, for instance, profitability and share prices have improved despite the fact that the price of oil increased substantially through that period. So the automatic assumption that higher oil prices mean lower profitability hasn't played out."

A central question for investors, says the analyst, is how much higher oil prices go from here. "When the situation blew up in Egypt, the price of oil flared up but then pulled back and it's quite conceivable that the same thing now happens with Libya," says Tyerman, who currently has a buy rating on both Air Canada and WestJet Airlines (WJA).

Still, regardless of what energy prices do in the near to intermediate term, some strategists argue that airlines might work as trades, but not as long term investments. So says Vitaliy Katsenelson, portfolio manager with Investment Management Associates and author of The Little Book of Sideways Markets: How to Make Money in Markets that Go Nowhere.

Katsenelson rattles off the reasons he avoids the airlines as a portfolio manager: high fixed costs, extreme sensitivity to economic growth, high rates of unionization, and a significant portion of costs driven by the unpredictable commodity of fuel prices.

"Investors see how the stocks come off the bottom and rocket up," Katsenelson says. "They see airlines merging and they think that this time, somehow, things will be different. That maybe now these airlines will be profitable. But it never changes."

Indeed, investors in the airline industry have always endured a lot of turbulence in their portfolios: there have been more than 180 bankruptcies in the industry over the past 30 years, and since deregulation in the late 1970s, analysts emphasize, the industry has suffered issues like capital intensity, cutthroat competition and oil price volatility.

Those who share Katsenelson's deep skepticism of airlines could consider using exchange-traded funds to short, or bet against, the uncertain industry. Analysts highlight two ETFs that could serve such an investment objective: Guggenheim Airline (FAA) and Direxion Airline Shares (FLYX). The principal difference between the funds is that FLYX owns only US-traded airline companies while FAA holds airlines traded on overseas exchanges.
No positions in stocks mentioned.
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