Oil spike threatens to undermine airline recovery

( Reuters ) - This week's record-high crude oil prices casts a shadow over a tenuous recovery in the U.S. airline industry, where top carriers have less protection than they did a year ago from devastating spikes in energy prices.

Soaring oil costs -- which have a direct impact on the price of jet fuel -- are a persistent problem for airlines, which have been struggling to cut costs, boost revenue and post consistent profits. Nymex crude futures topped $80 a barrel for the first time on Wednesday and set a new record on Thursday.

"It comes at a difficult time in the sense that we're finally seeing an uptick in yields," said Doug Abbey, an airline consultant at Velocity Group. "This is going to be a very challenging fourth quarter and first quarter."

The oil spike underscores the value of jet fuel hedges and the fear that critical hedging is going to be very difficult and expensive at current levels. Like insurance policies, hedges blunt risk by allowing companies to manage potentially crippling price swings.

While airlines have considerably more of their fuel hedged than they did three to five years ago, recent data show they are less hedged in 2007 than in 2006.

WEAKER HEDGES

In 2005, as Delta Air Lines Inc and Northwest Airlines Corp filed for bankruptcy, low-cost carrier Southwest Airlines Co was one of the few airlines to post profits thanks to its long-term hedging contracts. But recently, even Southwest has seen its protection erode.

The airline's hedging position is still the envy of the industry, but the gain in crude prices over the last year have prevented Southwest from locking in the same low prices it enjoyed in the past.

Southwest said in a regulatory filing that it had hedged 90 percent of its fourth-quarter fuel consumption at $51 per barrel of oil. That is compared with 85 percent of its consumption at $26 per barrel in 2005. Unhedged airlines paid anywhere from $41 to $70 per barrel of oil in 2005.

Although a tentative industry rebound has freed up airlines to buy hedges that were unaffordable a few years ago, experts say the protection has diminished since 2006.

"I think they were hedged better last year in a general sense," said Michael Waldron, an energy markets research analyst at Lehman Brothers.

According to Lehman Brothers commodities research, U.S. airlines on average hedged 31 percent of their fuel consumption, locking in an average price of $60.28 per barrel. That compares with an average hedge of 43 percent at $62 per barrel in 2006.

As oil prices rise, the price of derivative instruments used to offset the risk also increases, a factor that depletes the value of hedges and dissuades some airlines from buying them.

"My sense is that there is less hedging going on simply because it's very expensive to do it," said airline consultant Robert Mann.

BAD TIMING

The airline industry has been battered by high costs and competition that pressures fares.

The post-9/11 downturn saw the bankruptcies of UAL Corp, parent of United Airlines; Delta, Northwest and the former US Airways Group.

Other airlines, such as AMR Corp's American Airlines, restructured out of bankruptcy. During that time, the top carriers slashed labor and other costs, but the price of fuel, which is usually one of the top airline expenses, remains largely outside the control of carriers.

Furthermore, rising demand for jet fuel has put a heavy burden on refineries, leaving them vulnerable to maintenance problems that can slow or stop output. Consequently, the rise in the price of jet fuel can outpace the spikes in oil prices.

Airlines have had moderate success passing that burden on to the traveling public through fare increases. But further complicating the matter is the expectation oil prices will remain near current levels or even rise for the foreseeable future.

"If (oil prices) stay at this level and don't recede, (airlines) don't have an opportunity to get new hedges in place," said Standard & Poor's equity analyst Jim Corridore.

The price of oil is taking a toll on airline stock prices, he said. The Amex airline index has tumbled 20 percent this year, a decline that corresponds with a 30 percent gain in the price of Nymex crude futures.

"It's tough to be bullish on airline stocks right now with oil at these levels," Corridore added

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