High Oil Prices Bound To Crash Airlines' Party

Todd Shriber
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Crude oil for May delivery gained just 22 cents today to close at $86.84 a barrel on the New York Mercantile Exchange, perhaps a tame gain by recent standards, but with oil pushing $87 a barrel, $90 is logically right around the corner. The significance of $90 oil is not just the cost of $90, it is the specter of oil making its way back to $100. Triple-digits are good for basketball scores and for birthday checks from your grandmother, but seeing triple-digit oil is like a triple-digit golf score: Bad news.

High oil prices hamper a wide array of industries. One obvious example is airlines. According to Stifel Nicolaus, fuel costs comprise 25% of the total operating costs for airlines. The only thing airlines spend more money on is labor, including rich benefits for ticketing agents and baggage handlers and lofty salaries for pilots, but that is a discussion for another day. The current state of affairs shows an interesting theme playing out and that is airline stocks rising in unison with oil prices.

This is a party that is bound to end sooner rather than later and when it ends, the airlines will bear the brunt of the punishment. Over the past two decades, one of the easiest pairs trades to put on when oil prices have been high has been to go long oil futures or oil stocks and short the airlines. The efficacy of this trade is strong and practical enough that an investor need not be a hedge fund manager to figure out that high oil prices are almost a death knell for airlines.

Yet this trade would blown many investors out of the water over the past six months. Consider that in November of 2009, crude futures were hovering in the high 60s and low 70s. In other words, oil futures have gained at least 20% in the past six months. That should be good news for an ETF like the Oil Services HOLDRs (OIH) because oil services stocks are highly correlated to the price of crude and OIH is up about 10% in that time frame. More surprising is the performance of the Claymore/NYSEArca Airline ETF (FAA) which has soared 30% in the past six months.

There have been some recent statistics and anecdotes that may lure investors into FAA and its member stocks. People are saying planes are crowded again. Airlines said global traffic was up almost 10% in February. (Traffic was actually down in the U.S. in February). All of this has Delta (DAL), the largest U.S. airline, AMR (AMR), American's parent company, and US Airways (LCC) trading within about $1 or less of their respective 52-week highs.

As is so often the case when it comes to investing, it pays to engage in a little history lesson. A quick review of the charts of the aforementioned airline stocks shows that they were actually trading at higher prices in July 2008 when oil made its record high than where they trade today. Do not be fooled,. High oil prices inevitably catch up with airlines and they did in 2008. Oil was around $90 in October of 2008 and by that time, airline stocks had been obliterated. In 2008, fuel prices actually surpassed labor costs as airlines' biggest expense.

That scenario may not play out again, but it is difficult to envision a further rally in the airline sector if oil bulls continue to have their way. At the most basic level, this is Economics 101. Is it really wise to invest in a company that can do little to do control the price of volatile commodity that represents one of that company's biggest output costs while that commodity is in a pronounced uptrend? Probably not.