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Will Plunging Oil Prices Bring Relief for Airlines?

Adam Levine-Weinberg, The Motley Fool

For most of the past few months, it seemed that oil prices could only go one way: up. The spot price of Brent crude oil spiked from around $55/barrel in early October to a high of more than $71/barrel in late January.

Jet fuel prices quickly moved higher as well, cutting into airlines' profitability. Airlines with the tightest profit margins -- particularly United Continental (NYSE: UAL) and American Airlines (NASDAQ: AAL) -- had the most to lose. However, oil prices have taken a big step backward since the beginning of February, including a 10% decline last week. Barring another oil rally in the near future, this will reduce the pressure on airlines' profitability.

An American Airlines plane in flight, with mountains in the background

A recent oil price drop could bolster airline profit margins. Image source: American Airlines.

Oil fundamentals shift quickly

The oil rally of the past few months was driven by improving global economic growth and a successful attempt by OPEC, Russia, and several other major oil exporters to limit output. This combination of factors promised to quickly end the supply-demand imbalance that undermined oil prices beginning in 2014. Plunging oil production in Venezuela (caused by unrest, crumbling infrastructure, and poor management) also contributed to this rebalancing of the market.

However, U.S. crude oil stocks -- and stocks of petroleum products more broadly -- have increased for two consecutive weeks, according to the Energy Information Administration (EIA). Furthermore, the EIA reported a huge jump in U.S. oil production last week: to 10.25 million barrels per day, up from 9.92 million barrels per day a week earlier. At this time last year, output averaged just 9 million barrels per day.

The EIA supply numbers are based on estimates, so a big jump in a single week isn't always indicative of a broader trend. However, Baker Hughes reported on Friday that the number of oil rigs working in the U.S. jumped to 791 last week from 765 a week earlier.

US Oil Rig Count Chart

U.S. Oil Rig Count, data by YCharts.

In short, all signs are pointing to strong supply growth in the U.S. as nimble shale oil drillers take advantage of higher oil prices to ramp up production. If U.S. output does increase faster than previously expected in 2018, it will help keep a lid on oil prices.

Good news for two low-margin airlines

As of a few weeks ago, airlines expected to face steep fuel price increases in 2018. American Airlines projected that it would pay $2.07 to $2.12 per gallon for fuel in the first quarter, up from $1.70/gallon in the year-ago period. United Continental expected to pay $2.11/gallon, compared to $1.71/gallon a year earlier.

Fuel price increases of this magnitude would have a roughly 4 percentage point negative impact on most airlines' pre-tax margins. Typically, airlines would try to recoup these cost increases by raising prices.

However, United Continental has committed to a long-term strategy of increasing capacity in its Chicago, Denver, and Houston hubs in order to improve its competitiveness with its larger rivals. This is contributing to moderate overcapacity in the U.S. airline industry. Additionally, United hasn't been cooperating with rivals' attempts to raise fares.

The net result is that as of last month, United expected a breakeven first-quarter earnings performance, while American's guidance called for a meager 2% to 4% pre-tax margin. American Airlines CEO Doug Parker bluntly told analysts last month that fares are too low relative to oil prices.

A short-term fix, but not a long-term solution

If the market price of jet fuel stays near $1.80/gallon -- compared to roughly $2.00/gallon in late January -- airlines would still be paying more for fuel than they did in 2017. Nevertheless, with a smaller fuel price headwind, airlines would have a better chance of stabilizing their profit margins.

In the short run, this is obviously good news for American Airlines and United Continental. Both carriers' pre-tax margins fell into single-digit territory last year and are likely to fall even further in 2018 if fuel prices rise significantly.

However, from a longer-term perspective, it's worrisome that airlines are becoming dependent on low jet fuel prices to earn decent profits. Much of investors' renewed interest in airline stocks has been driven by the belief that airlines would adjust capacity when necessary to maintain their profitability. If such capacity discipline is now a thing of the past, investors may need to reevaluate the sustainability of airlines' profits.

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Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.