AMR: Ready to Fly?

12/10/2004 12:00 am EST

Focus:

Jamie Dlugosch

Editor, The Rational Investor

"One of the sectors I expect to benefit greatly from the bursting of the oil bubble is the airline group," says Jamie Dlugosch, editor of The Rational Investor. Here, he discusses his outlook for the "irrational oil market," and a beneficiary of a return to more "normal" oil prices.

"It would not be surprising to see stocks continue to move higher over the next few months. The biggest driver for those gains will be a continued reduction in oil prices. The hedge fund clan that spurred much of the speculative rise in crude, may be moving on to easier prey. As is typically the case, hedge funds hunt down the fast money. Today, that fast money is being made in the fall of the dollar. Hedge funds are becoming preoccupied with a sell the dollar buy the euro trade that is taking dollars from the oil markets. As that continues I expect oil to drop further in the first half of 2005. That alone will be the impetus for higher prices in the stock market.

"A closer look at the oil situation reveals a market that is screaming irrationality. The three major factors leading to the recent price increases include geopolitical uncertainty, growth in China, and hedge fund speculation. With two of the first three at a peak and starting to recede, expect the third wheel to come crashing down in no time. We just saw some of that during the last week of October. Higher oil inventories in the US sent the hedge fund crowd running for the exits. Crude dropped by $3 in one session. The very next day, China‚Äôs central bank raised interest rates for the first time in ten years, and oil dropped again. Once started, the rush for the exits may very well push oil back to $30 per barrel.

"With stocks so tightly bound to the oil market, I fully expect a significant rally if and when oil prices revert to more normative levels. Oil really is a great example of inefficiency. By no means is this a guarantee that stocks will rise, but it is an occasion where the risks appear to be in our favor. One of the sectors I expect to benefit greatly from the bursting of the oil bubble is the airline group. The oil situation has made a tough environment brutal, with many carriers now staring bankruptcy in the face. In hindsight this may be a good thing, as management can use the situation to extract more concessions from labor. As oil prices drop, it would be quite 'rational' to own airline stocks.

"Given this outlook, we own American Airlines (AMR NYSE) in our model portfolio. The airline industry has been decimated by many factors over the last several years. Starting with the terror attacks and ending with a record rise in fuel prices, most carriers are struggling to survive. The traditional hub and spoke airlines have been the hardest hit. The threat of bankruptcy has created breathing room as the big carriers extract massive pay cuts from workers. AMR Corporation (AMR) has been a leader in this regard having made the first round of cuts nearly a year ago. In the months after it renegotiated contracts, shares of AMR rebounded significantly. On the brink, AMR traded below $3 per share, but the shares rose to over $15 per share in early 2004 on the heels of aggressive cost cutting.

"With the prospect of sustainable profitability in the near future, it appeared safe to own airlines again. The spike in oil prices changed that dramatically. Initially, the shock of higher prices did little to dampen enthusiasm. Some airlines hedged against the higher cost. Unfortunately, nobody could predict how high prices would eventually go. By the summer of 2004, it became clear that oil costs would have a huge impact on the financial viability of airlines, and once again the big carriers were faced with a life threatening event. For those like Delta Airlines that had yet to secure wage concessions, the threat was even more severe. As it was, the airline stocks suffered as the price of oil went higher and higher. In fact, by the end of the summer there was a very strong correlation between stock price and oil price.

"AMR has lost nearly 60% of its value since peaking earlier this year. With most of that change due to the oil markets, any declines in oil prices will bode well for the stock. Last month, I discussed how I believed that the oil markets were a bubble. The biggest way to capitalize on the potential collapse of that bubble will be in the airline segment. As for AMR, analysts are expecting the company to bleed cash through the 2005 fiscal year. With the volatility in oil, those numbers are nearly meaningless. Eventually the pressure from the oil market will subside, and when it does, AMR should rebound. Buy AMR up to $10. I'm looking for a double from here."

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