Why Airline Shares Aren't Soaring As Oil Falls

Yes, both West Texas Intermediate and Brent crude prices continued their recent slide Tuesday in response to OPEC’s surprising decision to keep oil production rate up despite low prices. WTI stabilized at $37.59, while Brent fell to $40.59. But U.S. airline shares did not shoot up dramatically, as one would have expected.

To be sure, there were airline stock buyers yesterday, but they were more of the bargain hunter variety, buying as prices tumbled. The parent companies of the Big Three – American Airlines, Delta Air Lines and United Continental, saw their shares shed around 3% of their value Tuesday. American closed at $44.55, down 2.7%. Delta fell almost 3% to $50.97. United Continental holdings slipped more than 3% to $58.65. Southwest took the biggest beating, losing $4.48 a share (more than 9% of its value) to close at $45.03.

Share price drops that large are not pleasant, but normally they’re regarded as no big deal. But yesterday’s airline shares decline was triggered by something that spooked savvy stock traders.

Southwest had returned over the last few years to the kind of high single-digit and even low double-digit capacity growth rates that it had maintained throughout much of its 44-year history – until it reined in its growth in 2007. But in May the carrier began tweaking its renewed growth plans to account for some previously unexpected softness in demand. Southwest adjusted its plan for nearly 8% capacity growth this year, and 7% in 2016 downward to just 6%-7% this year and 5%-6% next year

Then the Dallas-based airline shocked analysts Tuesday with a warning that a key metric – the average amount of money it gets for flying one passenger one mile – will be flat to down about 1% in this year’s fourth quarter vs. the same period in 2014.

They might as well have announced that they’re launching service to Tehran. That’s how stunned airline investors were by Southwest’s disclosure that they’re now having to discount seats more than anyone previously realized in order to fill a high percentage of them.

In October in this space I asked, “Do Declining Unit Revenues At Airlines Warn Us Of A Coming Downturn?” Historically, declining airline unit revenues were viewed as really bad news. Only this year the declining airline unit revenues have been mostly ignored. Why? Because the fall of oil prices from around $100 a barrel in the summer of 2014 to the $45-$50 range most of this year served to mask the problem. U.S. airlines have been reporting record or near-record quarterly profits this year, so no one much worried about the key data buried in the weeds in their quarterly reports.

In October I wrote that “U.S. airlines are getting noticeably less money per available seat mile than they were a year ago. Not only does that mean their average fare prices are down sharply (nearly 20% from their peak in May 2014 according to a Bloomberg analysis). It means all that extra dough that they generate from charging for checking your bags and letting you select your seats, dinging you for other extra services, and hitting you hard for changing your itinerary still is not enough to offset the drop in fare prices.”

Southwest’s warning Tuesday morning drove home that message in dramatic fashion.

Both it and the industry have evolved significantly from the days when it was a plucky upstart discounter that invaded the big carriers’ markets with lots and lots of flights and low-priced seats. But Southwest is still the industry’s pricing bellwether in terms of domestic fare prices.

Other carriers always cut their prices to remain competitive with it, but Southwest never cuts its prices to remain competitive with them. In fact, historically there have been only three scenarios in which Southwest has cut prices: when it enters a new market and is seeking to grab market share; during the low travel demand periods of deep winter and mid-Autumn; and when the overall economy sagged.

Today Southwest is the largest U.S. airline in domestic passengers carried and domestic passenger miles flown. So it no longer needs to steal market share from anyone. And its fall/winter prices were set based on its already-lowered analysis of expected travel demand.

That it had to cut its fourth quarter fares even lower – which is what yesterday’s unit revenue warning really means – tells us that air travel demand is even weaker than expected. Did Southwest’s leaders badly misjudge the growth of demand – something they rarely do? Or is there a change taking place in the economy that’s impacting air travel demand more than anyone anticipated?

It’s still hard to know for sure, but yesterday’s drop in airline share prices even as oil prices cratered further indicates that there might be a problem growing in the larger economy. Oil is the lifeblood of any airline. At $100 a barrel it was their largest cost item. At $50 it became their second-largest cost item behind only their labor costs and most of the savings went to carriers’ bottom lines.

So it stands to reason that at $37 even less of the airlines’ cash will go to oil purchases and more will fall to the profit line. Thus, any drop in the price of oil should push airline share prices up.

Furthermore, since consumers will be spending less on gasoline and the goods trucked to them in vehicles that burn refined oil products, it stands to reason that some of their extra free cash likely would go toward more air travel, further increasing airline revenue in the months ahead.

So, for those clear and simple reasons airline shares should have jumped nicely yesterday.

That they went the other way instead tells us something – perhaps something very important.