When oil prices surged through 2007 and into 2008, many airlines ran for the hills, taking many planes out of service, cancelling orders for new planes and gearing up to conserve cash in case oil prices failed to fall back down. Boeing Co. (NYSE: BA), the world’s largest aircraft manufacturer, was able to ride out that crisis: sales fell just 8% in 2008 and reached a new record of $68 billion in 2009. The company’s exposure to the defense sector, which accounts for half of sales, saved the day.

#-ad_banner-#Fast-forward to 2011 and the dynamic is reversed. The defense department is looking at modest current cuts and potentially much larger cuts down the road. The commercial airline sector, though, has never looked healthier. as carriers benefit from a lean cost structure and a rebounding economy. In effect, Boeing has simply shifted from one leg of the stool to the other. Trouble is, the stronger leg may also start to buckle and shares now carry more risk than many investors realize. In one possible scenario, Boeing may be the worst-performing stock in the Dow Jones Industrial Average in 2011.

Here’s why…

Oil’s upward move
Jet fuel is the largest operating expense for airline carriers. Most carriers operated unprofitably when oil surged in 2008 and remained unprofitable into 2009. Oil prices fell, but so did air travel and airline prices. These days, the industry dynamics are much improved, as a rebounding economy is helping carriers push through price hikes to offset the impact of newly-surging jet fuel prices. AMR (NYSE: AMR), parent of American Airlines, has pushed through seven price hikes thus far in 2011, and all of them have stuck.

But airlines may soon run into trouble. Those price hikes are coming at a time when the consumer remains under duress, most recently from rising gasoline prices and many airline routes are quickly becoming very expensive. Shares of AMR are now just above the 52-week low on concerns that rising jet fuel costs and a possible slowdown in leisure travel will imperil current profit forecasts.
 

Some airlines aren’t waiting around to see how this will play out. United Continental (NYSE: UAL) announced on Friday, March 11, that it will take less efficient Boeing 737 and 767 planes out of its fleet and will no longer stand by prior expansion plans. Delta (NYSE: DAL) and AMR made similar comments in February.

No signs yet
Despite oil’s surge, global airliners have been ordering up new planes in recent weeks. Boeing still has a healthy backlog: the company is scheduled to deliver 500 planes this year, and any production cuts in 2011 are unlikely. If oil prices come back down, then Boeing will likely have dodged a bullet and 2012 production will likely be sold-out as well.

But what if oil prices stay above $100? What if they move to $110 or $120? That’s when the trouble begins. At that price, airlines don’t just mothball planes, they instead look to sell them into the used aircraft market. And as we saw in 2008, a rising tide of used planes for sale can sharply crimp demand for new planes, most notably those ordered by airplane lease finance companies such as AerCap Holdings (NYSE: AER).

It may also be a matter of time before investors start to account for the impact of an increase in competition. The duopoly of Boeing and Airbus has been broken by Canada’s Bombardier and Brazil’s Embraer (NYSE: ERJ) and companies in China, Russia and potentially Japan are also developing 150-seat planes to tackle the regional jet market. Industry publication AirInsight predicted that “while we don’t expect these programs to be particularly successful outside the home markets, these domestic sales will significantly eat into the market shares of Airbus and Boeing. To compete effectively, Airbus and Boeing will need to re-engine their current models around 2015, and introduce break-through technology in the 2020-2024 time frame to leap-frog these emerging competitors.” Yet Boeing and Airbus are counting on those markets as part of their long-term growth plans.

Defense outlook
As another concern, analysts tend to generally discount any talk of a major retrenchment in defense spending. Boeing’s defense unit saw sales fall 4.5% in the fourth quarter compared to the previous year to $8.2 billion, and analysts don’t currently expect to see a major drop-off in sales in coming quarters or years, especially since Boeing just won a large long-term tanker refueling contract. Part of the analyst bullishness stems from the fact that neither President Obama nor Defense secretary Robert Gates has suggested that drastic cuts will be necessary. But the recent bipartisan deficit commissions have. [See: “The Most Important Thing You Need to Know About our Nation’s Out-of-Control Debt”]

The commissions think a fairly hefty cut in defense spending will have to be included as part of the broad efforts to close the budget gap. That may mean that the Department of Defense may need to extend the usable life of many planes and other Boeing equipment, rather than order brand new equipment at past rates.

Action to Take –> It’s too soon to signal the alarm bells for Boeing. But if you own this well-known Dow component, it might be time to rethink your position.

This increasingly looks to be the Dow component most vulnerable to pricey oil. If oil prices rise past the $110 mark in coming weeks and months, look for the cycle of analyst downgrades for airline stocks to begin. That would also be an opportune time to short the stock, because if this happens, it won’t be long before Boeing is caught up in this maelstrom.

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