“Pack your bags… it’s on.”

So says Southwest Airlines (NYSE: LUV) CEO Gary Kelly at the end of the company’s latest television commercial.

He’d better hope so. The once trend-busting airline, whose savvy fuel hedging strategy and cheap, efficient service helped it chalk up profits, even as its rivals in the airline industry were collapsing, is now coming off three straight quarterly losses, including a $91 million first-quarter drop.

And the company’s May traffic dropped 3.6% from May 2008 – the end of a five-month spell that saw the airline fly 2.2% less revenue passenger miles (which measures miles flown per paying passenger) compared with January-May 2008.

But the airline’s problems are symptomatic of an industry that has partly overcome one big problem, but is now headlong into an even worse one.

The Price of Oil Hits Hard… But Recession Hits Harder

This time last year, the price of oil was around $130 a barrel, approaching the end of a stunning 12-month spike that would eventually see the black stuff hit a record $147.

Airlines like Southwest and Virgin Atlantic, which wisely hedged their fuel costs to combat the worse of the move, fared better than many others. Locking in a set price to avoid the violent day-to-day oil market fluctuations was a critical decision.

For example, Virgin started doing so in 2006 as part of a long-term strategy that recently helped the airline trump the industry trend and post a pre-tax profit of £68.4 million ($109 million) in the 12 months to the end of February. That was double the £34.8 million it recorded during the previous year. That thrashed its major rival, British Airways, which slumped to an annual pre-tax loss of £401 million ($639.4 million).

Today, oil prices are hovering around $70, down 46% from a year ago. And although this is sharply higher than the $40 level as recently as February, it’s nevertheless provided some relief for the airline industry.

But here’s the problem: That decline in oil prices has come as a result of the savage economic downturn in the U.S. and around the world. Global demand for goods and services has tumbled. Credit has dried up. Housing markets have bombed. Banks have gone bust. GDP growth has turned to contraction. Profits have sunk. And the jobless masses have risen around the world.

Hardly the recipe for increased airline travel.

The Airline Industry: A “Lose-Lose” Business Model

The problem with the airline industry is that in business terms, it can be “lose-lose,” no matter what the economy is doing…

When the economy is solid, demand rises and more people fly. But a rising economy also pushes up oil prices and offsets the airlines’ bottom line. Add to that the large number of carriers within the airline industry all fiercely competing and battling to win passengers, and that eats into profitability, too.

When the economy is struggling and the job market is poor, many people have less disposable income – and consequently fewer people want to fly. Here in Baltimore, for example, BWI Airport saw 7.5% fewer passengers in March, compared with March 2008. In addition to less demand, oil is a volatile resource, under threat from geopolitical shenanigans at any time.

Right now, of course, we have the latter. And the numbers paint an ugly picture…

The Airline Industry Projects Double Losses

The current situation just led the International Air Transport Association (IATA) to double its projected loss for the airline industry this year.

• From an estimated $4.7 billion loss as recently as March, it now forecasts $9 billion worth of losses.
• Airline industry revenues are projected to hit $448 billion this year – a 15% drop over 2008.
• By region, the numbers show a $1 billion loss for North American airlines this year (much better than the $5.1 billion loss in 2008, but this is largely due to the oil price decline)… a $1.8 billion drop for European carriers… and a $3.3 billion tumble for airlines in the Asia-Pacific region.
• On Monday, Japan Airlines, which boasts the best revenues in Asia, said it will cut its international routes by 10% during the current business year. It was the latest in a string of route cutbacks from global airlines.
• The IATA says passenger demand will fall by 8% to just over two billion this year, with cargo demand suffering a 17% drop, as the global economy slumps.

Quoted in the New York Times, the IATA’s director-general Giovanni Bisignani states, “There is no modern precedent for today’s economic meltdown. Our industry has been shaken. Whether this crisis is long or short, the world is changing. It will not be business as usual in the post-crisis world.”

2 Ways To Play The Airline Industry’s Future

This year, the airline industry will spend an estimated $106 billion on fuel – 35% less than the $165 billion it splashed out in 2008.

But as the global economy recovers and prices rise again, Bisignani says the airline industry’s future “depends on a drastic reshaping by partners, governments and industry.”

• Having risen pretty strongly off its March lows, the Airline Index ($XAL) could be set for some turbulence if the IATA’s projections play out. While you can play this downside through the index, it doesn’t have options available, so you may want to opt for the increased flexibility of an ETF.
• You can do so through the Claymore/NYSE Arca Airline (NYSE: FAA), which tracks the NYSE Arca Global Airline Index. It’s a relatively new ETF that only started trading on January 30, 2009. As such, its volume can be a tad light, but it’s rising, and the trading range is large enough to be able to profit.

Martin Denholm
Smart Profits Report