Flying High While Oil Sinks

08/21/2008 12:00 am EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Elliott Gue, editor of The Energy Strategist, finds a good short-term play on the recent drop in energy prices.

The selloff in crude oil, natural gas, and energy-related stocks continues, and I wouldn’t be surprised to see further selling over the next few weeks. The good news: this isn’t the end of the world or the end of the energy bull market. We’ve seen several corrections in the energy patch over the past few years, some even more severe than the past month’s move.

Oil prices have simply returned to levels last seen in early May. In fact, the move looks like a correction of a market that simply got extended toward the end of the second quarter.

Also, remember that a year ago oil prices were trading under $75 per barrel. Oil crossed $100 per barrel for the first time just about six months ago. This is hardly the bursting bubble and crash some have made it out to be.
 
But that leaves the obvious question of what to do right now. Consistent with my view that oil prices have more downside to come, I continue to favor stocks in the transportation sector.

For a shorter-term play in transports, I favor airlines. Airlines are heavily influenced by the path of crude. This makes the group an outstanding, short-term hedge against my further expected slide in crude.

Delta Air Lines' (NYSE: DAL) fuel costs soared by nearly $1 billion in the second quarter of this year.  That's a huge number [compared with Delta’s] market value of just $2.64 billion.

Delta's total fuel costs in the second quarter were $1.7 billion. Let's assume that Delta's fuel prices fall by just 15% this quarter. That works out to a $255-million fuel savings. That's an 85-cent-per-share impact on the bottom line per quarter. Current estimates are that Delta will lose 21 cents per share in the third quarter; it's easy to see how fuel prices can make the difference between a decent profit and a sickening loss for the airlines.   

I don’t believe that fuel prices have to crater for this trade to work out. With fuel prices rising so rapidly, it's all but impossible for Delta and the other airlines to manage their pricing, capacity and labor force to shore up profitability. If fuel prices just stabilize or stop rising, this task will become far easier.

And the major carriers are cutting capacity; they're literally ending certain unprofitable routes and retiring older, fuel-inefficient airplanes. Major capacity reductions are planned for this fall, providing yet another huge tailwind for the group.

Delta is among the most financially stable US air carriers. I don’t expect to hold the airlines for more than a few months; these aren’t long-term investments.

Delta remains a Buy up to its target of $9.25. (It closed above $8 Wednesday—Editor.) Investors should consider using a smaller-than-average position size to control risk on this play.

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