British Airways (LON:BAY) CEO Willie Walsh says it’s “the worst trading environment the industry has ever faced.”

But crude oil’s retreat from its early-July peak has led investors back into the industry, says Martin Denholm in The Smart Profits Report.

And Martin’s colleague Marc Lichtenfeld has given potential investors two stocks to watch should the uptrend continue. Here’s more from Martin…

If the world’s airlines were on the singles scene, looking for potential mates, many of them would be out of luck.

Having dressed themselves up as best they can, slapped on their best deodorant and after-shave, you can picture them at the end of a night of unsuccessful bar-hopping, looking drunk and desperate.

After all, what do they have to offer? It’s a grim business at the moment, with oil prices having pushed companies to breaking point and fuel prices now sucking up the bulk of annual expenditure.

Take British Airways, for example. The company reported a 90% plunge in its first-quarter profits, as fuel costs soared by 49%. BA projects a meager 3% rise in revenues this year in what CEO Willie Walsh calls “the worst trading environment the industry has ever faced.”

What’s This? A Pleasant Airline Experience?

For all its British charm and tagline as “the world’s favorite airline,” BA hasn’t helped its cause this year, thanks to the PR disaster around the opening of its swanky new Terminal 5 at Heathrow Airport in London.

Computers crashing. Thousands of bags lost. Hundreds of flights delayed or cancelled. The terminal resembled more of a campsite than anything else, as passengers lay around, increasingly not expecting to fly, but hoping to.

I’ve flown BA many times. They’ve always done the job pretty well. But over the past few years, the company’s higher prices (relative to other airlines – and especially in terms of taxes) have put me off.

Still, I chose BA for my recent trip back to Britain – and was impressed. Yes, BA ticket prices rose 7% over the past quarter, due to its fuel surcharge increase. But I nipped in ahead of the most recent hike.

Besides, the height of summer means there’s little difference between airlines’ overall prices. Plus, it was a direct flight from Baltimore, with the best departure and arrival times. Not to mention… free booze! As most other airlines charge for drinks, BA has maintained its free alcohol policy on international flights. And I’m not ashamed to say that I took full advantage! There was also a plentiful and diverse selection of in-flight entertainment. And no charge for checked bags or headsets. We Brits can be a generous bunch!

Consolidation Amid Chaos

It’s transatlantic routes that BA is depending on to generate a sizeable chunk of its revenue, and it seems the airline will take another stab at arranging a mega-alliance with American Airlines.

With the Open Skies transatlantic agreement having increased competition, the current state of the airline industry means that more co-operation is probable. Airlines cannot afford to get into a cost-cutting war with each other at a time when profits are elusive anyway.

Last week, BA detailed plans to merge with Spain’s Iberia, but its proposed alliance with AA (in conjunction with Iberia) will have to satisfy authorities that it doesn’t break antitrust laws. While not an official merger, complete with costs and bureaucracy, it allows airlines to split routes, charge the same prices, and share profits and costs.

Northwest and Delta have already succeeded in this type of deal with Air France-KLM (EPA:AF), but the BA-AA agreement might be harder to push through, as it would create a “dominant mega-power on transatlantic air routes from two of the largest EU members,” according to a spokesman for Virgin Atlantic.

This isn’t a new development for BA and AA. The two firms originally applied for antitrust immunity in 1997 and again in 2001, but BA refused to bow to regulators demands to give up what it thought were too many landing slots at Heathrow.

But with Iberia now on board (pardon the pun), the two hope for a positive outcome. They already have strong links through the One World Alliance and Iberia’s inclusion would give BA and AA a route into the Latin American market, where neither holds a dominant position. In addition, the firms argue that recent consolidation has already strengthened the position of some of its rivals.

And now that the Open Skies agreement has made Heathrow available for other airlines – rather than the previous arrangement, whereby just four transatlantic carriers could fly in there (BA, AA, United and Virgin) – the deal has a better chance of success.

Relief… From Oil

In addition to its transatlantic alliance efforts, BA (and indeed other airlines) is enjoying some much-needed respite from the oil market’s recent decline. With prices having slipped from $147 to around $119 in the space of just a few weeks, my colleague and commodities expert Lee Lowell said in his “Commodities Corner” column yesterday that the next support point could be $107 if the current downtrend continues.

Once upon a time, that price would have caused heart attacks among airline executives, but after this year’s brutal price runup, they’d gladly take it now.

Seems like a drop in oil demand from businesses and consumers alike because of the high price is finally leading to some air being let out of this blown up market. Having fallen for four straight weeks, gasoline prices are down 6% from their peak in July.

And the drop is helping the airlines…

Go Contrarian… It Works

Take a look at this chart…

It’s a yearly chart of the AMEX Airline Index (XAL). Note how the drop in oil prices over the past month has led investors back towards airline stocks.

Back on June 3, my colleague Marc Lichtenfeld highlighted XAL and pointed out that the industry may well be in line for a rebound if it could shrug off its two-year downtrend and form a “basing” pattern. Here’s what he said:

“Keep an eye on the XAL chart. Should the index “base” (stop going down and then flatline), or even reverse the downtrend and head higher, the market is likely signaling a recovery.

“I wouldn’t necessarily get into airline stocks for the long term, as I believe the business model is flawed, but an intermediate-term trade seems quite reasonable once the bleeding stops.”

In the column, Marc gave two airline stocks for potential investors to watch – Alaska Air Group (NYSE: ALK) and Southwest Airlines (NYSE: LUV). Alaska Air has edged down just 2.7%, while the ever-popular Southwest has reaped better rewards, jumping 21%.

And as Marc noted from his own recent flying experiences, flights remain very full – a trend that held true on my Baltimore-London round-trip, too. The depressed dollar and lousy exchange rate certainly didn’t seem to put many folks off a jaunt to England. Not a spare seat to be had. Same story on the way back, too.

Don’t get me wrong… airlines remain in trouble and a return to profitability seems a very long way off for many of them. But if oil prices continue to fall and stabilize, it can only spell good news for this most beleaguered of industries and gives it a chance to get back on its feet. Or, more appropriately, take off.

Source: As Oil Goes Down, Airline Industry Rebounds

The Atlanta-based Delta bought Northwest for $3.63 billion, all in stock, creating a single carrier with a combined enterprise value of $17.7 billion. The landmark deal is expected to ignite an industry consolidation wave, as small or struggling airlines go for size in order to compete with Delta’s newfound market heft at time when a slowing economy and soaring fuel costs are eviscerating profit margins for marginal players.

“Expect [the] dominoes to fall,” Bear Stearns Cos. Inc. (BSC) analyst Frank Boroch wrote in a note to investors.

Four smaller U.S. airlines have filed for bankruptcy in the past month – Frontier Airlines Holdings Inc. (FRNT), Skybus Airlines, Aloha Airgroup, Inc. and ATA Airlines Inc.

And now that the first major hurdle of Delta’s Northwest acquisition has been cleared, talks between UAL Corp.’s (UAUA) United Airlines and Continental Airlines Inc. (CAL) will elevate in priority.

Since 2001, U.S. carriers have shed more than 150,000 jobs and lost more than $29 billion.

Looking ahead, a report from Calyon Securities predicted the U.S. airline industry would lose more than $1 billion in 2008, mostly from the one-two combo of high fuel costs and shrinking demand, Reuters reported. However, top carriers Delta and Southwest Airlines Co. (LUV) are best positioned to weather the storm, Calyon analyst Ray Neidl said.

The new Delta is expected to generate more than $1 billion annually in revenue, even as it streamlines operations and trims overhead. And its balance sheet will have an expected liquidity of about $7 billion at the close of the deal.

“Today, we’re announcing a transaction that is about addition, not subtraction,” Richard Anderson, Delta’s Chief Executive Officer, said in a statement.

What’s In Store for Investors

Under the transaction’s terms, Northwest shareholders will receive 1.25 Delta shares for each Northwest share they own – a 16.8% premium based on April 14 closing prices.

The merger is subject to the approval of Delta and Northwest shareholders, and must also pass muster with regulators. It is expected that the regulatory review period will be completed later this year.

Board Members, Pilots Shuffled

Delta’s Anderson will be chief executive officer of the combined company. Delta Chairman Daniel A. Carp will become chairman of the new Board of Directors.

Northwest Chairman Roy Bostock will become vice chairman. Ed Bastian will be president and chief financial officer.

The board of directors will be made up of 13 members, seven of whom (including Anderson) will come from Delta’s board, and five of whom will come from Northwest’s board, including Bostock and Doug Steenland, the current Northwest CEO. One director will come from the Air Line Pilots Association (ALPA).

Delta’s 7,000 pilots sealed the agreement by supporting a new labor agreeing that includes an equity stake.

Northwest’s 5,000 pilots will be asked to join a contract before the deal closes, but Reuters reports that they will use “all resources available to aggressively oppose” the deal after the unions could not agree on how to work under one seniority umbrella, a key determinant of shifts, pay scale and what airplanes they fly.