For airlines, oil is proving a two-edged sword

Outside the energy sector, no other industry is as vulnerable to high oil prices as airlines. Soaring fuel prices, by far their biggest operating cost, diverted billions of dollars this year that otherwise would have flowed to their bottom line.

So finally, some welcome relief. Crude-oil futures fell as low as $75 a barrel in New York trading Wednesday, down by nearly half from the record-high $147 they hit back in July. Typically, this would give airline stocks a huge lift.

So why is the benchmark Amex Airline Index still down 47% this year?
While cheaper crude breathes new hope into airlines, it carries other penalties. Oil is down because demand is grinding lower. OPEC just slashed 100,000 barrels a day from its 2009 demand growth forecast, citing shaky financial markets and mounting evidence that the global economy is in recession.

Included in the downturn is a drop in travel. In their latest quarterly reports, Delta Air Lines and American Airlines parent AMR Corp. gave us a glimpse Wednesday of how tough times are making it harder to fill seats. Hardly surprising. And the trend is likely to extend well into next year as passengers tighten their belts.

Airlines, too, have been tightening their belts, cutting flights and the number of seats they make available in a bid to ram through higher fares. Delta, for example, said it expects to cut domestic capacity by as much as 14% over the next few months. Combined with lower fuel costs, this puts the company on track toward what it called a “modest” fourth-quarter loss, hopefully less than the $50 million it lost in the third quarter. See full story.

AMR, helped by falling oil prices, actually managed to eke out a third-quarter profit. To keep things headed the right direction, the company plans to further reduce domestic capacity in the fourth quarter by about 12.5%. See full story.

But here’s the rub. As cost pressures from high oil prices ease, airlines face a creeping temptation to lure passengers away from competitors by cutting air fares. It’s classic market behavior in an overcrowded industry.

This might be great news for the traveling public. But it could be terrible for long-suffering airline investors, scuttling hope that the industry might finally catch a double break from lower fuel costs and the meaningful capacity cuts needed to sustain profitability.

Finding the elusive balance in this industry has for decades been about as easy as walking a sword’s edge.