On Monday, the price of Brent crude -- the international oil benchmark -- fell below $50/barrel for the first time in months. That leaves it down 20% from where it stood around $63 at the beginning of July.
Lower fuel prices should drive higher profits for airlines. Photo: The Motley Fool
Despite the big drop in crude oil prices since last year, fuel is still one of airlines' biggest costs. As a result, any further reduction in fuel prices should provide a big earnings lift for the airlines. At major carriers like American Airlines , Delta Air Lines , and United Continental , that could lead to substantial share buyback activity in the next year or so.
The supply demand correctionThe recent turmoil in the oil market comes as investors are starting to realize what should have been obvious all along: Oil production is still far outstripping demand. OPEC is pumping more oil than it has in years. Meanwhile, U.S. oil production is still up by nearly 1 million barrels year over year and U.S. crude stockpiles are 95 million barrels above the five-year seasonal average.
The recent rout in oil prices is almost certainly unsustainable. At $60/barrel, plenty of energy companies seemed willing to invest in production increases. With oil at $50/barrel or less, the appetite for investment will be far lower.
Eventually that will lead to production declines in places like the U.S. and Canada where output has remained strong so far. However, that could still take months to occur, and with the summer driving season nearing an end, demand will drop off, too. As a result, oil prices could remain weak well into 2016 until the market fundamentals change. (If Iran oil exports surge next year, it could delay the market rebalancing even further.)
Cheap oil will drive strong airline cash flowThe airlines would love oil prices to stay low for as long as possible. But even one more year of extremely low oil prices would create a big windfall for them.
American Airlines, Delta Air Lines, and United Continental all consume about 1 billion gallons of jet fuel each quarter. The decline in oil prices just since July 1 translates to a roughly $0.30/gallon reduction in the cost of jet fuel. For American Airlines -- which doesn't hedge its fuel costs -- that represents a windfall of more than $300 million per quarter as long as it lasts.
American Airlines will see a more than $300 million quarterly tailwind from the recent drop in fuel prices. Photo: American Airlines
At Delta and United, which are slightly smaller and do engage in some hedging, the benefit may be closer to $250 million per quarter at the moment as there would be some offsetting hedge losses.
This $1 billion or greater annualized earnings tailwind will provide a significant lift to these airlines' already strong cash flow. American, Delta, and United may use this excess cash to fund increased share buyback programs.
Returning the extra cashAll three airlines have raised their buyback programs significantly in the past few months. Delta announced a new $5 billion buyback in May, while American and United both increased their buyback authorizations to $4 billion last month, up from $2 billion and $1 billion, respectively.
Delta leads the industry with a $5 billion buyback plan. Photo: The Motley Fool
Even before the most recent fuel price drop, all three airlines were generating enough cash to invest in new planes and technology, pay down debt, and catch up on pension contributions, while still returning plenty of capital to investors. This suggests that they don't have any pressing needs for the extra cash they will earn if fuel prices stay depressed.
As a result, they could use this windfall to speed up their share buybacks. And with the stocks all currently trading for less than 10 times forward earnings, they will be able to buy back a lot of stock, making a significant dent in their share counts and driving further EPS growth.
With the price of Brent crude above $60, American Airlines, Delta Air Lines, and United Continental were on pace to buy back billions of dollars of stock each in the next two years or so. Now that oil is even cheaper, that timeline is accelerating. The longer oil stays below $60, the more shares the airlines will be able to buy at bargain prices and retire. That will lead to higher earnings per share in the future -- even after oil prices (eventually) recover.
The article Oil's Latest Tumble Provides More Fuel for Airline Share Buybacks originally appeared on Fool.com.
Adam Levine-Weinberg owns shares of United Continental Holdings, and is long November 2015 $40 calls on American Airlines Group and long January 2017 $40 calls on Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. 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.
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