Aviation fuel prices: the logic of supply-demand. Airline stocks could be attractive

High oil prices, whether or not they are really being pumped by speculation, are certainly affected by a built-in price push due to uncertainty about supply, as well as a sentiment that demand elsewhere in the world remains strong. So long as that situation remains, airlines will suffer. But a price turnaround to the downside could be almost as rapid as the recent rise if sentiment shifts substantially, in an increasingly fragile market. Even a USD20 fall in global oil prices would cause airline stocks to surge.

The bottom line of the supply-demand equation is that the price should at some stage reflect underlying demand in the market. And, if demand softens as economies slow, the simple next step is: the price should come down. That at least is the logic. Until now, that logic does not seem to have applied, as the cost of a barrel of crude went through the ceiling.

In his half yearly presentation to the US Senate, Bernanke yesterday most pointedly raised the joint spectre of credit softening, along with inflation. This is the economic manager's nightmare, as the tool of lower interest rates, producing a lower dollar, only fuels inflation. But to increase interest rates to slow inflation risks further dampening economic activity, and so on.

As the Fed Chairman said yesterday: "The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth." However, "the currently high level of inflation, if sustained, might lead the public to revise up its expectation for long-term inflation," which could stimulate "an unwelcome rise in actual inflation over the longer term."

In many other parts of the world - notably the fastest growing aviation regions, the Middle East and Asia - inflation is in fact currently the biggest fear, while economic slowdown is only just appearing on the horizon. Governments of countries from the Gulf, through south Asia to China are currently grappling with inflation rates that still disguise, or even temporarily offset major signs of economic slowdown. So interest rates are being forced upwards.

The Gulf states and India already have double digit inflation, economic tiger Vietnam's is in the high twenties and the gap between China's GDP growth and its inflation rate is now wafer thin. The fast growing economies of South America and eastern Europe are feeling similar pressures.

So long however as the major non-US economies are still showing consumer strength, actual global fuel consumption remains high. But once the signs emerge of economic slowdowns elsewhere, oil price sentiment must surely shift. And, as we have seen recently, there is a high dose of sentiment in the existing price, suggesting that the price could drop as quickly as it rose, once that point is reached.

Yesterday, US contrarian billionaire investor, Wilbur Ross, put down USD80 million to help save Indian LCC, SpiceJet, awash in the sea of red ink that is India's airline business. He may be taking a longer term view of the market. But, for others looking at an inflated oil price, the potential exists for a quick upside, as global economies cool.

Watching the inverse correlation between airline share and oil price fluctuations recently, the short term view could have merit.