How Will Oil Prices Impact Alaska Air’s Valuation?

The US aviation industry was considered a poor investment due to heavy losses suffered by the airlines in the past. However, plummeting global crude oil prices have discarded this old stigma. Given that jet fuel costs constitute nearly a third of an airline’s total operating expenses, the 50% drop in oil prices over the last nine months has accelerated the bottom line of all major US airlines. Alaska Air is one of the beneficiaries of the fall in oil prices, as it has helped the airline’s stock price to soar by over 35% in the last nine months. Our current price estimate for Alaska Air stands at $69 per share, assuming a gradual recovery of oil prices over the next two to three years. However, in this article, we will discuss two scenarios that could have a significant impact on the airline’s current valuation.

See our complete analysis for Alaska Air here

Base Case: Gradual Oil Price Recovery

Since July of last year, crude oil prices have plunged from over $110 per barrel to $45 per barrel in January this year on weak global demand, led by slow growth in the Chinese economy, and surplus oil production due to the rising tight oil production in the US.  In addition, the Organization of Petroleum Exporting Countries’ (OPEC) decision to maintain its current production rates has further aggravated the demand-supply mismatch. While the decline has weighed heavily on oil producing companies in the US, it has been extremely profitable for most of the US airlines, particularly Alaska Air. In 2014, the Seattle-based airline’s net profit went up by almost 20% to $605 million due to a decline in its fuel as well as non-fuel costs.

Over the last two months, crude oil prices have increased to $60 per barrel, showing signs of recovery due to the large cutbacks on production by major oil companies. We currently expect oil prices (Brent) to average around $75 per barrel this year and gradually increase to $85 per barrel over the next two years. Hence, in our base case scenario, we forecast Alaska Air’s mainline fuel costs (as a percentage of passenger revenue) to fall from 34% in 2014 to 29% over the next two to three years before reverting back to 33% by the end of our forecast period. Consequently, the airline’s EBITDA margin is expected to improve from 27% in 2014 to over 30% in the next two years and, thereafter, fall back to its 2014 levels by the end of our forecast period.

See our Base Case Scenario for Alaska Air here

Bear case: V-shaped Oil Price Recovery (-19%)

If we look at a more optimistic oil price scenario, where we presume that demand for crude oil will improve significantly due to increased economic activity in China and, concurrently, the tight oil production in the US will decline, there could be a possibility of a sharper, V-shaped recovery in crude oil prices. Moreover, if the OPEC decides to change its current stance and cut its production, we estimate the crude oil prices to reach over $120 per barrel by the end of our forecast period.  In that case, we estimate Alaska Air’s mainline fuel costs to rise sharply to over 40% of its revenue by the end of our forecast period, significantly higher than 34% in 2014. Accordingly, the EBITDA margin of the airline will fall drastically from 27.4% in 2014 to under 20% by the end of our forecast period. The price estimate for Alaska Air in this scenario would fall to $56 per share, a 19% downside to its stock price in our base case scenario.

See our analysis for V-shaped Oil Price Recovery for Alaska Air here

Bull case: Sustained Decline in Oil Prices (+17%)

Contrary to our V-shaped recovery scenario, if demand for oil does not improve either because of a continued slowdown in the Chinese economy, or due to the use of alternative fuels owing to technological advancements, oil prices will take longer than expected to recover. Additionally, if the OPEC continues to operate at its current production levels or alternatively plans to increase its production rates to eliminate competition and increase its market share, the global oil market will experience depressed oil prices for a prolonged period. If this scenario becomes a reality, we estimate Alaska Air’s mainline fuel costs to drop to 25% of its revenue over the next two years, and then increase to almost 27% by the end of our forecast period, boosting the airline’s profits to new heights. In this case, the airline’s EBITDA margin will escalate to 34% in the next couple of years before stabilizing at 32% in the outer years of our forecast period. Driven by this, we arrive at a price estimate of $81 per share for Alaska Air’s stock, an upside of 17% to our current price estimate for the airline.

See our analysis for Sustained Decline in Oil Prices for Alaska Air here

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