Airline stocks have been brutalized this quarter due to an irrational knee-jerk reaction by investors.

Investors are afraid that new flights added by Southwest Airlines Co (NYSE:LUV) will cause a price war, and lead to lower profits for the entire industry. But these fearful investors are focusing exclusively on one issue, while turning a blind eye to the unique profit tailwinds that airlines enjoy today.

As income investors, we likely have an opportunity to benefit from this irrational fear in two ways:

Investor fear has led to cheap valuations. Lower stock prices and healthy profit margins gives us great value for investing in the industry, with significant opportunity to profit from a rebound in stock prices.

Investor anxiety is pushing option premiums higher. With prices for option contracts trading at high levels, we can set up income trades that give us very competitive annualized rates of return.

This week, airline stocks began to rebound, following a favorable industry article from Barron’s. Based on the discounted valuations for these stocks and the positive reaction to the Barron’s piece we’re asking four key questions about the industry.

Is Capacity Really an Issue?

The million dollar question for airline stocks is whether competition will stifle prices, or whether the industry will continue to operate profitably.

Wall Street analysts’ favorite metric for airlines is Revenue per Available Seat Mile (or RASM). The idea is that if revenue for airline seat increases, total profit will increase as well.

If airlines add more seats, the number of “available seat miles” will increase. So unless revenue also increases, the RASM will decline. Traditionally, a lower RASM will cause airline profits to decline as well.

The problem with this reasoning is that the number of seat miles isn’t always directly tied to an airlines cost. So if an airline can cut costs (say by paying less for a gallon of jet fuel), then an airline can grow profits even if the RASM metric drops.

And that’s exactly what is happening in the airline industry today. Fuel costs have dropped by roughly 40% over the past year, and yet investors are worried about an expected 3.5% drop in revenue per seat mile.

Analysts currently expect that the U.S. airline industry will add an additional 3% to 3.5% of capacity this year.

According to JPMorgan’s research team, each percentage increase in capacity should cost the industry about $850 million per year. At the same time, each $0.05 decline in jet fuel costs should offset roughly $850 million in fuel costs.

The costs associated with a 3.5% increase in capacity could be directly offset by a 17.5-cent decline in the price of jet fuel.

So the costs associated with a 3.5% increase increase in capacity have been more than offset by the 40% decline in jet fuel. And this doesn’t account for any additional revenue that might be added as a result of higher capacity.

Over the past year, the price of a gallon of fuel has dropped from roughly $2.80 to a current price near $1.70. Clearly the cost savings from lower fuel prices have a much bigger impact on airline profitability than the danger of higher capacity.

Are Low Fuel Costs Sustainable?

After falling sharply in the second half of 2014, U.S. oil prices have bounced to a range near $60 per barrel and have traded in a tight range for nearly two months now.

Our bullish expectations for airline stocks is based heavily on our assumption that oil will not trade higher (and may in fact move considerably below $60 in the next few months).

There are many reasons to expect oil prices to remain under pressure for the rest of this year.

  • Saudi Arabia continues to keep production levels high.
  • U.S. oil companies are becoming more cost efficient
  • U.S. production has been robust despite a drop in the rig count
  • Iran has the potential to add oil production to the global market
  • Poor emerging market countries have financial incentives to keep pumping

In late April, we stated that the oil rally wouldn’t last. Since then, it has become even more clear that global production levels will remain high.

It is interesting to note that even though we are entering a seasonally strong period for energy markets (peak driving season in the U.S.), oil prices have remained range-bound. If the summer driving season can’t break oil prices out of their range, what will happen when this source of demand expires?

Low oil prices should naturally keep a lid on fuel costs for airlines. Even if jet fuel prices bounce a bit from their current level near $1.70, we shouldn’t see prices get anywhere close to where they were trading last year at this time. And with lower fuel prices airlines should report favorable profits in upcoming quarters.

What IS the Worst-Case Scenario?

Based on the low valuations for airline stocks, it appears that investors are already pricing in a challenging environment for domestic airlines. But what would a worst-case scenario actually look like?

According to this weekend’s Barron’s article, a Barclays analyst recently put together a model that measured what would happen to the industry if oil prices rose to $85 and the economy slipped back into a recession.

Even in this environment, the analyst expected that the airline industry would remain profitable and that before-tax earnings would only fall by 7 to 15 percentage points. While this isn’t exactly a rosy picture, we should note that the major airline stocks are already trading at valuations that imply that investors expect this type of earnings decline to occur.

With such a pessimistic valuation, it would only take a small amount of bullish information to start to shift investor sentiment to a more bullish stance, leading to an expansion in valuations and higher stock prices.

But what could cause that shift in investor sentiment?

Could Earnings Season Be the Catalyst?

With just a few more days left in the second quarter, investors can start looking forward to Q2 earnings announcements and even pre-announcements.

The major airlines aren’t expected to report earnings until the second or third week in July. But given investor uncertainty in the area, it wouldn’t be surprising to see airlines pre-release earnings estimates to help calm investor fears about rising competition.

Investors can also look forward to airline traffic data for the month of April which should be released at the end of the second week in July.

Earnings data and traffic data is unlikely to send airline stock prices any lower. This is because investors are already expecting weak data following the Southwest capacity increases. Essentially, the bad news has already been “priced in” for the industry.

On the other hand, any encouraging information would likely send airline stocks higher. Bullish earnings data could spook short-sellers, triggering a short-covering rally. And if investors believe that capacity is holding steady, the low valuations for airline stocks could be enough of an incentive to trigger new buy orders.

Airline table 2015-06

Volatility = Opportunity

The sharp drop in airline stocks over the past two months creates a unique opportunity for income investors.

Lower stock prices naturally send option prices higher. This means that we can sell put option contracts at a premium price, giving us more income in exchange for our agreement to buy shares of stock.

For airline stocks that we already own, we can sell call contracts at higher prices, giving us more income as we wait for the stock prices to rebound.

All told, this industry is primed for a rebound, while uncertainty gives option sellers the upper hand in exploiting the opportunity. We suggest scaling into airline positions now, before the rally sends stocks any higher.

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