The approximate 70% decline in oil prices over the last year and a half has inflicted a great deal of pain on energy debt and equity investors. While the casualties from the collapse in energy prices have been well documented, the beneficiaries of the collapse have not been as well reported.
In addition to consumers and a variety of industrial users, no group benefits more from lower oil prices than the airline industry. About 20% of an airline’s costs are fuel related, which is down about 700 basis points from a year ago, but still material. Since most airlines are largely unhedged, the decline in oil price flows right to the bottom line and has contributed to the record profitability which is shown in this week’s chart.
The drop in oil prices has also coincided with a major structural shift in the market, as the last seven years have witnessed a period of bankruptcy and subsequent merger among the major airlines. Currently, about 80% of domestic capacity is now controlled by American Airlines, United, Delta, and Southwest Airlines, which creates better pricing power and more capacity discipline. Two other major changes over the period are the introduction of baggage fees, which has added billions of high-margin revenue, and the shedding of legacy pension liabilities via the bankruptcy process.
While the big four airlines’ equity performance was mixed in 2015, investment grade and high yield airline bonds outperformed their respective benchmarks. Equities have suffered from slower revenue growth and concerns about capacity creep, and the market seems to assign a lower multiple to earnings generated from lower oil prices as opposed to revenue growth. Bond investors, however, care about free cash flow, regardless of its source, as long as it recurs, and it appears the oil windfall is here to stay for a while. Importantly, airline management teams have taken a balanced approach to the use of their free cash and allocated it to both share repurchases and debt reduction.
Key Takeaway: The outlook for airline credit remains favorable in 2016 given the outlook for lower oil prices. Terrorism, cyclicality, labor relations, and capacity discipline remain top of mind for investors, but the tailwind from sub-$50 oil goes a long way to cushion these concerns. Also, in a period where the broader corporate market is experiencing a degradation of credit quality, airline bonds continue to have upward rating migration. A final critical point is that most airline bonds are collateralized largely by relatively new in-production aircraft and offer good downside protection, given historical recovery rates.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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