Are Airline Stocks a Great Way to Play Low Oil Prices?

By Markets Fool.com

This Christmas has been a good one to many in the market. After a lull earlier in the month, stocks roared back to record highs last week, and low gas prices along with an improving job market have also been a boon to retailers in the all-important holiday shopping season. According toMasterCard, retail sales from Black Friday improved by 5.5% over a year ago, with spending on services growing faster than spending on goods. But of all of the players out there, perhaps no one has benefited more from low oil prices than the airline industry.

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Indeed, airline stocks have surged as oil prices have fallen. Since Oct. 13, when the market bottomed out,United Continental is up 62%,DeltaAir Lineshas gained 59%, and American Airlineshas soared 82%. Meanwhile, oil prices are down by more than a third. Analysts have also significantly lifted next year's earnings estimates across the industry. United is now expected to make a per-share profit of $8.27, versus an estimate of $5.95 90 days ago, while the other airlines have seen similar jumps. Additionally, United's earnings are seen jumping more than 60% next year despite revenue remaining flat, owing almost entirely to the drop in fuel prices, which is clearly having a major impact on airline economics. Let's take a closer look at what it means.

This is some serious savings
The three major airlines above will use about 4 billion gallons of jet fuel each in 2014. In previous years, that fuel consumption accounted for $12 billion to $13 billion in annual expenses, or about a third of total operating expenses, as jet fuel prices have fluctuated between $3.06 and $3.27 per gallon. Fuel is the airlines' largest expense. After trading close to $3 for most of the year, the price of jet fuel is now just $1.66,, or close to half of what it's been in recent years. If it remains around this level next year, airlines will be able to potentially cut their operating expenses by about 16%. For an industry that is known for operating at a loss, or at very slim profit margins, that difference is huge. United, for example, could have saved as much $6 billionlast year, giving it a profit of $6.5 billion, instead of $571 million.

Hedging strategies employed by Delta and United -- but not American -- will cut into this benefit, but the savings will still be worth billions of dollars if prices remain this low.

So will airfares ever come down?
In a functioning free market economy, lower commodity prices should lead to lower consumer-level prices due to competition. However, the airline industry has been slow to react to this sudden shift in economics.

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There are a number of reasons for this. First, the airlines have not yet received the full benefit of the price drop as the low prices are working their way through the production pipeline -- i.e., fuel consumed today was purchased months ago -- and due to hedging effects, which mitigate the benefit from the price change. Second, this industry has survived countless bankruptcies, which have chastened operators. Before passing along savings to consumers, they are likely to take the opportunity to shore up their own financial position by paying off debt and making investments in their businesses. American Airlines recently announced that employees would get a 4% raise above their union contract, for example. Finally, after several mergers, the four major airlines -- Southwest,United, American, and Delta -- control 80% of the market, so competition within the industry is much lower than it used to be.Tellingly, the major airlines have said they would not expand capacity, a conservative move designed to prevent industry overcapacity and empty seats, a problem that has long plagued the airlines.

That discipline should benefit investors, even if it comes at the expense of disgruntled passengers.

Will the stocks keep flying higher?
Senator Chuck Schumer recently called for an investigation into the airlines' refusal to lower fares, but the probe is unlikely to gain traction. The major reason is that a healthy and profitable airline industry free of bankruptcies and government bailouts is in the public interest. Perhaps airlines are being stingy with their fuel savings, but as American Airline's decision to raise wages shows, they will use the savings in one way or another. How they do so is up to them to determine.

That's a good sign that the stocks will continue to move higher. The ultimate determinant, of course, will be oil prices, and no one truly knows where those will go, though the Energy Information Administration and other agencies predict low prices through next year as booming U.S. supply and OPEC's decision not to cut production should help keep crude prices down. Based on next year's earnings, airline stocks look dirt cheap. United trades at a forward P/E of 7.9 while American's multiple is just 6. By contrast, the P/E for the S&P 500 is currently 20.The windfall profits may be temporary, but a number of other factors favor the industry's future, such as decreased competition, improved operating capacity, and a consumer with more discretionary income, thanks to the improving economy.I'd say that's enough reason to bet on airlines outperforming again in 2015.

The article Are Airline Stocks a Great Way to Play Low Oil Prices? originally appeared on Fool.com.

Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends and owns shares of MasterCard. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.