How Sensitive Is American Airlines’ Price To Crude Oil Prices?
The sudden plunge in crude oil prices in mid-2014 led to a turnaround in the fortunes of the US airline industry. Since fuel costs form the core operating cost of an airline, the sharp drop in this cost boosted the earnings of these airlines. In turn, the airlines utilized the increased profits to revamp their operating fleet as well as balance sheet to return higher value to their shareholders. However, the rebound in crude oil prices over the last few quarters has led to a decline in the profitability of these airline companies. In this note, we show how a change in crude oil prices can impact the profitability as well as valuation of American Airlines (NASDAQ: AAL) using our interactive dashboard.
No Hedge Policy Makes American Highly Susceptible To Oil Price Movement
Fuel costs constitute roughly one-third of an airline’s operating costs. Hence, a marginal change in crude oil prices can significantly impact its profitability. Consequently, airlines hedge a large portion of their annual fuel consumption at lower oil prices in order to protect themselves from the volatility in oil prices. However, unlike other legacy carriers, American Airlines does not hedge its fuel consumption, making its bottom line highly susceptible to even a small movement in oil prices.
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Based on our analysis, a $1 per barrel rise in crude oil price could result in a 1% rise in American’s fuel cost. For instance, if the oil prices jump by $5 per barrel, it will cause the airline’s fuel expense to shoot up by 5% (blue bars). This will cause the airline’s net income margin to drop and result in lower earnings per share.
If crude oil prices rise by $5 per barrel, and we assume the same P/E multiple of 11.8x, we arrive at a price estimate of $39 per share, which is roughly 21% lower than our base case price estimate of $50 per share. Thus, we figure that American’s valuation is highly sensitive to the movement in oil prices.
Do not agree with our forecast? Create your own price forecast for American Airlines by changing the base inputs (blue dots) on our interactive platform.