Oil prices surged between mid-August and early October, with the price of Brent crude topping out at more than $85 per barrel. This increased the pressure on airlines to boost unit revenue to offset higher costs -- and pressured shares of some lower-margin airlines.
The oil price rally was driven primarily by the fear that U.S. sanctions on Iran would trigger a global supply shortage. That fear began to dissipate over the past month -- and nearly vanished after the U.S. government granted temporary sanctions waivers to eight oil-importing countries earlier this week. Lower oil prices should lead to better profitability for airlines. That's particularly good news for American Airlines (NASDAQ: AAL) and Spirit Airlines (NYSE: SAVE) .
The potential fuel cost headwind was substantial
The late-summer oil price rally drove the price of Gulf Coast jet fuel up to a peak of nearly $2.35 per gallon in the first week of October. Including transportation expenses and fuel taxes, this would have pushed airlines' fuel costs above $2.50 per gallon.
While fuel prices had moderated somewhat by mid-late October -- when airlines released their Q4 forecasts -- most carriers still expected higher fuel costs to weigh on their earnings. But some airlines were more vulnerable to rising oil prices than others.
For example, American Airlines is starting with a profit margin near the bottom of the industry. That means any further deterioration in its profitability would have a severe negative impact on its earnings. Its Q4 guidance calls for an adjusted pre-tax margin between 4.5% and 6.5% -- down from 7% a year earlier -- based on an average jet fuel price between $2.30-$2.35 per gallon (up from $1.91 per gallon a year earlier). At the bottom of the margin forecast range, American's pre-tax profit would decline by about a third on a year-over-year basis.
High fuel prices pose a major threat to American Airlines' profitability. Image source: American Airlines.
Meanwhile, Spirit Airlines is particularly susceptible to fuel cost increases because its low nonfuel costs mean that fuel accounts for a bigger piece of its cost structure than at other airlines. For the fourth quarter, every $0.10-per-gallon increase in the price of jet fuel would reduce its pre-tax margin by about 1.3 percentage points, all else equal.
Prices are coming down again
Fortunately for American Airlines and Spirit Airlines, fuel prices moderated last month, as investors began to turn their attention toward threats to global oil demand. This week, the U.S. dashed any realistic hope of a quick rebound by granting partial oil sanctions waivers to China, India, Japan, Greece, Italy, South Korea, Taiwan, and Turkey.
Without sanctions waivers, these countries would almost certainly have been forced to cut their imports of Iranian oil to zero beginning this week. Given that Iran is a major oil exporter, this could have caused a short-term supply shortage, driving oil prices higher.
The waivers will allow these countries to continue importing oil from Iran for at least 180 days. That said, the level of oil sales allowed under the waivers is generally less than what these countries had been importing from Iran earlier this year.
Demand worries, rising oil inventories, and the looser-than-feared sanctions regime have combined to drag the Brent crude price down to just over $70 per barrel, the lowest price in nearly three months. That has also brought jet fuel prices down.
Expect better profit margins
For the past few days, the price of Gulf Coast jet fuel has lingered around $2.10 per gallon, about $0.25 per gallon below the high reached in early October. It's also lower than the fuel price estimates that American Airlines and Spirit Airlines used to build their forecasts.
In recent quarters, American Airlines' average "all-in" fuel price has tended to be about $0.18 per gallon higher than the average jet fuel spot price for the same period. Spirit's fuel price is usually about $0.06 per gallon higher than what American pays. American's Q4 fuel price forecast of $2.30-$2.35 per gallon thus implied an average Gulf Coast jet fuel price of about $2.15 per gallon. Spirit Airlines' $2.46-per-gallon fuel cost forecast assumed an even higher Gulf Coast jet fuel price of roughly $2.22 per gallon.
If fuel prices remain near today's level, it would help American Airlines achieve a pre-tax margin near the high end of its guidance range this quarter. Spirit Airlines could be in even better shape. Lower fuel prices could potentially boost its Q4 pre-tax margin by about 1 percentage point relative to what its guidance had implied. That could be the difference between flattish earnings per share and double-digit EPS growth.
Of course, the oil market is very volatile, so there's a chance that the recent downturn in fuel prices won't last long. But if a new oil price rally fails to materialize, it could pave the way for higher earnings at American Airlines and Spirit Airlines, supporting shares of both companies.
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Adam Levine-Weinberg owns shares of Spirit Airlines. The Motley Fool owns shares of Spirit Airlines. The Motley Fool has a disclosure policy .