Fuel Efficient Airlines

In investing, the prospect of crisis has always been a sort of summons for me. It’s like when I was a little boy and the ice cream truck’s jingle sent me running for loose change on a hot summer day. These days, I’m just trying to get at goodies of a different sort — profitable investment ideas, instead of ice cream bars.

And today’s aviation industry has a big crisis on its hands. As a percentage of airline costs, fuel is now about 35 percent of the total — up from only 13 percent at the start of the decade. It is the airline industry’s No. 1 expense. The cost of fuel puts enormous pressure on the industry. At the same time, regulators are pushing for cleaner planes with fewer emissions.

“The price of oil has challenged and changed all realities for the aviation industry,” says Tim Clark president of Emirates, a Dubai-based carrier. “This is the greatest crisis in aviation’s history — bigger than the Gulf wars, Sept. 11, SARS and past oil shocks.”

If oil prices stay where they are and nothing else changes, the airline industry will lose about $6 billion this year, compared with a profit of $5.6 billion last year. Many airlines will be taking that familiar stroll into the bankruptcy courts. Globally, 24 airlines have already filed in just last the seven months.

The industry is trying — and will try — lots of different tactics to fend off elimination. One of these is to push for more fuel-efficient aircraft. And that is the opportunity for investors to cash in on this crisis.

It starts with the jet engine. Recently, the Wall Street Journal published “Jet Engine Makers Launch New War” — all about the drive for new fuel-efficient engines. The piece notes that airlines worldwide want to replace their existing fleets with next-generation planes, not the current oil-guzzling models. The goal of the jet engine makers — or rather, the mandate put to them by their customers — is to deliver at least double-digit gains in fuel-efficiency.

As the WSJ reports: “Developing fuel-efficient engines requires the use of exotic alloys and ceramic coatings that can cope with internal engine temperatures that would be above the melting points of untreated metal components.”

Enter cobalt. It’s a tough metal with a high melting point of 2,700 degrees Fahrenheit. This higher melting point allows it to maintain its strength at higher temperatures than other metals can. Cobalt alloys have higher melting points than either nickel or iron alloys.

As a result, one of the main uses of cobalt is in superalloys such as those that jet engine makers need. In fact, the making of superalloys consumed about a quarter of global cobalt production, of which about 75 percent wound up in aircraft.

Cobalt would seem to have a nice backdrop of long-term demand. But it doesn’t stop there. Defense spending is also on the rise globally. A Financial Times report on aerospace notes that India, China, Brazil and certain Middle Eastern countries are all upping their defense spending. India alone may spend $40 billion in 2009.

Cobalt is an important part of all that, too. In fact, the U.S. and the Soviet Union used to stockpile cobalt for defense purposes. Those stockpiles are long gone, but the role cobalt plays in defense still exists.

As exciting as the aerospace angle is, a potentially bigger market could be batteries for hybrid cars. As I pointed out in the last issue, there are 5-10 pounds of cobalt in a typical hybrid car battery. Hybrid car sales will probably hit 500,000 cars this year. And that is growing rapidly.

Kitco recently noted that cobalt holds an electric charge better than almost any other metal. That makes it hard to replace, even at $50 per pound. “And the current electric batteries work so well,” Kitco notes, “[that] there is little incentive to change their structure (and other metal prices have skyrocketed, as well as cobalt — nothing is cheap anymore).”

With the failure of banks and the troubles of big financials such as Fannie Mae, cobalt seems a nice place to be. A while ago, I recommended a “cobalt play” to the readers of my investment service, Mayer’s Special Situations. The name of the stocks is OM Group (OMG: NYSE). I should warn you that the stock is a bit speculative. But let me share a few of the particulars…

OMG carries a seemingly absurd valuation. It’s not often that you find profitable and growing companies with no net debt trading for big discounts to book value. The specialty chemical industry — a tribe to which OMG belongs — is undergoing heavy consolidation. Companies are getting bought out left and right. Dow Chemical bought Rohm and Haas for a 74 percent premium. And then Ashland came along and bought Hercules for a 38 percent premium.

Companies that make low-margin chemicals are looking to beef up on companies that make high-margin, or specialty, chemicals. Because OMG is cheap and very profitable, it has to be on someone’s radar. I hope that it doesn’t get bought out. I think we’ll do better holding the stock. But the deal-happy scene in the chemical business is another potential backstop of value here.

Hard to believe that anyone could buy all of OMG for anything less than at least book — which is $36 per share. And even that would bring howls of protest. After all, the stock was in the $50s for much of the past year. We will see.

In any event, let’s bring this back around to the aviation crisis. A familiar theme in the pages of my letters over the years has been this Templetonian notion of focusing on the opportunities that problems present. The late great John Templeton made this idea a key component of his investment — and life — philosophy.

The high price of oil is a big problem for many industries.

So if you have a good way to mitigate the high price of oil, you have a business. I think the big winners over the next few years are going to be those companies that have a solution to the high price of oil. Those companies have products that other people will pay up for, because fuel-efficiency is a must. The aerospace industry must become more fuel-efficient.

Cobalt alloys will be a big part of that trend.

Chris Mayer
July 22, 2003

P.S.: Cobalt alloys are certainly going to be a big part of the coming efficiency renaissance in energy. But there has also been another breakthrough recently that could be the biggest moneymaking opportunity available to you. Some are already calling this energy breakthrough a “miracle” and for good reason too. My readers of Mayer’s Special Situations have already been told about this.