Buy, Sell or Hold: The Libya Crisis and Record Oil Prices Will Ground United Continental Holdings Inc. (Nasdaq: UAL)

The growing Middle East unrest - and the impact that the turmoil and the resulting uncertainty is having on global oil prices - is clobbering the airline sector's bottom line. The crisis is far from over, and the implications of the higher fuel costs have not yet been fully discounted by the market.

The bottom line: It's time to sell United Continental Holdings Inc. (Nasdaq: UAL) - before it breaks down to new levels of weakness (**).

An Industry Under Fire

Airline economics are nightmarish during a period of rising prices. In fact, at current levels, fuel accounts for about 40% of an airline's costs - a hefty jump from 30% last year and only 25% a decade ago.

And jet fuel - like its gasoline-pump sibling - is derived from crude oil.

Crude prices touched their highest points in two-and-a-half years last week: Oil futures traversed the $100-a-barrel level in New York, and hit an intraday high of nearly $115 in London.

The price of jet fuel reached $3.04 a gallon on Thursday.

For New York and London crude futures - and for jet fuel - these are the highest prices since October 2008.

And as that old Bachman-Turner Overdrive (BTO) tune tells us: "You Ain't Seen Nothing Yet."

The Middle East crisis - which ignited this run-up in crude prices - is destined to get worse.

In Libya - which accounts for 2% of the world's oil and exports a million barrels a day - production already was down by as much as 400,000 barrels a day last week. The crisis in that country is going to "escalate alarmingly," Navi Pillay, the United Nations' high commissioner for human rights - and the world's top human-rights official - said Friday.

And if it does, you can be sure that unrest and civil disobedience will spread to other Middle East/North Africa (MENA) nations - many of them much bigger oil producers than Libya.

Money Morning Contributing Writer Kent Moors, one of the world's top oil-industry consultants and analysts - has repeatedly stated that $150-a-barrel crude oil is very possible and outlined four "aftershocks" that could make his prediction come true.

Japan's Nomura Holdings Inc. (NYSE ADR: NMR) has an even bleaker view. The Tokyo-based investment bank said Wednesday that the loss of all oil production in Libya and Algeria (a North Africa neighbor that's also experiencing protests) could cause crude prices to skyrocket to $220 a barrel.

Unfortunately, rising oil prices aren't the only headwind that airlines now have to buck. I see five major challenges that, brought together, form a list I've entitled "Five Reasons to Sell United."

And here they are:

  • Higher fuel costs will take a direct bite out of the company's bottom line.
  • The increased fuel costs are prompting airlines to raise fares, which is forcing many consumers and business travelers to reconsider travel plans.
  • Increased credit-default-swap (CDS) costs to insure company debt.
  • The cost of issuing debt - which capital-intensive businesses such as airlines need to be able to do in order to finance their operations - will rise, since borrowers will see airlines as a bigger risk.
  • And the higher fuel costs will crimp both profits and cash flow, reducing the ability to bolster profits by repurchasing stock.

To understand why this is so, let's take some time to understand United Continental.

The Not-So-Friendly Skies

Among the many investing axioms often quoted by institutions, one says (quite candidly): "You can't hedge forever." While United has some hedges against higher fuel costs in place, most of those will be gone (expired) by this time next year.

This limits United's ability to absorb higher fuel costs going forward. The company's hedges may help the firm offset rising costs all the way to $110 per barrel. But above that price level, the carrier will feel the pain.

And if oil-and-fuel prices remain elevated at this level or higher for any length of time, the airline's bottom line will sustain serious damage.

As United passes its higher fuel costs on to consumers in the form of higher ticket prices - a reality we're already seeing - consumers will very likely reduce what they spend on air travel. That's just basic economics.

"Although airline management teams continue to express optimism regarding air travel demand and the sustainability of capacity discipline in the wake of industry consolidation, the recent surge in energy prices highlights the industry's vulnerability to sharp and sudden changes in jet fuel costs," said a Fitch Ratings Inc. report released last week.

The cost of credit-default swaps (CDS) on United Continental debt also have started to rise. This will affect the ability of the company to come to market with fresh debt. The higher the CDS costs, the more it costs the company to insure its debt - and the more it costs to issue debt.

An important secondary impact of this development is that energy costs will eat away at free cash flow (FCF), which will make it tougher for the company to retire debt early or to buy back stock.

The Airline of Airlines

The original United Airlines was founded in 1934. United Continental is the result of the merger that brought together United Airlines and Continental Airlines. It created a company with 80,000 employees who operate approximately 5,800 flights per day. The airline flies to 371 airports throughout North, Central and South America, Europe and Asia. The company is based in Chicago.

One result of the merger was a large pile of legacy debt left over from the two formerly independent carriers.

In addition to the debt service, the merged company now has to deal with higher fuel prices.

United Continental’s shares closed Friday at $23.95. They are trading pretty much in the middle of their 52-week range of $15.64 to $29.75.

The stock market had a small but sharp correction last week as oil prices spiked. The price of oil retreated a bit late in the week on news that the margins in "futures shops" were increasing. This helped drive down oil prices as speculators had to sell or raise cash from someplace else. That allowed UAL shares to pop up a little from the hard selling they had seen.

Let's use that mild "pop" in UAL's stock price to sell into. There are far safer places to have your money than in an airline stock during a period of sustained rising fuel prices.

Action to Take: "Sell" United Continental Holdings Inc. (Nasdaq: UAL) - at the market, and before it breaks down to new levels of weakness

United is a highly liquid stock. Let's look to sell any legacy exposure you have to UAL and hold cash during these turbulent market times. The Middle East is in the middle of a revolutionary period; it will not regain prior stability in the near-term.

United Continental is a "Sell" as long as energy supplies are unstable and causing recessionary fears in the company's biggest markets.

(**) Special Note of Disclosure: Jack Barnes has no interest in United Continental Holdings Inc. (Nasdaq: UAL).

[Editor's Note: "Buy, Sell or Hold" columnist Jack Barnes started his career at Franklin Templeton in 1997, working in the company's fund-information department - just as the Asian contagion infected the Asian tiger countries. He launched his own RIA shop in 2003, just as the second Gulf War was breaking out. In early 2006, after logging a one-year return of nearly 83%, Forbes named Barnes the top stock picker in its "Armchair Investors Who Beat the Pros" competition. His two audited hedge funds generated double-digit returns in 2008. Barnes - the author of the popular blog, "Confessions of a Macro Contrarian" - retired to the beach in the summer of 2009, and continues to write from there now.]

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