Airlines Play the Oil Game Smarter This Time Around

This time, airlines are playing it smart. But airline passengers may not like it. United has become the latest to join the airline bandwagon in hiking airfares to combat ever-rising oil prices.

The fare increase, $10 on domestic routes and $20 on international ones, follows on an industrywide price hike initiated by American Airlines last week that has so far pulled in Delta, Northwest, Continental, and Southwest.

No one wants to stick it to consumers at a time when flight delays and baggage snafus are making headlines for being at all-time highs. But facts are facts. Airplanes need fuel, and crude oil is poised is at $89 a barrel and going nowhere but up.

Airlines are worried that high oil prices could soften or stall their hard-won return to profitability. Southwest just posted a third quarter net that nearly tripled, while American's income was more than 10 times higher than the same period last year (granted, performances not hard to improve upon).

Wall Street reacted positively to the fare increases over the past week, maybe for the same reason they welcomed the string of write-offs from banks—there's some comfort in seeing a company address a problem that is known to be a potentially existential threat.

But airlines can't continue to rely just on passing the cost on to the consumer.

As fuel continues to exert pressure, what will keep airlines from tanking?

Much is made of hedging practices—investment positions that airlines can take which gain value when oil prices rise. When prices first began their breakneck ascent in 2005, airlines were wounded by the fact that they lacked the free cash on their balance sheets to make any significant investment.

Now that airlines finally have the necessary financial leverage, every major carrier has a hedging position, says Jim Corridore, an equity analyst at Standard & Poor's who covers the airline industry.

While most airlines have locked in prices on 20 to 25 percent of their fuel needs, the leader, Southwest, says it has hedged 70 percent of its fuel supply at $51 a barrel.

An alternative to keeping costs low is to keep revenue yield growing. Corridore says he just upgraded Continental to a strong buy based on its focus on international routes and business travelers, which tend to yield higher fare prices and fuller planes.

Richard Aboulafia, who covers airlines for the Teal Group, agrees that oil prices are already so high that airlines missed their major financial opportunity to hedge.

He also stresses that the most successful airlines going forward will be those that keep their planes full and focus on their highest-margin routes.

by Liz Gunnison