Oil Need Not Burn Airlines

FEBRUARY 25, 2011    THE WALL STREET JOURNAL

By LIAM DENNING

In one way, airlines have moved beyond the aftermath of the financial crisis. But it isn't good news.

The history of airline stocks over the past five years or so can be broken into two periods. Prior to Lehman Brothers' demise in September 2008, the sector moved almost perfectly in opposition to the oil price. After that, the relationship turned on its head, with airline stocks moving up with Brent. This made sense because oil's recovery paralleled those in credit markets and travel.

All this has just changed again. Looked at on a rolling 90-day average, the NYSE Arca Airline Index's positive correlation of 77% with Brent crude oil at the end of December has swung to an inverse correlation of 57% today. Oil's strength has shifted from being an expression of economic growth to a symptom of geopolitical risk, thereby endangering growth itself. Airline stocks have tumbled this week.

Yet barring Libya's violence spreading, particularly to Saudi Arabia or Iran, likely sending fuel prices rocketing, this could be a good time to buy.

Some stocks look cheap, with United Continental Holdingsand Delta Air Lines both trading at about 4.5 times 2012 forecast earnings. Also, yields on airline debt hardly have moved, suggesting fears of oil bringing on a liquidity squeeze remain low.

That's a big difference from 2008, and reflects airlines' progress in consolidating and cutting capacity. Fewer seats provide some leverage for passing on fuel-price increases to passengers. Even if fuel prices stay elevated this year, both Delta and United should have free cash flow after capital expenditure, according to brokerage Soleil Securities. That really would represent a break with the past.

Write to Liam Denning at liam.denning@wsj.com