In a notable turn of events, the Organization of the Petroleum Exporting Countries (OPEC) – the international cartel of oil producers – has decided to cut oil output for the first time since 2008. The development is expected to add to the woes of the airline sector, which has already been grappling with multiple macroeconomic headwinds.
The airline sector has already been reeling under a plethora of issues like a surge in terror attacks, Brexit induced uncertainty, unit revenue issues, falling ticket prices and technological glitches, to name a few. The bearish Zacks Industry Rank of 204 (out of more than 260 groups) currently carried by the Transportation-Airline segment further highlights the gloomy scenario.
At its meeting in Algeria, some of the world’s biggest oil producers like Saudi Arabia, apparently agreed to cut production to a range of 32.5–33 million barrels a day from the current level of 33.24 million barrels a day. However, the organization has decided to wait till November to chalk out the details of the scheme.
The decision to curb output to combat the problem of supply naturally led to a surge in crude oil prices, which jumped around 5% to approximately $47 a barrel.
Cheap Oil: Godsend for Carriers
It is a well-documented fact that the health of airline stocks is inversely related to oil prices. This is because fuel costs represent one of the most significant expenses for carriers. Oil prices have been declining from the $100 a barrel mark since mid-2014 owing to oversupply of the commodity in the face of lackluster demand.
Cheap oil has aided the bottom lines of carriers immensely by enabling significant savings as their operating expenses have been much lowered. The substantial reduction in oil prices has boosted the financial health of carriers, in turn, supporting these companies to engage in investor-friendly activities like dividend payments and share buybacks. In fact, carriers like Southwest Airlines (LUV - Free Report) and Delta Air Lines (DAL - Free Report) have already announced dividend hikes this year.
Banking on their financial stability, these carriers are not only looking to reduce their debt levels but are also sharing more profit with employees. Earlier this year, American Airlines Group (AAL - Free Report) decided to embrace the profit sharing scheme after opposing it previously. This is a clear indication of the popularity of this employee-friendly scheme in this regime of solid financial health for carriers, courtesy of cheap oil.
Apart from the above benefits, cheap oil has helped carriers to deliver impressive earnings performances in the past few quarters. In the second quarter of 2016, carriers like American Airlines Group, Alaska Air Group (ALK - Free Report) , JetBlue Airways Corp. (JBLU - Free Report) , Spirit Airlines (SAVE - Free Report) and Copa Holdings (CPA - Free Report) outperformed on the bottom-line front owing to cheap oil. We note that Copa Holdings, which sports a Zacks Rank#1 (Strong Buy), is a good investment option. You can see the complete list of today’s Zacks #1 Rank stocks here.
Will OPEC’s Decision Hurt Carriers?
The aforesaid factors clearly suggest that carriers have reaped enormous benefits from cheap oil . In this scenario, OPEC’s decision to curb output is unfavorable for the already struggling airline sector as lower production is likely to result in higher crude price. In fact, even before OPEC’s decision, oil prices had improved significantly from the 12-year low of around $26 a barrel in February this year. Moreover, given that oil prices have been low for over two years, it has been already priced in.
At a recent conference, Delta Air Lines stated that it believed that the era of high profits due to low fuel costs is behind it. In fact the prospect of a further rise in oil prices, which is a likely scenario in view of the OPEC decision, could be welcomed by carriers.
The scenario of rising fuel costs should provide further scope to raise ticket prices, thereby boosting revenues. Moreover, higher oil prices may help mitigate capacity overexpansion – another long standing problem for carriers. However, only time will reveal the nature and extent of the impact of the OPEC decision on carriers. We expect investors, interested in the airline space, to remain focused on the burning issue going forward.
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