Green Energy Investing For Experts, Part IV
Tom Konrad, CFA
Mass air travel is incompatible with a sustainable economy. Air travel is energy and capital intensive, creates a gigantic carbon footprint, and is likely to remain dependant on the high energy density of fossil fuels much longer than surface transport. As such, it is a prime candidate for the short side of a clean energy portfolio.
I’m writing this post on a United Airlines (UAUA) flight from Baltimore to Denver in a seat that cost me $99, plus $15 to check a bag. One sign of the economic unsustainability of flying me and my luggage at 8 cents a mile is airlines increasingly undignified scramble for marginal revenue, like that charge for checked baggage.
My flight left a half hour late because of airlines’ desperate attempt to raise more revenue without raising prices by charging for checked baggage. This has the unintended but unsurprising consequence of encouraging people to bring larger and more carry-on baggage, and spend more time wrestling it into the overstuffed overhead bins.
Because most airlines are now charging for checked bags, it will be difficult for an airline to switch to a more rational policy that does not encourage passengers to bring excess carry-on baggage causing needless delays without making their prices seem relatively more expensive than their competitors. (It’s interesting, if not statistically rigorous, to note that JetBlue (JBLU) does not charge for the first checked bag, and Southwest (LUV) does not charge for the first two. Both usually seem to be among the best airlines for on-time departure rates.)
Airlines blamed an increase in flight delays on weather in October. I blame it on the increase in passenger awareness of the increased cost of checking bags. In the short term, dropping ticket prices and charging for baggage will probably create a boost for airlines bottom lines. In the long term, delays and strained backs from packing fewer, heavier bags can only decrease demand for air travel, just as the indignities of airport security have already made many potential passengers think twice when considering air travel.
The Icarus Industry
The above rant about checked baggage is just an example. Airlines’ economic woes are longstanding. Airlines’ current pursuit of short term revenues at the expense of the industry’s long-term viability is more a symptom than a cause of industry woes. Rather, the problem is chronic over-investment (by both private investors and governments) in the airline sector. Flight has a visceral emotional appeal to humans, and industries with emotional appeal attract both government support and investment dollars, even from investors and governments who should know better.
With nearly unparalleled emotional appeal, the airline industry has been in a state of chronic oversupply practically since its inception. This deprives airlines of pricing power, and makes it impossible for the industry to recoup its true costs over the long term. Over its entire 120 year existence, the airline industry has racked up a net loss. I think the Financial Times aptly summarized the consequence of these horrible economics in the line: "Grown up investors avoid the airline industry."
As bad as the history of the airline industry has been, I expect the situation to get worse over the next few years. As we’ve seen since 2008, air passenger demand is highly sensitive to the health of the economy. Hopes of economic recovery are seen by industry insiders as key to a "return" to industry profitability. But in the current era of tight oil supplies, economic recovery will boost demand for oil, and raise the price of jet fuel, airlines’ single largest cost category. The following slide is taken from a 2004 presentation by Dr. Chris Smith of SH&E, an airline consultancy [pdf.] With oil prices now around $70 a barrel, we will have seen another increase in the fuel cost category almost as large again as the rise shown.
My $114 flight on a Boeing 757 from Baltimore to Denver alone used about 18 gallons jet fuel (using numbers from here). Unlike motorists, airlines pay little or no tax on jet fuel, meaning that any increase in oil prices will cause a much larger percentage increase in airline operating costs than it does for ground transportation.
In short, airlines are a major source of marginal demand for oil. Since the realities of peak oil constrain the expansion of supply, increases in demand for oil fueled by economic growth or decreases in supply caused by depletion must be matched to decreases in demand somewhere in the economy. Air travel’s profligate use of oil and relative price sensitivity mean that the industry will continue to reduce consumption faster than other transport sectors. Given slow turnover in the airline fleet and stagnant efficiency improvements, most of the decrease in oil use will have to come from a decrease in passenger miles traveled.
Substituting alternative fuels for oil is also unlikely to help the economics of aviation. A recent Rand study states, "Early in our study, we recognized that certain fuels may be more appropriate for automotive applications than for aviation. Moreover, supplies are limited for nearly all the alternative fuels we examined." (Thanks to Jim at The Master Resource Report.) In other words, alternative fuels don’t solve the underlying problem of not enough liquid transportation fuel to go around.
There’s also the real chance that airlines will not only have to deal with peak oil, but climate change legislation as well. Even if a global tax on air travel does not come out of the Copenhagen summit, airlines are an easily identifiable target for lawmakers and other groups interested in reducing global warming emissions.
None of this will not be good for airline stocks, making the industry a prime candidate for the short side of a green portfolio, the focus of this series. (So far, I’ve also looked at the Mexican economy, and Shale Gas.)
How to Short Airlines
There is an airline sector Exchange Traded Fund (ETF), the Claymore/NYSE Arca Airline ETF (FAA), but, as I found with the iShares MSCI Mexico Index Fund (EWW), it is not widely held, and shares are not available for shorting. Like Mexico, but unlike shale gas, I expect peak oil to erode the economics of aviation over time, and I think this erosion is fairly likely. Hence, my preferred instrument is to short a stock in combination with a long call on the same stock, and my second choice would be a short call spread. (See the Mexico entry in this series for my reasoning.)
In the case of EWW, I chose to use a short call spread, because most of the EWW’s holdings are not traded on US based exchanges, and so I would also have had trouble obtaining individual Mexican shares to short. In contrast, many airline shares are widely traded and held, so, rather than selling a short call spread that might require me to cover in haste if an early exercise left me in a short position without available shares to borrow, and so I chose to short individual airline stocks.
Since I’m not an airline industry expert, I wanted to short a representative sample of the airline industry similar to what I would have found if I were to short FAA, so selecting airline stocks to short was as simple as picking the largest holdings of FAA.
The top three holdings are Delta Air Lines (DAL) at 16.6%, AMR Corp (AMR) the parent of American Airlines at 16.3%, and Southwest Airlines (LUV) at 14.7%. Beyond these three, the next largest holding is United Air Lines (UAUA) at only 4.4%. Since the top 3 holdings compose 47.6% of the ETF, shorting these three should provide most of the diversification benefits of shorting FAA, but with much better liquidity. While FAA trades an average of 21 thousand shares a day, Delta, AMR, and LUV trade about 12, 18, and 9 million shares a day, respectively. They are also all widely held, making it simple to borrow shares to short, and exchange traded options expiring in January 2012 are available. In contrast, the longest-dated options available on FAA are for June 2010.
Since airlines are one of the least green and most energy intensive forms of transport, a green investor should seriously consider shorting DAL, AMR, and LUV (combined with appropriate out-of-the-money long calls) as an investment in efficient transport.
DISCLOSURE: Short EWW, UAUA, AMR, DAL, and LUV.
DISCLAIMER: The information and trades provided here and in the comments are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.