CROSS-EXPERTISE RESEARCH 10 March 2015 What if oil stays low long-term? The oil shock has not only surprised in terms of scale but also raises the issue of its duration. The world economy and financial markets will be all the more impacted if oil does not promptly return to its average and trends in a fluctuation range close to current levels. Outside our core scenario (Brent at $60/b in 2015 and $70/b in 2016), it is this prospect of lastingly low oil, at $52/b in 2015 and $56/b in 2016, that our report explores. After presenting the factors underlying this scenario – oil demand trend, responsiveness of current production, environmental policies and strategic stakes – we analyse the macro implications. These are the fruit of vast revenue redistribution between exporting and importing countries, clear increase in deflationary pressure, and a positive supply shock for many sectors. This leads to modification in terms of trade, a strengthening of purchasing power and an opportunity for companies to pick up their margins and underpin the investment cycle. All these items maintain the nascent imbalance between developed and emerging economies. The macro vision is accompanied by sector impacts, direct and indirect, that vary broadly between sectors. For the directly concerned sectors, impacts are very negative on the earnings and financing of oil groups and hence on development prospects. Sharp reductions in investment have already been announced and a cut in operating costs is likely to follow. Despite these cuts, balance sheets will remain under pressure, encouraging the sector reshuffle underway. The OCTG tubes sector is particularly hard hit after the massive investments in new capacities in the previous cycle, while pressure in oil services is likely to lead to a phase of restructuring and consolidation. For credit, the consequences are direct on American HY owing to the overrepresentation of energy in credit indices, increasing the likelihood of default on this segment. Indirectly, lastingly low oil leads to identification of losers and winners (mainly), notably depending on operating costs (for example for airlines), and supplementary consumption impact (Retail, Food-FMG, Media, Construction Concessions, Hotels & Leisure) for various sectors. As for socially responsible investment, the key point lies in the capacity of states to meet their carbon commitments. Lastly, econometric analysis of the relations between sector sub- indices making up the Eurostoxx and the oil price helps determine a basket of sectors benefitting from oil that stays low long term. Chief Economist Patrick Artus +33 1 58 55 15 00 Multi Asset Strategy Evariste Lefeuvre +1 212 891 6197 Abhishek Deshpande +44 20 32 16 92 93 Nathalie Dezeure +33 1 58 55 99 93 Karim El Ali +33 1 58 55 62 90 Economic Research Sylvain Broyer +49 69 97 15 33 57 Thomas Julien +1 212 891 6219 Bei Xu +33 1 58 55 14 83 Credit Research Thibault Cuillière +33 1 58 55 80 56 Yvan Pavlovic +33 1 58 55 82 86 Sandra Soyer +33 1 58 55 82 19 Jean-Baptiste Teissier +33 1 58 55 10 08 Equity Strategy Sylvain Goyon +33 1 58 55 04 62 Benoit Peloille +33 1 58 55 03 07 Stephen Ausseur +33 1 58 55 05 35 SRI Research Orith Azoulay +33 1 58 55 52 05 Equity Research Anne Pumir +33 1 58 55 05 20 Baptiste Lebacq +33 1 58 55 29 28 Alain Parent +33 1 58 55 21 82 Antoine B.-Champeaux +33 1 58 55 33 67 Pierre-Edouard Boudot +33 1 58 55 05 24 Nicolas Langlet +33 1 58 55 00 95 Jérome Bodin +33 1 58 55 06 26 Grégoire Thibault +33 1 58 55 34 45 Pierre Tegner +33 1 58 55 24 34 Arnaud Schmit +33 1 58 55 96 85 Philippe Ourpatian +33 1 58 55 05 16 Geoffrey d’Halluin +33 1 58 55 05 36 Georges Dieng +33 1 58 55 05 34 Michael Foundoukidis +33 1 58 55 04 92 Global Markets research.natixis.com Bloomberg access NXGR Distribution of this report in the United States. See important disclosures at the end of this report.
Transcript
CROSS-EXPERTISE RESEARCH
10 March 2015
What if o il s ta ys low long-te rm? The oil shock has not only surprised in terms of scale but also raises the
issue of its duration. The world economy and financial markets will be all the more impacted if oil does not promptly return to its average and trends in a fluctuation range close to current levels. Outside our core scenario (Brent at $60/b in 2015 and $70/b in 2016), it is this prospect of lastingly low oil, at $52/b in 2015 and $56/b in 2016, that our report explores.
After presenting the factors underlying this scenario – oil demand trend, responsiveness of current production, environmental policies and strategic stakes – we analyse the macro implications. These are the fruit of vast revenue redistribution between exporting and importing countries, clear increase in deflationary pressure, and a positive supply shock for many sectors. This leads to modification in terms of trade, a strengthening of purchasing power and an opportunity for companies to pick up their margins and underpin the investment cycle. All these items maintain the nascent imbalance between developed and emerging economies.
The macro vision is accompanied by sector impacts, direct and indirect, that vary broadly between sectors. For the directly concerned sectors, impacts are very negative on the earnings and financing of oil groups and hence on development prospects. Sharp reductions in investment have already been announced and a cut in operating costs is likely to follow. Despite these cuts, balance sheets will remain under pressure, encouraging the sector reshuffle underway. The OCTG tubes sector is particularly hard hit after the massive investments in new capacities in the previous cycle, while pressure in oil services is likely to lead to a phase of restructuring and consolidation. For credit, the consequences are direct on American HY owing to the overrepresentation of energy in credit indices, increasing the likelihood of default on this segment.
Indirectly, lastingly low oil leads to identification of losers and winners (mainly), notably depending on operating costs (for example for airlines), and supplementary consumption impact (Retail, Food-FMG, Media, Construction Concessions, Hotels & Leisure) for various sectors. As for socially responsible investment, the key point lies in the capacity of states to meet their carbon commitments. Lastly, econometric analysis of the relations between sector sub-indices making up the Eurostoxx and the oil price helps determine a basket of sectors benefitting from oil that stays low long term.
Global Markets research.natixis.com Bloomberg access NXGR Distribution of this report in the United States. See important disclosures at the end of this report.
2. Tempora ry or long-te rm fa ll in o il p rices ? 6 Short-term trends: a strategic decline 6 Medium-term scenario: determinants for low oil 7 Brent between $50 and $60/b over 2015 and 2016 12
3. Macro cons equences o f las tingly low o il 13 How do energy prices spread to economies? 14 The resulting impacts on public action 19 Summary of the macro impacts: euro zone and Asia, the big winners 21
4. SRI: Ambiva len t s igna ls fo r the environment 23
5. Financ ia l equ ilib ria in o il s ectors th rown off kee l 25 Oil companies: cash-flows evaporating 25 Oil services: pressure at all levels 40 OCTG equipment: prepare for the worst 44
6. Sec tor impac t mos tly pos itive 49 Aerospace: low oil prices are good news 49 Food retail: positive direct and indirect effects 50 Media: Support for consumer spending and thus for advertising stocks 55 Construction & Concessions : good news for Motorways and Airports 56 Food-HPC: strong sensitivity to oil, especially for Unilever 57 Capital goods: impact will vary from one group to another 62 Utilities: very low impact 65 Hotels, Leisure & Catering: positive to varying degrees 66 Automotive: a positive effect that must be qualified 67
7. Our s tra teg ic ana lys is 70 Brent vs. Eurostoxx 600: an econometric analysis 70 Equity strategy: how to play lastingly low oil? 75 What consequences for the credit market? 78
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1. Introduction
After the event, it is possible to explain why the slide for oil has been so abrupt. It is now necessary to respond to the following dual question: will the shock last and is it a response to a real change of paradigm, a ‘new normal’, characterised in particular by lastingly low oil?
Explanation of the 2014/15 crash forms an integral part of the more general issue of ongoing low prices. The precursors for the decline were masked for four years by the relative stability of oil prices at around $110/bbl. There was not necessarily complacency but rather the idea, valid up till then, that the influencing force was not necessarily supply/demand imbalance but purely budget considerations. Breakeven prices, required to balance the public accounts of many oil producers, provided a reasonable estimate of the equilibrium price. Temporary shocks (Libya for example) could lead to price fluctuations but the strength of these ‘breakevens’ systematically justified a return to the average. This analytical framework is no longer valid, having suffered the double shock of the change in ‘marginal producer’ policy (Saudi Arabia) and new production conditions, in the US in particular.
The arguments justifying lastingly high oil are generally based on some macro and technical assumptions: oil demand is driven long term by emerging countries. Supply (American notably) is founded on rather low quality hydrocarbons; world reserves are in very onerous extraction zones and increasingly unstable politically. A part of these arguments are now open to criticism.
The idea according to which the catch-up for emerging countries is a lasting phenomenon is increasingly questioned. The structural limits to their growth are many: chronic current deficits, excess debt in the private sector. More generally, many countries are close to the ‘middle income trap’, a transition phase from growth based on the sole accumulation of production factors to a momentum based on sounder usage of these. The idea of a gradual slowdown for emerging countries is all the more justified in that the dollar is on a clear upward trend, synonymous with deterioration in terms of trade and hence lesser ‘easy’ growth for emerging countries.
American oil production is rich in liquids (NGLs) but if offers a dual advantage: its marginal cost is falling steadily thanks to technological progress. The chart below shows that the production investment ratio has fallen substantially since 2007. The implementation of a new well is much faster than for the extraction of traditional oil (some months). This increases the elasticity of supply versus demand and is in clear contrast with traditional extraction-investment-exploitation cycles.
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Chart 1: Investment ratio per unit of production ($ capex for 1,000 b/d produced)
Sources: Datastream, Natixis
Rather than seek a justification for the lasting rise (or maintenance at a high level) for oil in the strength of emerging countries – where catch-up seems to have entered a more complex and difficult phase – it seems that extraction technologies (less capital intensive) and the location of marginal production locations (soils or sand, more politically stable countries) argue for a new reading of the oil market and, as a corollary, a lasting low oil price. This view is all the more justified in that the marginal producer has altered strategy, a radical option which is unlikely to be questioned for several years.
Our report develops this assumption ($52/b in 2015 and $56/b in 2016) by exploring many other avenues. Aside from factors which could justify a lastingly low oil price, we analyse the sector consequences of such a scenario and its impact on different asset classes.
The suddenness and scale of the oil price decline since the end of summer 2014 has led to a vast transfer of global revenues and a sharp increase in deflationary pressure in a number of countries. It also raises several questions about the real reason for this decline, especially as oil prices seem to have levelled off at around $50/60: is this just a temporary crisis and will prices rapidly revert to their long-term average? Or are we about to enter a period of sustainably low oil prices? This note discusses these issues and illustrates how the impact of an oil crisis varies widely depending on whether it is temporary or permanent.
Short-term trends: a strategic decline
It is impossible to quantify accurately the relative contribution of supply and demand factors to the fall in oil prices. It would appear however that it has not been the most decisive factor as there has been a marked de-correlation with world trade (note the striking contrast with 2008/09 in the chart below). Moreover, although the fall in Brent prices was concomitant with the rise in the dollar, the strength of the greenback cannot alone explain the plunge over the last few quarters (the chart shows a rupture in Brent price trends compared with other commodities).
Chart 2:
World trade and oil prices US dollar and oil price changes vs. others Commodities (3-month change)
Sources: Bloomberg, Natixis
We will discuss demand factors in more detail in the next section. Even if the slowdown in growth in China, in numerous emerging economics and the Euro zone have undeniably played a role, above all, it was the combination of surplus supply and a change in the OPEC’s strategy that explains this major downturn.
This is because global oil output capacities have continued to shoot up, mainly owing to increased US and Libyan output. Above all, the OPEC countries' refusal, in particular Saudi Arabia's, to continue losing global market share explains why the cartel no longer wants to curb its output and has thus caused a situation of over-supply.
Is the fall in oil prices temporary (lasting a few months) or long-term (lasting a few years)? This question is particularly crucial insofar as it influences inflation, monetary policy, bond yields and corporate earnings.
Investment/supply adjustment
It is often said that falling oil prices discourages investment in the most expensive oil types (shale oil, tar sands, Arctic, ultra-deep water offshore oil) and supports oil demand. If history were a reliable predictor of future trends, it would indicate that investment cuts after a drop in oil prices is a lengthy process. Nevertheless, the shale revolution has introduced new prospects in this field, as it is a drill-intensive type of production, and enjoys more spending headroom. Thus the flexibility of oil companies' investment budgets that is historically estimated at 10/20%, is largely enhanced in the current cycle: independent US companies have announced they are slashing capex by 50/60% and even groups like ConocoPhillips that are exposed to unconventional US oil, have announced a 30% investment budget cut. The greater level of flexibility afforded by shale oil should work both ways and we might think that an increase in prices to above breakeven should trigger a new phase of investment that would put a “cap” on prices.
There are several reasons why investment might not lead to a fall in production in the short and medium term. Indeed, capex cuts could above all affect exploration and not drilling activities. Moreover, a downturn in production could happen, as is always the case, more than a year later, or even more, if spending cuts are concentrated in exploration. As a consequence, the argument for a rapid change in supply does not factor in the massive wave of investment over the last few years – and which should increase production in 2015 and in 2016.
Naturally the number of rigs in operation has plummeted over the past few months, and the chart below shows that the trend has affected, and will continue to affect investment. Even so, if horizontal drilling continues in the USA, US oil output trends will not necessarily depend on the number of rigs in operation alone. Moreover, even if a certain number of producers might default on their bond repayments (junk bonds) and thus exit the market, technological progress and the fall in a number of related costs (services) might also suggest that the breakeven price (that offers an acceptable IRR) could fall between $50/bbl and $55/bbl. History has shown that cost functions change over time.
(1) OPEC production (2) Non-OPEC Production Ratio (1) / (2) (in %)
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Chart 4:
World: Investment in exploration
and oil output
United States: Investment in mining operations
and no. of rigs (yoy %)
Sources: Datastream, IMF, Bloomberg, Natixis
Strategies of oil producing countries
The mismatch between oil supply and demand is nothing new and has widened significantly over the past several years, owing to the output of non-OPEC member countries. What is new, however, is the attitude of the marginal producer Saudi Arabia and its wish to allow the market to set prices in order to stem the arrival of new entrants in less profitable techniques (unconventional US oil Ghana's and Venezuela's output, etc.). This strategy was preferred to the risk of losing market share by reducing a supply glut. The equation below is usually just a formulation. It becomes a rule when the OPEC can no longer or, most importantly, no longer wishes to curb its output.
World demand – non-OPEC output = implied "call" on OPEC output
The OPEC's strategy is clear and seems sustainable: increase the OPEC’s market share in global output, thus keeping oil prices low long enough for there to be an irreversible cut in investment in producing expensive forms of oil. For Saudi Arabia, a rapid up-tick in prices would mean a loss of revenue without any long-term favourable impact.
The question is whether or not non-OPEC countries will be forced to cut their production rapidly. US and Canadian producers seem to want to do so: the IEA in its February monthly review began to revise down its growth forecasts for North-American supply by 300,000bpd in Q3 15 and 500,000bpd in Q4 2015. However, this reduction should be contained. As a result of the previous investment cycle, numerous projects are entering into the production phase or are ramping up in 2015/2016. Last, the extent and timing of the impact of lower investment budgets on existing production and in particular on mature production, particularly in maintenance (acceleration in the rate of decline) is difficult to quantify.
Last, the fall in prices should not prompt non-OPEC countries to trim production against a backdrop of public finances already heavily strained by falling oil prices and, in the absence of cooperation, they will be confronted with a real prisoner's dilemma.
Amid this, global supply could remain high and OPEC's production could surpass “the call on OPEC” for quite some time.
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Demand
Beyond cyclical factors, oil demand can be affected by structural parameters: the structure and make-up of world trade, Chinese structural reforms, environmental policies, demographics.
− Investment
Investment, which is the component of world demand that consumes most energy, has not returned to its historic levels. It has remained stagnant since 2012 at 22% of GDP vs. 23.5% on average between 2003 and 2008. Even if economic trends seem to be improving, to the extent that certain emerging countries are easing interest rates amid falling inflation, that the Euro zone credit squeeze has run its course and that the outlines of the Juncker investment plan are taking shape, the current global investment cycle should remain pretty downbeat. In terms of world trade, we see growth of 4 to 5% p.a. between 2015 and 2017, a pace below the 2002/2008 average (6.6%).
− China
On the one hand, the change in China's growth strategy should argue in favour of weaker oil demand. Nevertheless, growth expected for the country’s transportation sector and its delay in accumulating strategic reserves means that the relationship between the Chinese slowdown and the country's oil imports is particularly hazy.
The slowdown in Chinese growth is inevitable with the economic switch from an old growth model focused on exports and investment, to a new model based on sustainable growth, more sensitive to the quality of the environment and more service-focused. This could significantly slow down production in a certain number of heavy industry sectors and globally weigh on commodities prices. Nevertheless, oil demand should move in different directions given the levels of oil consumed by the transportation sector which now surpasses industry as the biggest consumer of oil products. This is in addition to a growing number of private cars on the road, up 9% (yoy) in H2 14.
Chart 5: China: Oil imports and GDP growth (yoy %) China: Automotive sales (%yoy)
Sources: Bloomberg, Natixis
China's strategic oil reserves stood at 12.43m tonnes at end-2014, i.e. around 90 million barrels and 16 days of imports. According to ‘The long term planning of the National Petroleum Reserve (2008/2020)’, China will attain reserves of 500 million barrels in 2020. The country is therefore behind on its plans and also well behind other countries (reserves of the EU and Japan represent 90 days of consumption). Storage capacities total 103 million barrels and should quickly reach 168 million barrels. In theory, China will need to import 410 million barrels by 2020 to reach the Plan's target, i.e. an average of 68.3 million barrels p.a., or 3% of imported oil in 2014.
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− International trade
Since the Great Recession, world trade has struggled to grow at a faster pace than world GDP for one main reason: the slowdown in the pace of internationalisation of value/production chains. Their geographic dispersal has led to faster expansion in the transportation of goods, particularly semi-processed goods than in final demand. The elasticity of international trade to world GDP had even jumped to 2.5x in the mid-1990s. It has now fallen back to 0.8x, as low as it was in the 1980s.1 This should argue in favour of weaker oil consumption per unit of world GDP. One example among others: industrial developments in Eastern Europe (Poland, Czech Republic, Turkey, etc.), the transportation of semi-processed goods on the European production chain are been significantly shortened. The global economy is now more focused on a re-regionalisation model, rather than a globalisation one.
− Demographics
Is this a generation-Y effect? On the contrary has it been tied to the ageing of the population in developed countries and new modes of working? The distance in kilometres travelled per annum and per capita is no longer increasing, particularly in the USA. Even as the number of vehicles increases, as is the case in Europe (530 vehicles for every 1,000 inhabitants today vs. 504 in 2008), the share of passenger transportation in GDP has stagnated since 2008.
− Environmental policies
European and US public policy encourages energy solutions that are less polluting than fossil fuels. In an effort to reduce Co2 emissions, the EU28 is aiming for 27% of its energy consumption to derive from renewable sources by 2030. This figure stood at 14% in 2012, up 4 points vs. 2004.
Despite the expansion of shale oil and gas, the USA has not been inactive either. As part of its clean power plan, the US Environmental Protection Agency wants to cut the energy sector's GHG emissions by 30%, i.e. to below the 2005 figure before 2030. Standards for US trucks and light vehicles are expected to evolve by 2016, as is the case in Europe. The Department of Energy has set a target to reduce carbon pollution by 3 billion tonnes before 2030.
These policies and the associated technical progress have all improved the energy efficiency of the major global players. This is not merely due to the development of the tertiary sector in economies. Industry needs less energy to produce in most developed countries and in certain emerging countries, with the notable exception of Brazil and India. The result of this shift is that the share of oil on global energy consumption has fallen since 2001.
Share of oil in global consumption of primary energy (%)
Sources: BP, Natixis
Carry strategies
Last, investor demand resulting from strategies triggered from the carry/contango markets will only support oil prices in the short term. In the medium term, barring massive inventory cuts, it will take longer than expected to reduce these stores of surplus onshore and offshore oil. The higher the stock levels, the longer it will take to deplete them and the longer it will take for stock reductions to support prices.
Chart 7:
OPEC: expected daily call in 2015 (mbpd) Projected crude stocks at Cushing
1mn bbl per week stock build 1.5mn bbl per week stock build2mn bbl per week stock build Cushing stocks (mn bbl)
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Operational maximum:10% of total shell capacity of 85mn bbl
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Brent between $50 and $60/b over 2015 and 2016
Econometrics has taught us that the share of oil in global energy has a weak but direct impact on oil prices.2 Thus, without drastically restricting oil supply, the reasons we have mentioned above suggest that oil prices will remain low in the long run.
As we see it, the likeliest scenario is for (Brent) crude prices of between $50 and $60/bbl for several years (at least two). This will discourage investment in the most expensive forms of oil (see table 1), while preserving positive levels of profitability in conventional oil.
Table 1: Marginal cost of oil production
$/bbl Conventional oil 23 Deepwater offshore 52 Shale/Tight oil 70 Very heavy crude 86 Tar sands/shale 115 Arctic 120
Source: IEA
We have drawn up a scenario based on low assumptions for oil (Brent at $52/bbl in 2015, then $55.7/bbl in 2016). It assumes that the OPEC will maintain its policy over the next two years and a limited impact on output growth from the reduction in oil investment. It does not factor in the return of Iranian or Libyan oil to the market. In this last scenario, oil prices could fall and remain at new lows as long as equilibrium remains marked by a supply glut. This scenario is improbable however. The situation in Libya is very unstable, with conflict leading to production and export breakages and the government and rival militias fighting over oil terminals. In this context, production is intermittent. According to PIRA estimates, Libya will produce between 100,000 bpd and 200,000 bpd, but the current situation could lead to lower output. Moreover, EU sanctions (embargo) cannot be ruled out. As for Iran, talks with the P5+1 group started again on 2 March. Though the two parties have agreed to reach an agreement by end-March, the outcome is very uncertain, with in addition the return of the Republicans to the American Senate.
2 Our estimates for the 1995-2012 period suggest that a 1 percentage point drop in the share of oil in energy consumption would see Brent prices fall by
0.12%. For further details see Flash 2013-359 “The determinants of the oil price”.
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3. Macro consequences of lastingly low oil
The fall in oil prices and ongoing low oil for several years will have many repercussions on the world economy. Above all, this entails a transfer of revenues from oil exporting countries, mainly emerging economies, towards oil importing countries, mostly developed economies, but not only (China, India, Taiwan, Thailand, Indonesia and even Brazil are net importers). This transfer of revenues is not a nil sum game and the IMF estimates that a 10-20% fall in oil lifts world GDP by 0.05%.3 The main reason is that oil exporting countries commonly display savings rates above the world average, with part of the income from export revenues invested in sovereign funds. The fall for oil is thus beneficial worldwide, but some regions will benefit more than others, according to their oil dependence.
Chart 8: Oil balances
Countries net importers of oil (% of GDP) Countries net importers of oil (millions of barrels/day)
Countries net exporters of oil (% of GDP) Countries net exporters of oil (millions of barrels/day)
Sources: IEA, Natixis
3 “Commodity and Market Review” in the World economic outlook October 2013, table 2, page 7.
On paper, energy prices are diffused to economies in three ways:
− Terms of trade: revenues derived from foreign trade by oil importing economy increase when the oil price slides relative to the price of its exports. We then say that the terms of trade have improved. More revenues are available to finance consumption and supplementary investments. Conversely, for oil exporting economy, the fall in oil prices undercuts its terms of trade and, unless it saves less or borrows more, less few revenue is available to finance growth. As a knock-on impact, variation in the terms of trade can impact currency prices, as it influences the current account balance. A fall for oil can thus lead to a rise for currencies of importing economies and to a dwindling for currencies in exporting economies (or to multiple interventions by the central banks when the forex regime is fixed, as in the Middle East for example).
− Demand: the impacts on demand are linked to the impact of energy prices on inflation (energy represents 8-10% of the total consumer price index in a developed economy). When prices fall, real revenue increases. There is little likelihood that this supplementary revenue will boost savings: first of all because it stems from recurrent spending (car fuel, heating fuel); secondly, because it is distributed to all revenue classes. Consumption must thus increase. The positive impact on demand can also be prolonged by monetary policy; the sharp disinflation stemming from the fall in oil can trigger interest rate cuts by central banks targeting inflation.
− Supply: supply impacts stem from the role of energy in the production of goods and services. A fall in the price of energy used can: 1/ either be saved by the producer, in which case it makes a supplementary profit that can be invested at a later stage, which peps growth; 2/ or be passed on to the consumer in the form of a fall in the prices of goods produced, which favours consumption but increases the risk of deflation (the decline in energy prices spreads to other goods and services).
These impacts are either immediate, notably on demand, or temporary, notably on profits. But the decline in the price of energy can also have longer term impacts. Any supplementary investment generated can increase the growth potential for an economy. The relative variation in the price of an energy source compared with others can alter the energy mix consumed by a country and make public policy choices redundant. Of course, this is the case for countries that have developed non-conventional oil or renewable energies. The non-retention of cost falls for producers make result in a deflationary spiral in the economy, undercutting investment and growth potential.
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Chart 9: Energy prices and economic activity
Source: BCE
In practice, we see that the first two types of impacts are already spreading to economies. Terms of trade are improving substantially in the euro zone but not in the rest of the G4: only barely in Japan, where the sharp fall in the currency works annuls almost all the benefits from of the fall for oil, not in the US when the strong dollar works against the impact, and still less in the UK which exports oil. Terms of trade are improving in oil importing emerging countries (China above all, but also in India), while they are deteriorating in Russia, a net exporter of oil and in Brazil due to the forex trend. Household consumption is picking up fast in the G4 by disinflation; not in emerging countries, either because their currency is collapsing (Russia), or as energy consumption is subsidised, the fall in world prices does not favourably impact demand. Several central banks have already eased their monetary policy in reaction to low inflation: the ECB with its QE, but also other central banks close to the euro zone (Switzerland, Denmark, Sweden) and some emerging countries (China in November 2014 and February 2015, India in January 2015, Indonesia in February 2015).
G4: Inflation (y/y in %) BRIC: Inflation (y/y in %)
Sources: Datastream, Natixis
If oil remains at current levels for the next three years, instead of heading towards $75 at end-2016 in our core working assumption, we think that household consumption will be one percentage point higher in the US and in euro zone cumulatively over three years (cf. table 2). In the euro zone, at the pump prices have adjusted faster in Germany and Spain than in France and Italy. It is therefore likely that consumption will benefit more from low oil in the first two countries that in the latter two (+1.5 point in Germany and Spain vs. +0.7 point in France and Italy).
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Study of the correlation for the euro zone between variations in oil prices in local currency and consumption expenditure by type of good (table 3) suggests that food, household consumer goods, rents, water and domestic energy profit more than other goods from a fall for oil. Above all, this concerns consumer staples. We infer that the fall for oil favours the most modest revenue classes, who consume more when their revenue is less rationed. However, we also see that compressible goods and services such as leisure also benefit from a fall in oil prices. This suggests that the least well off do not save but spend the increase in revenue stemming from lower energy prices.
Table 3: Correlation between the price of oil and final household consumption spending by sector of consumption in the euro zone y/y in % Simultaneous Postponed Food products and soft drinks 0.2 -0.2 Alcoholic drinks, tobacco 0.1 0.1 Clothing and shoes 0.4 -0.1 Housing, water, gas, electricity and other fuels 0 -0.3 Furniture, household equipment, home maintenance 0.6 -0.2 Healthcare 0.1 0.1 Transport -0.4 0.2 Communication 0.2 0 Leisure and culture 0.3 -0.1 Education 0.4 -0.1 Hotels, cafés, catering 0.6 -0.1 Other goods and services 0.3 -0.1 Total 0.2 -0.1
Source: Natixis
Longer term, demand for private vehicles could be impacted by low oil. Note that the fall in fuel prices is unlikely to impact car demand, as this is driven by other factors (age, habit amongst the young, credit, etc.) and as a large part of the consumption rebound in the auto sector has already been absorbed by the scrappage premium programmes put in place in the last few years. However, the decline in the price of fuel could have a bearing on the type of vehicle demanded, probably with a slight jump in demand for the less economic vehicles. And yet, we do not think that the lasting fall for oil will result in a clear jump in demand for energy intensive goods/services owing to stricter regulatory standards.
As for supply, comparison of the two subcomponents of the manufacturing sector PMI surveys gives an idea in real time of the impacts of the fall for oil. Indeed, we see that the price of inputs has declined more than sales price, in reaction to the fall for oil, in the G4, large euro zone countries and leading emerging countries. The slide for oil has thus allowed the world manufacturing sector to lift its margins. The detail for the G4 suggests that the recovery for company margins is of a similar scale in the US, UK and euro zone. Margins are only declining in Japan. In this country, input prices indeed increased in H2 14, the abrupt fall in the currency having erased the impacts of the fall for oil. In the BRICs, the situation varies. Margins are up sharply in India and China since last July. While their rise stems solely from the fall input prices in India, selling prices remaining stable, Chinese industry has abandoned part of the rise in its margins by slashing its selling prices. This may be explained by the production overcapacity for heavy industries which are declining at present owing to the structural transition for the economy. In Russia and to a certain extent in Brazil, margins are down however. This stems from the depreciation of the currency which, as in Japan’s case, has erased the impacts of the fall in input prices. Russia has even been forced to raise selling prices to cope with this but insufficiently compared with the increase in input prices.
This rise in profits is temporary. Traditional phenomenon in a positive supply shock, it indicates however that risk of deflation via oil is not great. Indeed, if profits increase, it is because producers do not pass on the full decline in production prices to consumers. The decline in prices is thus limited to energy and does not spread to other goods.
Given that they retain a part of the generated margins, the sectors most favoured by the fall for oil are unsurprisingly those which consume the most energy, i.e. air transport, chemicals, and energy producers aside from oil companies (table 4). Econometrics suggest that Spanish manufacturers are more favoured than others, notably in the energy sector.
Table 4: Impact of a 10% rise in the energy price on producer prices: breakdown by main business
% Germany Spain France Italy Euro zone Agriculture and fisheries 0.36 0.29 0.34 0.29 0.35 Manufacturing sector 0.27 0.34 0.21 0.27 0.29 o/w: Chemical materials 0.70 0.92 0.50 0.38 0.70 Basic metals 0.64 0.54 0.29 0.52 0.59 Energy 4.82 5.15 4.12 4.90 4.88 Construction 0.18 0.18 0.16 0.23 0.20 Services 0.12 0.20 0.13 0.18 0.16 Commerce 0.14 0.21 0.20 0.24 0.19 Transport 0.63 0.79 0.46 0.44 0.60 Road transport services 0.47 0.90 0.62 0.50 0.64 Waterway transport services 0.50 1.42 0.57 0.29 0.63 Air transport services 2.46 1.85 0.67 1.01 1.53 Telecommunications 0.09 0.19 0.12 0.14 0.12 Other services 0.07 0.12 0.08 0.12 0.10
Source: ECB
-30
-20
-10
0
10
20
-30
-20
-10
0
10
20
03 04 05 06 07 08 09 10 11 12 13 14
USA UEM Japan UK
-30
-20
-10
0
10
20
-30
-20
-10
0
10
20
03 04 05 06 07 08 09 10 11 12 13 14
Brazil Russia India China
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The resulting impacts on public action
Beyond impacts on the terms of trade, demand and supply, a lasting decline in oil prices will also impact economies. We are thinking above all of public finances and energy policy choices. The public finances of developed economies will be little impacted directly by the slide for oil, the taxes directly received on fuels not being a function of prices. In the US and in Europe they represent a fixed amount per gallon/litre sold. The impact on VAT revenue on oil products is downward, however, but should be offset by the increase in VAT inflows stemming from accelerated consumption. In the US, only producer states (Texas, Louisiana, Oklahoma and Alaska mainly) are likely to suffer from the fall in prices, via the decline in taxes on oil businesses and via the impact of automatic stabilisers with a decline in business expected in these states. Canada is an exception in this sense: in this country, tax revenues from several provinces depend on oil exports. However, if we look more broadly at countries where implicit taxes on energy are the highest, we can conclude that public finances in the UK, countries in northern Europe and Italy will be more impacted than elsewhere (table 5).
Table 5: Implicit tax rate on energy in 20121
€ Denmark 303.61 UK 276.26 Italy 233.43 Sweden 216.86 Malta 200.37 Greece 186.13 Germany 185.29 Luxembourg 181.29 Netherlands 180.2 EU (28 countries) 172.78 Slovenia 172.24 Ireland 172.12 France 161.6 Austria 145 Cyprus 141.29 Portugal 134.07 Finland 127.63 Spain 114.16 Belgium 102.36 Poland 96.38 Estonia 91.12 Croatia 87.43 Czech Republic 79.08 Hungary 75.41 Latvia 70.43 Lithuania 69.65 Romania 68.13 Bulgaria 65.51 Slovakia 47.52
1 € gathered per tonne of oil equivalent consumed
Source: EC
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As for emerging countries, countries which subsidise energy prices could see their public finances improve with the fall for oil (Indonesia, Malaysia, Myanmar, and India) on the condition of a weaker fall in tax revenue linked to oil. Remember also that several oil exporting emerging countries subsidise oil products for their domestic consumption (Middle East, Algeria, Tunisia, Venezuela, etc.). For these countries, the negative impact on the public finances will be reduced by a fall in domestic subsidies.
Amongst the leading emerging countries, it is in Russia that the public finances are hardest hit, as half of budgetary inflows stem from the energy sector. Up till now, the balance has not been especially hard hit as public spending is denominated in national currency and the slide for the rouble has offset the decline in oil revenues in dollars. However, oil maintained at $50/bbl in a context of stabilisation of exchange rates is likely to reduce revenues from Russian government inflows in RUB by over 20% in 2015. This will probably lead to fiscal adjustments with cuts to public expenditure.
Other emerging countries with heavy subsidies on energy prices may profit from the low oil price to reform the budget and cut public spending. This is the case for Malaysia which announced the elimination of oil and diesel subsidies in December 2014. Indonesia is also committed in this sense, putting a ceiling on subsidies of diesel and ending aid for petrol as of 1 January 2015. However, tax inflows on oil and gas represent 1/5th of the budget of the Indonesian government, and the net impact of the decline in subvention combining the low oil price on improvement in the budgetary balance is not determined.
Finally, the budgetary solvency of indebted states (we are thinking of Italy and Japan of course) could suffer from low oil. Lastingly low inflation reduces nominal growth and works against the decline in deficit and debt/GDP ratios.
Past energy choices may no longer be as profitable in case of low oil. The US is seeing its comparative advantage with shale oil and gas (2 points of GDP vs. Europe, 3 points of GDP vs. Japan) narrow. A lasting decline is also likely to dent US growth. Part of the recovery for the American economy is based on the energy revolution over the last few years. And this is largely based on year extraction of shale gas and oil. Natural gas is the energy most used by American industries (notably in the production of chemical products and metals which use natural gas derivatives), which offers an advantage on the international level with very low prices de-correlated from the price of oil. These industries could suffer lastingly from the relative fall in productions costs for international competitors thanks to lower oil and natural gas. A loss of competiveness probably increased by the supplementary rise of the dollar is probable in such a scenario. And, in case of a lasting decline for oil, investment spending in shale oil and gas extraction sectors may return to a level similar to that before the crisis, which would imply a permanent decline of $60bn for investment in structure, i.e. 0.3-0.4 point of GDP. In Europe, we are thinking of course of the reduced profitability of investments in renewable energy. Germany and countries in northern Europe will be hit.
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Summary of the macro impacts: euro zone and Asia, the big winners
Table 6 summarises all the impacts of a slide for oil on economies: impacts in terms of trade (improvement in trade balances and forex); impacts on demand, notably consumption, either directly by disinflation, or indirectly by the easing of monetary policy in the wake of the disinflation; impacts on supply by a temporary rise in profits and by a return to investments or, conversely, an obstacle to investment in the oil sector; impacts on the public finances (type and amount of the taxes on energy, energy subsidies, revenues on oil exports and budgetary solvency in case of low inflation); impacts on past choices in energy policy.
Summing up the positives and negatives for the main economies (G7, BRICs and intermediary emerging countries), we see that the euro zone and Asia, emerging and developed, are the main winning regions. These regions are both net importers of oil. Demand will be more stimulated in the euro zone, however, than in Asia. This is due to differences in forex trends (depreciations in Asia which diminish terms of trade and disinflation impact), but also because energy consumption being subsidised in many Asian countries, an oil counter shock will have less direct impact than in the euro zone.
Note that in the euro zone, France will derive greater advantage from low oil than its two large neighbours. Germany now feels the reduced profitability of its choice in favour of renewable energies (abandonment of nuclear). The Italian public finances will suffer more than the others from the situation, owing to the high level of energy taxation and solvency erosion (debt higher than elsewhere).
In Asia, demand in Indonesia will be less stimulated than in India, China and elsewhere owing to the major subventions that smooth the oil cycle. However, the public finances of Indonesia will improve markedly. In Japan, the choice of a low currency substantially reduces the positive impacts of low oil.
Outside these two regions, Russia is clearly the big loser, like Canada, also a net oil exporter. Paying the price of renewed energy independence, the US does not gain much. On the contrary, the investments in the oil sector and the energy policy focused on shale oil and gas mean that it loses a competitive edge over other G7 countries. We have not mentioned the Middle East but it is clear that this region is also a loser with a forex regime (US dollar peg) which will even be unfavourable in terms of sound budgetary balance.
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Table 6: Summary of the impacts of lasting low oil on the main economies in the current context
Terms of trade Demand Supply Resulting impacts Total impact on Economy
(trade balance / forex)
(consumption / disinflation /
monetary policy)
(profits / investment /
specialisation)
Public finances
Energy policy
(sum of the signets)
(tax revenues, energy subsidies, solvency)
(past choice)
G7 US 0 + - 0 -- -- Canada - + - - 0 -- Japan + + + - 0 ++ UK - ++ + - 0 + Germany ++ ++ + 0 -- +++ France ++ ++ + 0 + ++++++ Italy ++ ++ + - 0 ++++ BRIC Brazil - 0 + - 0 - Russia -- 0 - - 0 ---- India + + + + 0 ++++ China ++ + + 0 0 ++++ MIKT Mexico - + + 0 0 + Indonesia ++ 0 0 + 0 +++ South Korea ++ + + 0 0 ++++ Turkey + + + 0 0 +++
Obviously the first stage in the debate consists in considering that sustainably low oil prices is a major threat to the pursuit of targets for decarbonising the economy and in particular the search for energy efficiency gains in energy-intensive sectors (the economic incentive is automatically lower) and the further expansion of the renewable energy sector (their relative economic equation suffers).
More generally, the strain that this environment is putting on growth could be such that it might encourage States to review their carbon timetables. As a reminder, in preparation for the eagerly-awaited Paris Conference of the Parties to the United National Convention on Climate change (COP 21), in December 2015, the 192 nations must submit their carbon targets for 2020 to the UN in March. Oil-producing countries, most of which are not in the OECD, will be the hardest-hit and might have to revise down their ambitions. And yet, looking to find ways to share the effort between developed and developing countries is one of the prerequisites to hope for a post-Kyoto global agreement on climate change in Paris...
Even so, amid high oil prices, although reducing energy consumption is a very powerful economic driver, bear in mind that for several decades, the political and regulatory dimension for decarbonising economies has, in itself, bee, a key driver for investment in low-carbon technologies. Moreover, by their very nature, these policies are medium/long term in scope, extending out to 10-20 horizons. The sustainability of the current oil pricing environment is therefore a decisive issue for States’ capacity to meet their carbon commitments.
We think for example that this pricing climate will not push the EU to review its climate or renewables commitments. Remember that last October, the EU signed up to Climate/Energy targets out to 2030, including, in particular, a 40% reduction in CO2 emissions (vs. 1990 and -20% by 2020) and a binding target of having a 27% share of renewables in the European energy mix (vs. 14% today).
Similarly, the European Commission is on track to adopt a structural reform of the carbon market, that is hoped will better adapt the EU Emission Trading Scheme (ETS) mechanism to economic reality and support (via the creation of a reserve market) the price of a tonne of carbon, which so far, has failed to send the much-hoped-for signal to industrialists... Up till now, within the EU ETS, the price of a tonne of carbon is virtually exclusively driven by Brussels policy challenges regarding cyclical and structural reforms to the cap and trade mechanism. For this reason, the collapse in oil price has not had any notable impact on carbon prices. More generally, the shared observation is that carbon market mechanisms, having come under assault from persistent lobbying by industrialists, have not proven to be very effective as price signals.
At the same time, and it becomes very clear upon analysing the capex cuts announced by integrated oil companies, sustainably low oil prices tend to seriously undermine the profitability of certain oil projects that are among the most carbon-intensive or the riskiest environmental-wise, similar to the conclusions of lawyers on the notion of stranded assets, by taking another route than carbon restrictions. This is illustrated in the successive announcements of the shelving or postponement of offshore Arctic or tar sands exploration projects. Carbon Tracker goes even further, estimating that 92% of tar sand projects (at the discovery stage) in the coming decade will require oil prices upwards of $95/boe.
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Moreover, this low pricing environment in our view creates, the “ideal” platform for increasingly vocal proponents of a national, regional and, why not, global (one can always hope!) carbon tax. Similarly, as State subsidies of fossil fuels are increasingly a matter for debate, this low pricing environment also provides favourable conditions for a radical overhaul of government mechanisms supporting fossil fuel consumption.
Lastly, we would emphasize that although reports are likely on certain renewable projects, some renewables (on-shore wind, solar in certain geographies in particular) have reached, against a backdrop of a massive reduction in technological and equipment costs, their network parity and should, – in our view – weather the low oil price storm.
5. Financial equilibria in oil sectors thrown off keel
Oil companies: cash-flows evaporating The sharp fall in oil prices since June 2014 and the prospect of them remaining at a low level, with $52/b in 2015 and $56/b in 2016, will have very negative impacts on oil groups’ earnings and financing situation. They have started to announce significant reductions (10-35%) in capex budgets and are working to pare operating costs. Despite these cuts, balance sheets remain stretched and dividends could be at risk. We are maintaining our Underperformance rating on the sector, steering clear of the most vulnerable players in terms of shareholder returns: ENI (Reduce; target price €14.5) and OMV (Reduce; target price €22.4).
Fast reactions to the price slump
The downturn in crude prices in summer 2014 came in a specific environment for the industry. As early as 2013, a number of oil companies, notably Statoil and Total, became concerned about the inflationary drift in costs in the sector, which was making future developments uneconomical, despite crude price assumptions of close to $100/b. Against this backdrop, quite a few projects, across a range of geographic zones, were pushed out. Meanwhile, independent oil companies (E&P), notably those exposed to shale developments, were beginning to call into question their business model which was based on overconsumption of cash flow given the debt levels reached. Groups like Chesapeake, Devon, Hess as well as smaller players such as Sandridge began, under pressure from the markets, to cut back investment budgets and divest assets as early as 2013/14.
Sharply lower oil prices then acted as a spur for companies to step up the policies already in place. The fact that the slump was so swift and to broadly unsustainable levels for the sector as a whole, merely exacerbated the difficulty.
Very significant cash flow impact
In view of the sensitivities given by the groups and based on our price scenario of $52/b for 2015 and $56/b in 2016, the negative impact on 2015 net profits works out to around 89%, all else being equal, relative to 2014 earnings and around 81% for 2016 net profits all else being equal. ENI and OMV are set to be the most affected given their greater-than-average earnings sensitivity in the sector.
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Table 7: Calculation of sensitivity to crude prices
Nonetheless, we need to exercise caution in this analysis, bearing in mind that companies’ sensitivity indicators are seen as reliable only for limited fluctuations in crude prices. With a change of $47/b, the indicators are less credible. For continental European firms, €/$ variations are another factor in earnings volatility, ENI being the most exposed to changes in the euro.
Table 8: Calculation of sensitivity to €/$ variations M currencies Chg. (%) Pre-tax impact Post tax impact 2015 impact for a €/$ rate from 1.33 to 1.10
Impact 2015 pre tax Impact 2015 post tax Total ($) +0.1,$/€ -700 -200 -1,610 -460 ENI (€) +0.05,$/€ -280 -100 -1,288 -460 Repsol (€) +0.13,$/€ -350 -200 -619 -354 OMV (€) +0.1,$/€ -250 -175e -575 -403
Sources: Companies, Natixis
The fall in earnings automatically produces reductions in cash flow, which are also very significant and all the more damaging because the capex is on a high base.
The financing imbalance created by lower oil prices has led groups to scale back their capex budgets. But the adjustment seems to be on a larger scale and faster than in previous crises. Indeed, oil budgets have historically had a low level of flexibility as projects that are already in progress do not tend to be halted. In the previous crisis, in 2008/09, only the Manifa project (>€1.5bn) was rescheduled. This development had been launched in July 2008, just before the rapid collapse in prices and work was still in the early stages. The most flexible portion of the budgets is exploration spending (2/4%). In 2009, major groups reduced their capex by 13%. Globally, world E&P capex budgets are estimated to have been cut by 15%.
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Table 10: Majors’ capex trends between 2008 and 2010
However, relative to 2009, investment in shale oil and gas has made budgets more flexible. Indeed, developments in this area tend to be very intensive in terms of drilling, where there is greater spending flexibility than for a deep-water field.
The initial investment trends given by the majors show a faster pace of reduction than that seen in the previous cycle downswing. The pattern is likely to become more marked in 2016 given the flexibility resulting from projects not being launched but also the impact of lower prices in the services chain. Shell estimated its budget flexibility at 10% in 2015, with 30% in 2016 and 50% in 2017. But this flexibility also has an impact on production (and therefore cash flow) as budget reductions affect work in mature zones where the rate of decline is rapid: OMV estimated the decline in its mature zones in Austria and Romania at 10%/year, without work.
The speed of the investment cut-backs stems both from proactive attitudes and passive trends.
Proactive attitudes: drastic exploration budget cuts from a high base
Drawing on the themes highlighted by the successes of the major exploration groups (Tullow, BG, Anadarko, Repsol), all the groups stepped up their exploration expenditure. The 2013 results were, however, disappointing and the hopes placed in a number of new zones failed to live up to expectations, though further drilling will have to provide confirmation. Because of the poor results in drilling, exploration spending booked as charges has increased and taken a toll on quarterly earnings. Basins that had been the focus of previous acquisition were also subject to impairments (Brazil/BP, Liquid Rich Shale/Shell).
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Project status overview
Table 13: Key projects in the pipeline
Projects Operator Type Zone Estimated launch date Status
Bressay Statoil Offshore North Sea UK FID 2016 Selection of concept expected in 2015 Johan Castberg Statoil Offshore Barents Sea Selection of concept expected in 2015 Rosebank Chevron Offshore North Sea UK No more official date In FEED phase Mad Dog phase 2 BP Offshore Gulf of Mexico No official date Existing plans revised West Nile Delta BP Offshore Egypt On hold (political situation) Fram Shell Offshore
Cancelled
Browse LNG Woodside LNG Australia FID expected mid 2016 Delayed several times, FEED expected in 2015 Prince Rupert Petronas LNG Canada 2019, FID delated in 2014
Scarborough ExxonMobil LNG Australia FID delayed in 2013, no date FLNG option seen as the best option Edradour Total Offshore UK Development launched in June 2014 Maria Wintershall Offshore North Sea Development contract awarded in January 2015 KGD 6 Reliance Offshore India Blocked by a legal dispute Kudu
Offshore Namibia Tullow withdrew from partnership in November 2014
Banda Gas export Tullow Trunkline Africa Project approved on 29 May 2014 Prosperidade Anadarko Offshore Mozambique First gas expected in 2017
Bonga SW RD Shell Offshore Nigeria FID expected in 2015-16 Rosebank Chevron Offshore North Sea UK FID expected in 2015 FEED entered in 2012
Area 4 FLNG ENI LNG Mozambique FID expected end 2015 Browse FLNG Woodside LNG Australia FID expected mid-2016 NEB 3 Adco Onshore EAU EPC due for completion in Q4 16
Khurais expansion Aramco Onshore Saudi Arabia Start of production expected in 2017 Nasr Field development Adma Opco Offshore UAE Start-up expected end-2018 LNG Canada Shell Onshore Canada FID expected 2016-17
Sources: Companies, Natixis
As excessive cost pressures were severely undermining project profitability, companies began to push out developments in all the major basins from 2013. Many were subject to re-engineering phases with a view to lowering costs. On Kaombo, for example, Total obtained a cost reduction of $4bn for a project valued at over $20bn. BP is also in the process of reviewing the budget for Mad Dog 2, down from $22bn to $14bn.
Plummeting oil prices are encouraging this trend for project deferral, which means groups have to review the stress-test scenarios for developments.
Passive trends: end of investment cycles
The drop in investment levels announced by the main international players relates in part to the completion of an extensive phase of activity, culminating in a number of major project launches as early as 2013 (with some difficulties as well) and in 2014, and continuing in 2015 and 2016.
The projects with the highest capital intensity (in bold in the tables) are also in most cases, particularly for Australian LNG, long-plateau developments offering upsides through debottlenecking, tie-backs and expansions.
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Table 14: Main start-ups in 2013
Shell BP Total ENI Repsol ExxonMobil Chevron ConocoPhillips Majnoon Atlantis North MLE Margarita Ph2 Kearl Papa Terra North Rankin North Rankin CAFC Sapinhoa Nigeria Satellite BC-10 El Merck Carabobo Kipper Tuna Turrum El Merck Gumusut Chirag Junin Gumusut Kashagan1 Kashagan1 Kashagan1 Kashagan1 Angola LNG1 Angola LNG1 Angola LNG1 Angola LNG1 Jasmine Jasmine Abo Ph3
1 Difficult start-up.
Sources: Companies, Natixis
Table 15: Main start-ups in 2014 Shell BP Total ENI Repsol ExxonMobil Chevron ConocoPhillips
Mars B Mars B Block 15-06 Block 15-06
PNG LNG Jack/St Malo Cardamon Na kika Ekofisk South Ekofisk South
Cold Lake Nabiye Tubular Bells Ekofisk South
Petai Kinnoul Laggan Tormore Kinnoul
Barzan Big Foot
CLOV CLOV Perla Perla CLOV
Sunrise Ofon2 Lucius
Lucius Bonga SW Bonga SW Bonga SW Bonga SW
Hadrian South
Hadrian South
Goliat
Sources: Companies, Natixis
Table 16: Main start-ups in 2015
Shell BP Total ENI Repsol ExxonMobil Chevron ConocoPhillips
Gorgon
GLNG
Sapinhoa Gorgon Gorgon AP LNG
Surmont 2
Big Foot Surmont 2
Eldfisk Eldfisk
Eldfisk
Moho North (Ph 1 bis)
Sources: Companies, Natixis
Companies that were at the end of their investment programmes had therefore begun to scale back their budgets. This has weighed on the trend for goods and services prices since 2013, particularly capital costs which have stabilised.
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Shifting value chain
Chart 12: Construction cost and operating cost trends upstream (base 100 in 2000)
Source: IHS CERA
With reduced cash flows, all groups now have to drastically ramp down their investment spending. Several segments in the services industry are starting to see price reductions, particularly those most exposed to exploration activities, namely drilling and seismic. This negative momentum is all the more marked given that new capacity will continue to come on stream in 2015 in these two segments.
In the previous crisis of 2009, companies’ production costs saw a similar reduction to that of services. The drop in unit production costs came to 5% on average.
Cost adaptation, while it may not be immediate, is all but inevitable. The financial and stock-market performances of oil services companies suggest that this is under way.
90110130150170190210230250
2000 2002 2004 2006 2008 2010 2012 2014
Upstream Capital Cost Index Upstream Operating Cost Index
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Chart 13: Cost adaptation time in previous crises
Source: BP Upstream presentation, December 2014
Impact of reductions in non-operated investments
The effects of lower investment budgets is spreading through the industry, with the impact both for operated projects, for which the groups are leading developments, but also non-operated projects for which they are partners. The proactive attitude of operators such as Statoil in a country like Norway where it is one of the main operators, has a knock-on effect on all the groups active there.
Shareholder returns at risk
High payout ratios
The scale and duration of the fall in prices could undermine shareholder returns. Share buybacks are the first to be targeted in the case of reduction and in our sample, Shell, BP and ENI are the only players active in this sphere.
Table 18: Share buybacks since 2012 M currencies 2012 2013 2014
Royal Dutch Shell ($) 1,492 5,000 2,357 BP ($) 0 5,475 4,055 ENI (€) 0 0 292
Sources: Companies, Natixis
Dividends could also be revised if the crisis persists. On this front, ENI, with a payout ratio of nearly 100% in 2014, is clearly the most exposed, although, unlike the previous crisis of 2009 when ENI had to cut its dividend, groups still have access to bank credit.
2004 2007 2010 2013
40%
30%
20%
10%
0%
-10%
20%
15%
10%
5%
0%
-5%
Oil Price (LHsc) Upstream costs (RHsc)
lag
lag
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Table 19: Pay-out ratios
M currencies Adjusted net profit 2014e Dividend paid 2015e Payout ratio (%)
BP ($) 12,292 6,078 50 Royal Dutch Shell ($) 22,562 11,866 53 Total ($) 12,837 6,679 52 ENI (€) 3,707 4,434 120 Repsol (€) 2,003 1,499 74 OMV (€) 1,133 677 60
Sources: Companies, Natixis
To address the issue of cash consumption due to dividend payments, BP, following Macondo, and Repsol, after the expropriation of YPF, put in place scrip mechanisms, allowing dividends to be paid in shares. The flipside of limiting cash outflows is that it dilutes EPS. Total announced at the Q4 earnings release that it was putting in place a scrip dividend mechanism, with an expected option to receive payment in shares. Two-thirds of the dividend could be paid in shares.
Low gearing ratios prior to the crisis
Having maintained proactive portfolio management policies, groups now have comfortable gearing ratios which should allow them to absorb a portion of the cash flow deficit. The ratings agency S&P, which revised the outlook for the whole sector to negative and placed ENI and BP on negative watch, noted that compared to 2008, the combined debt of the five European majors amounts to $240.4bn, versus $162.9bn, so their flexibility is reduced.
To strengthen balance sheets, while there is an abundant supply of cash and rates low, Total issues €5bn worth of hybrid notes at the start of February. Repsol is also planning a hybrid bond issue of €5bn to refinance the acquisition of Talisman.
Based on the deficits identified, gearing ratios should remain in the desired range, except for OMV, Total and ENI where they could rise to nearly 40%.
BP 19.7 20.5 10%-20% Royal Dutch Shell 19.2 13.8 0%-30% +10% on gearing ratio creates resource of $20bn
Total 23.7 31.9 <30% +1% on gearing ratio creates a resource of $1bn ENI 24.5 22.0 10%-30%
Repsol 27.6 14.3 Keeping investment grade OMV 28.8 33.6 <30% long term
Sources: Companies, Natixis
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Sector reshuffle
For ‘aggressive’ reasons (portfolio repositioning, discounted valuations) or defensive ones (balance sheet strengthening, synergy generation), oil crises tend to lead to sector reshuffles. As things stand, we do not see a wave of mergers similar to 1998/2000 until the rise in prices becomes visible, with transactions picking up on the exit from crisis.
Consolidation in times of crisis
Wave of consolidation in 1999/2000
Chart 14: Crude prices in 1997/99 ($/b)
Source: Datastream
The price slump from 1997, which gathered momentum as of the Jakarta OPEC meeting in November 1997, acted as a trigger for the string of mergers in 1998/2000.
Table 21: Major deals in 1998/2000
Acquirer Target Date Price ($bn) Methods of payment Arco Union Texas Petroleum 04/05/1998 2.5 Cash BP Amoco 11/08/1998 48.2 Stock Exxon Mobil 27/11/1998 75.3 Stock Total Petrofina 01/12/1998 11.6 Stock Repsol 15% YPF 21/01/1999 2.0 Cash BP Amoco Arco 01/04/1999 26.8 Stock Repsol 85% YPF 01/05/1999 13.4 Cash Elf Saga Petroleum (failure) 29/05/1999 2.2 Cash Statoil-Norsk Hydro Saga Petroleum 11/06/1999 2.6 Cash and stock TotalFina Elf 05/07/1999 54.0 Stock Chevron Texaco 15/10/2000 35.1 Stock Phillips Conoco 18/11/2001 35.0 Stock
Sources: Companies, Natixis
It is worth noting, however, that major moves began to be announced in August 1999, while the low point price-wise came in December 1998/February 1999. Visibility on the upturn in prices did not improve until the third quota reduction was unveiled at the OPEC meeting in March 1999.
8
12
16
20
24
28
1997 1998 1999 2000
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Table 22: OPEC quota trend in 1998/99
Date Change in quota Aid from non OPEC players 29/11/1998 Increase of 2.5 Mb/d
(+10%) to 27.5 Mb/d
31/03/1998 Reduction of 1,245 Mb/d Norway promises reduction of 100,000 b/d 24/06/1998 Reduction of 1,355 Mb/d Russia, Oman and Mexico promise reduction of 500,000 b/d 23/03/1999 Reduction of 1.7 Mb/d Non-OPECs promise reduction of 388,000b/d Cumulative Reduction of 4.3 Mb/d (-15%) Promised reduction of 988,000 b/d
Sources: OPEC, Natixis
Less repositioning in the financial crisis of 2008/09
Chart 15: Crude price trend in 2007/09 ($/b)
Source: Datastream
The price collapse triggered by the 2008 financial crisis did not generate the same frenzy of deals as in 1998. The decline was indeed more dramatic and swifter, with OPEC quickly announcing output cuts of 4 Mb/d. Importantly, the crisis greatly limited access to bank credit.
Table 23: Acquisitions in 2008/09 Acquirer Target Date Price in $bn Methods of payment ConocoPhillips 50% Origin Energy 30/10/2008 8 (AUD$9.6bn) Cash ExxonMobil XTO 14/12/2009 41 Titres
Sources: Companies, Natixis
Overall, these transactions had fairly mixed results. They did help reposition portfolios and increase groups’ scale and resistance, but operating and financial performances have disappointed.
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Fresh motivations in 2015
Mega mergers harder to imagine
At this stage, we do not expect any mega mergers, for four reasons:
− The financial performances of the majors have disappointed, as they have struggled to maintain profitability against a backdrop of high prices. Big is no longer beautiful. Some have even divested operations through spin-offs to boost profitability, among them downstream activities (Marathon, ConocoPhillips).
− The giant mergers of 1998/2000 were largely on a national basis. The two cross-border deals proved unconvincing. BP-Amoco-Arco is subject to legal entanglements in connection with the Macondo accident and Repsol parted company with YPF after a damaging expropriation process.
− Over the course of the wave of mergers, the anti-trust authorities adopted an increasingly tough stance in terms of their demands, making synergies more complicated to implement. Also, “safe” countries that are a particular focus of attention, such as Australia, Norway or recently Canada, after CNOOC’s offer for Nexen, have tightened the rules in relation to predators.
− Major players in the sector are talking more about asset purchases, which includes small single-asset companies rather than large-scale targets.
Meanwhile, large operators have been weakened by the current turbulence:
− BG Group’s management has changed and the company has yet to make any moves on the asset disposals that will help fund production growth, which has proved disappointing.
− The dividends of ENI and Statoil are seen as being under threat, given their investment requirements and financial structures. But the fact that these national champions are partly state-owned suggests that mergers are not on the cards.
− With the Sword of Damocles hanging over BP because of heavy US penalties and Rosneft’s exposure to international sanctions, the group again looks under pressure in the low price environment. The scale of the potential liabilities could thus put predators off.
The sector reshuffle has begun
Under severe pressure from lower crude prices, independents have seen their valuations slump by around 51% since the high points of June 2014 for those exposed to international markets, and by 40% for those active on the US onshore market.
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Table 24: Valuation of independents with international exposure
Companies Price at Market cap Market cap Chg. Geographical exposure
27/02/15 M currencies $m 16/06/14 ($m) (%) Afren (£) 0.09 95 147 2,634 -94.4 Nigeria, Ivory Coast, Kurdistan, Ghana, Saint Tomé et Principe,
Congo, Ethiopia, Kenya, Seychelles, Tanzania, Madagascar, South Africa.
Africa Oil ($CAD) 2.39 884 708 2,166 -67.3 Kenya, Ethiopia, Somalia, Puntland. Gulfkeystone (£) 0.49 439 679 1,246 -45.5 Kurdistan, Algeria DNO (NOK) 14.98 15,329 2,009 3,634 -44.7 Kurdistan, Yemen Cobalt ($) 10.24 4,212 4,212 7,705 -45.3 Gulf of Mexico, Gabon, Angola Northern Petroleum (£) 0.05 5 8 43 -81.5 French Guyana, UK onshore Gulfsands Petroleum (£) 0.01 1 2 7 -75.7 Syria Ophir Energy (£) 1.39 789 1,219 2,394 -49.1 Tanzania, Madagascar, West Africa Hardy Oil (£) 0.50 36 56 119 -52.6 India Chariot Oil & Gas (£) 0.09 24 37 62 -41.0 Namibia Premier Oil (£) 1.69 861 1,330 3,127 -57.5 Indonesia, Vietnam, North Sea, Pakistan, Kenya, Mauritania,
Algeria, Libya, Egypt, Azerbaijan, Russia, China, Thailand, Malaysia, Indonesia, Brunei, Australia, Ghana, Equatorial Guinea.
EOG Resources ($) 75.08 22,447 22,447 30,129 -25.5 US onshore, Canada, Trinidad and Tobago, North Sea, China, Argentina.
Chesapeake Energy ($) 89.72 49,206 49,206 62,318 -21.0 US onshore. Devon ($) 16.68 11,093 11,093 20,286 -45.3 US onshore. Noble Energy ($) 61.59 25,190 25,190 31,910 -21.1 US onshore, Gulf of Mexico, Equatorial Guinea, Cameroon,
eastern Mediterranean (Israel et Cyprus). Southwestern Energy ($) 47.23 17,275 17,275 27,506 -37.2 US onshore Linn Energy ($) 25.08 9,643 9,643 16,354 -41.0 US onshore Continental Resources ($) 12.02 4,033 4,033 10,320 -60.9 US onshore
Sources: FactSet, Companies, Natixis
The sector consolidation that has begun is being driven by a number of factors:
− A defensive approach, with link-ups aimed at strengthening balance sheet structures and generating synergies within a particular geographic zone (as with the planned combination of Afren and Seplat or Salamander and Ophir).
− A search for positions facilitated by attractive valuations (Repsol’s offer for Talisman, with a premium of 42% but a valuation still 27% below that of mid-June 2014).
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IOCs have so far played a fairly small role in the reshuffle and are still in a position to sell assets rather than buy.
Table 26: Asset disposal plans $bn Plan Period Achieved Previous plan Period
Royal Dutch Shell 15 2014/2016 11.6 BP 10 2013/2015 4.0 38 2010/2012
Total 10 2015/2017
10-15 2012/2014 ENI 15 2014/2017 7.6
BG 2012/2014 14.5 Statoil 2010/2014 23.0
Sources: Companies, Natixis
The substantial slump in the valuation of upstream assets could prompt IOCs to tailor their disposal programmes towards midstream or downstream assets (pipelines, storage, networks). Companies could also opt to seize acquisition opportunities.
Filling out portfolios
Table 27: Geographic breakdown of production
% BP Total RD Shell ENI Repsol (pre-Talisman)
BG Statoil
OMV
USA / Gulf of Mexico 19.5 3.3 13.9 7.4 9.2 9 14 Russia / Caspian 30.2 9.7 5.2 6.3 14.5 3.9 Europe / North Sea 4.2 17.1 24.8 21.3 1.8 15.8 75.2 73.6 North and West Africa 10.0 28.6 10.9 54.3 10.2 23.7 10.6 11.0 Middle East 7.4 23.3 11.9 5.5 Asia / Pacific 11.8 10.6 22.1 10.7 13.6 5.7 South America / Trinidad and Tobago. 16.8 7.3 1.2 74.6 22.9 Others 0.1 10.0 4.2 0.5 0.2 0.3
Sources: Companies, Natixis
The upstream profiles of the various European groups show a high degree of contrast, with overexposure to zones putting their portfolios out of kilter, as with BP in Russia, ENI in Africa and Statoil or OMV in Europe.
Acquisitions could be aimed at:
− Establishing a major position in a zone with a view to finding a new growth platform.
− Bolstering existing exposures to take advantage of synergies.
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Table 28: Potential developments
Companies Weaknesses Opportunities
Shell Profitability of US downstream and global downstream Exposure to east Africa, strengthening LNG BP Russian exposure, US litigation Exposure to Africa, including east Africa Total Russian exposure, limited exposure to shale Exposure to east Africa, strengthening LNG, US onshore ENI Overexposed to Africa, limited exposure to shale Strengthening onshore in US, Middle East, South America
Oil services: pressure at all levels If oil prices remain low, this will encourage oil companies to continue adjusting their investment budgets in order to balance their finances. E&P (Exploration & Production) capex should be cut by 15% in 2015 and should then, at best, remain flat in 2016. All segments along the oil services chain will see their markets shrivel: exploration budgets cut (-20% in 2015e), awards pushed back further, margins continually under pressure. In such circumstances, the oil industry will have to transform itself. This will involve forming closer ties between oil companies and subcontractors, which will benefit the most integrated oil service companies, or even carrying out M&A. As a result, we prefer asset-light profiles. GTT (Buy, target price €65) is our top pick. Fugro (Neutral; target price €22), Subsea 7 (Neutral; target price NOK75) and Petrofac (Neutral; target price 800 p) are potential targets. We steer clear of those with the weakest balance sheets (Saipem, PGS, SBM Offshore, Bourbon).
Chart 16: E&P capex and oil prices
Source: Natixis
All segments along the oil services chain are affected
A tough time for exploration
Exploration is the most early-cycle of all the segments and is already being affected by the lower oil price. This market is expected to contract by 20% in 2015. Oil companies are focusing on mature basins and abandoning frontier zones. The seismic market is set to shrink by about 15% in 2015. As for the offshore drilling segment, new capacity is coming on stream and oil companies are losing their appetite, taking a heavy toll on day-rates which are down by more than 30%.
Greenfield projects pushed back
Setting exploration aside, oil companies have little leeway to adjust their capex budgets as projects that have already kicked off are almost never shelved. Brownfield projects (extension/modification of existing units) are the main adjustment variable in development and production budgets. If oil prices continue to fall, oil companies will delay launching new greenfield projects and regain flexibility as and when ongoing projects are completed. As far as E&C (Engineering & Construction) companies are concerned, their healthy backlogs provide cover for 2015 but delayed awards will take a toll on their activity as of 2016.
Oil companies might have to limit themselves to strategic projects with the closest deadlines. This is the case, for example, of:
− Mexico, where block auctions are scheduled for 2015 as part of the constitutional reform.
− the Gulf of Mexico (the American part), where lease rounds are scheduled for 2016.
− new zones, such as Mozambique, where ENI and Anadarko intend to launch LNG projects.
− exploration licences nearing expiry: oil companies will want to meet their exploration commitments (seismic, drilling) in order to get their licences renewed.
− From the license expires on blocks
Margins under pressure
Oil companies are scaling back their investments not only because of a smaller volume of projects being launched but also because service prices are falling. Certain ongoing offshore drilling contracts are having their prices renegotiated (by about -20% to -30%). Signed and sealed E&C contracts do not come with any rebates but it is now more difficult to negotiate amendments, putting margins under pressure.
The oil industry will have to reinvent itself
Oil-producing fields are being depleted and oil companies will have to renew their reserves, so they will not be able to cut back their E&P investments forever. Moreover, pressure on the services chain has its limits. Project costs are rising not only because of fatter margins at service companies, but also for the following reasons:
− The increasing complexity of projects.
− More stringent regulations and safety standards.
− The over-engineering of oil companies, which means that certain equipment and facilities are oversized.
So if oil prices remain low for a long time, the oil supply chain is likely to overhaul itself by establishing closer working ties between oil companies and service providers.
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Restructuring… then M&A
The oil services sector is resolutely adapting to the slowing market, and it might have to adjust its headcount and capacity further. Moreover, a wave of consolidation is likely, with defensive deals between small players and strategic operations for the sector’s leaders.
More restructuring
The full-year reporting season was an opportunity to announce restructuring measures involving staff cutbacks and capacity adjustments.
Table 29: Main restructuring programmes announced
Company Date announced Main restructuring measures CGG 26-Feb.-15 Fleet reduced from 13 to 11 vessels - 400 staff cutbacks in 2015 – capex cuts Fugro 27-Feb.-15 Capex cuts – full or partial disposal of the Subsea division and Seabed JV SBM Offshore 11-Dec.-14 1,200 staff cutbacks (11% of the workforce) Subsea 7 Dec.-14 170 staff cutbacks (Norway) Technip Feb.-15 Fleet reduced from 25 vessels in 2015 to 20-23 in 2017 – partnerships in new assets to reduce capex Schlumberger Jan.-15 Withdrawal of 6 seismic vessels – 9,000 staff cutbacks (worldwide) Halliburton Jan.-15 6,000 staff cutbacks (worldwide) Baker Hughes Jan.-15 7,000 staff cutbacks (worldwide) Weatherford Jan.-15 7,000 staff cutbacks (worldwide)
Sources: Companies, Natixis
These restructuring efforts might not be enough if oil prices remain low for a long time. This is the case, for example, of CGG which has launched the second phase of its restructuring plan and is cutting its fleet to 11 vessels (vs. 13) after having withdrawn 5 seismic acquisition vessels in 2014.
One of the challenges facing the sector’s groups will be to hold onto key resources and know-how in anticipation of the cycle upturn.
M&A on the cards
The slowing services market should trigger a wave of consolidation.
Several groups have had their credit ratings downgraded on account of lower oil prices (Petrofac, which owns production assets), shrinking markets (CGG and PGS in the seismic segment, Seadrill in the offshore drilling segment) or exposure to struggling clients (Petrobras).
We have identified a number of potential defensive deals, particularly between ‘tier 2’ and ‘tier 3’ players:
− In the seismic segment, a merger between the two newest entrants, Polarcus and Dolphin Geophysical.
− In the offshore segment, the sale of Fugro’s Subsea division. The McDermott / Petrofac alliance could, eventually, result in the two groups merging.
− The leading oil service providers could seize opportunities to beef up/diversify their business portfolios. Such more strategic operations do not seem imminent and are likely to wait until visibility on oil price trends improves.
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This is the case, for example, of:
− Technip: “Technip should not grow by doing more of the same”, says T. Pilenko, its CEO. Growth will come from developing its services and product range. In the services segment, one priority is reservoir technologies despite the aborted deal with CGG. Groups like Reservoir Modeling are potential targets. In the equipment segment, the ‘subsea factory’ theme is a growth relay for the medium/long term. Players in the SPS segment (Subsea Production Systems – FMC, Cameron, Aker Solutions) are so large that alliances between them would be the easiest arrangement.
− Schlumberger: Technip’s argument in favour of combining reservoir and engineering technologies suggests that Schlumberger could look for a way into the E&C market. Lastly, CGG’s restructuring and the new focus on less capital-intensive activities (GGR) to the detriment of data acquisition activities should, ultimately, revive the group’s speculative appeal. We think Halliburton / Baker Hughes could be a potential buyer as it has a similar profile to Schlumberger.
OCTG equipment: prepare for the worst If oil prices remain low for some time, the tubes sector will be heavily affected as it invested massively in new capacity during the previous cycle. It always takes a long time to adjust capacity in this type of industry whereas the market is volatile because of fluctuating oil prices. North American is the biggest market as far as the consumption of OCTG (Oil Country Tubular Goods) tubes is concerned, and has always been the most sensitive (smaller players with less solid balance sheets and higher breakeven points since the development of the shale segment). The Middle East should, once again, fare well.
As the markets deteriorate, tube manufacturers have begun to react by announcing staff cutbacks and capex reductions and also by booking impairment charges. Portfolio premiumisation is still a strategic priority for companies wanting to avoid being penalised even more by tubes imported by Asia in particular.
In light of this, we favour players with solid balance sheets and which could become takeover targets, such as Schoeller Bleckmann (Neutral; target price €69).
Pressure on the drilling segment
If oil prices remain low for some time, it will have a big impact on the number of drill rigs in operation and, ultimately, on tube consumption. According to the initial projections published by tube manufacturers, OCTG tube consumption could fall by close to 50% in 2015 and we also need to take destocking into account. If this scenario lasts for a long time, lots of market operators (clients) will opt to keep their capex budgets small so that they can balance their finances.
North America is the most volatile market
North America is the most sensitive market and alone accounts for 45% of global demand for OCTG tubes. Independent companies which still benefited from hedges in early 2015 will also have a rough ride. Investments and therefore drilling activities will be slashed even more drastically if oil prices remain below cash breakeven levels, despite companies having learnt their lesson and lowered their breakeven points (the figure of $10/year is often mentioned).
The rig count began to fall in August 2014 and has continued to decline ever since. It stood at 1,358 rigs on 13 February 2015, of which 78% oilrigs, i.e. down by almost 406 rigs yoy in the USA.
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Chart 17: Oil rig count and WTI prices
Sources: Baker Hughes, FactSet
All in all, the North America rig count is almost 30% lower than when it peaked in September 2014. The downtrend is unlikely to reverse any time soon. During the last market trough (2007/08), the North America rig count plummeted by almost 60% in the space of 9 months (peaking on 12 September 2008 and bottoming out on 19 June 2009). It then managed to rebound thanks to an upturn in the number of oil rigs to the detriment of gas rigs.
So the situation observed early this year is likely to continue deteriorating. According to the IEA, 48% of US output has a breakeven point above $50/b and about 63% of volumes will have fallen below this breakeven point by 2020. So the rig count is set to fall below the low point that it reached during the 2008/09 crisis, and we think total tube consumption in North America could drop below 2m tonnes/year.
Chart 18: North America rig count and US consumption of seamless tubes
Sources: Baker Hughes, MBR, Natixis estimates
Promising zones are at risk
New promising shale oil and gas zones, such as Argentina (100 kt of OCTG in 2013) with the development of Vaca Muerta in the Neuquen basin, could also be threatened by big oil groups deciding to cut their capex budgets. Like the development of unconventional reservoirs in the USA, drilling in the Neuquen basin requires premium tubes which will provide support for tube manufacturers’ margins. The cost cuts, achieved thanks to progress on the learning curve, are limited given that oil is priced at between $50 and $60 and that this is an emerging zone, ultimately making investments somewhat unattractive.
The most resilient region in these circumstances would be the Middle East (1.3 Mt of OCTG in 2013), where the rig count is historically a lot less volatile. Extraction costs per barrel in this part of the world are advantageous, encouraging oil investments.
Chart 19: Middle East rig count and Brent prices
Sources: Baker Hughes, FactSet
Saudi Arabia (574 kt of OCTG) still wants to continue investing despite the drop in oil prices, with the aim of increasing and regaining market share. Saudi Aramco has since H1 14 adopted an aggressive destocking policy (after having awarded lots of mega tenders for tubes over a long period), so it should quite naturally return to the market as of H2 15.
During previous downcycles and market downturns, this region has always proved highly resilient and we think it will be again this time around.
Surplus capacity in the market, adjustments on the cards
A market downturn with disastrous timing
Tube manufacturers have enjoyed a boom in the North American unconventional market in the past ten years, thanks particularly to the development of directional and horizontal drilling. Tube consumption has soared by 160% since 2009. To meet this demand, groups have invested in new premium capacity which is only just beginning to reach the market.
Chart 20: Overview of new tube capacity in North America (Mt/year)
Sources: Companies
These new facilities were aimed at keeping up with growth in the North American market. This market is now trending downwards, which is likely to create surplus capacity as of 2015 and the situation is set to worsen after Tenaris starts up its new plant (capacity for 650,000 tonnes/year, to become operational as of 2016 after a planned ramp-up period of two years). These new facilities have now started producing, but the demand will no longer be there. So with oil prices at between $50 and $60, we expect demand for seamless tubes to fall by 44% between 2014 and 2016.
Such market conditions suggest rather that tube manufacturers’ margins will continue to contract, so the big question is what will happen with tube imports from Asia. Import duties will last until 2017.
Upcoming adjustments
Adjustments to headcounts and investment budgets
As the market continues to slow down, we expect to see more staff cutbacks (employees or temps). Groups like Vallourec approach the permanent staff issue based on 3/5 years of standard activity. Variations in business activity at a peak or a trough are managed using local solutions to increase flexibility (labour loaned from one plant to another, reduced working hours, fixed-term contracts, etc.). Vallourec began to adjust its workforce back in 2014 with the number of hours worked in its rolling mills cut by 15% and its headcount reduced by 7% (its age pyramid was conducive to departures). The programme it has launched is ambitious in terms of the targeted cost savings (€350m) and the time-frame (2 years). Called Valens, it aims above all to make certain functions more centralised (purchasing, IT, HR, etc.) in order to become more flexible and generate savings.
For groups not in the midst of a heavy investment spree, capex will be adjusted and should be limited mostly to maintenance. Vallourec has just emerged from a massive investment drive and its normative capex level has dropped by more than 20% to €350m. Groups are clearly focused on generating free cash-flow.
Accounting adjustments
The changing environment and assumptions used in the financial asset impairment tests should encourage groups to book more impairment charges. Vallourec already wrote down its assets by €1.1bn in 2014 (€539m for European assets and €522m for its new Brazilian plant). The Brazilian Jeceaba plant was written down due to oversupply and fierce competition in the Middle East, as the facility is geared towards exporting premium products which are then threaded in this zone in particular.
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So far no impairment charges have been booked for the American assets, and we think they could end up being considerable if oil prices stay low for a long time, especially considering the average age of production plants in this part of the world.
Vallourec’s North America Cash-Generating Unit passed the annual asset impairment tests in 2014, but the group might have to write down its value if the oil price remains in the region of $50/$60 for several years.
This might also be the case for Tenaris, which has taken the investment decision for a new 650 kt plant in the USA which is set to start up in 2016 with a 2-year ramp-up period.
Potential impact on group ratings
In these circumstances, the balance sheet will be affected, penalising the gearing ratios of those groups that have booked impairment charges, and Net Debt/EBITDA ratios will also be inflated because of weaker EBITDA.
Rating agencies have already placed Vallourec on negative watch; any further adjustments to its capital and an oil price below $60 could prompt them to downgrade its credit rating (currently at BBB/A-2 with a negative outlook at S&P, which adopted this outlook as there is a risk of the EBITDA margin falling well below 15% over 2015/16), thus pushing the group’s borrowing costs upwards. The groups most at risk in our sample are TMK and Vallourec.
Tenaris (net cash position) and Schoeller Bleckmann (even after taking over 67% of Resource Well Completion Technologies in Canada) have more comfortable balance sheets and face little risk in these conditions.
More downtrading on the demand side?
The cost of an OCTG tube accounts for 5/7% of a well’s total costs. Drilling companies want to curb their costs and could be tempted to resort to cheaper tubes; in the unconventional segment, this could put the focus on semi-premium connection tubes which generate much lower margins than premium tubes.
This could benefit Korean and Indian companies to the detriment of the stocks in our sample which are more positioned at the high end of the market, such as Vallourec which generated 66% of its business from heat-treated products in 2014 (58% in 2008 and a target of 70% for 2019). However, premium products are likely to remain essential for all offshore/ultra-deep offshore developments (25% of drilling activity outside North America).
Aerospace: Low oil prices are good news Fuel is the biggest expense for airlines. So the steep fall in oil prices will boost their earnings growth and this, combined with robust traffic trends, should raise demand for new aircraft and thus support the aerospace sector. Our top picks in the sector are Safran (Buy; target price €74), MTU AeroEngines (Buy; target price €94) and Airbus Group (Buy; target price €73). For the short term we are more cautious about Zodiac Aerospace (Neutral; target price €29) and Rolls-Royce (Neutral; target price 930 p).
With oil at $50-60 per barrel, we estimate that fuel accounts for 21% of an airline’s opex (at $50 per barrel). This is significantly lower than when fuel costs peaked at 35% of total costs but fuel is still their biggest expense, well ahead of maintenance, ownership or staff costs. The percentage is even higher for low-cost airlines than for traditional airlines, which means they will become even more cost-efficient.
So airlines are likely to become extremely profitable over the coming years, as from 2015, assuming air traffic remains robust. IATA expects their combined net earnings to reach $25bn in 2015, which is an all-time high.
Table 30: Combined net earnings of IATA member airlines vs. global traffic trend
$bn 2008 2009 2010 2011 2012 2013 2014 2015e
Net result -26.1 -4.6 17.3 8.3 6.1 10.6 19.9 25.0 Global traffic (% chg.) 1.9 -1.1 7.9 6.3 5.1 5.4 5.9 7.0
Source: IATA
Historically airlines spend more on new orders and maintenance when they generate more profit and traffic is buoyant, and this is a very likely scenario given the planned cuts to airline ticket prices.
In such a scenario airlines will need new capacity and have to place new orders. This should largely offset the fact that the fleet renewal market (35-40% of the total market vs. 60-65% for the new capacity market) will probably be a little less buoyant, as airlines have less of an incentive to switch old aircraft for recent more fuel-efficient models.
As regards the maintenance segment, engine manufacturers and companies with prominent aftermarket activities (Safran, MTU Aeroengines, Zodiac Aerospace and, to a lesser extent, Rolls-Royce) will benefit fully from the fact that airlines are in a healthier position and will keep their aircraft in service for a little longer.
Food retail: positive direct and indirect effects If oil prices remain low for some time, the situation will have an overall positive direct and indirect impact on the food retail sector. It could boost margins by at most 30bp. Direct impacts will include 1/ stronger sales via trading up (+10bp for the margin), 2/ lower logistics costs (+4bp) and 3/ a mechanical boost to the margin as petrol will account for a smaller share of the sales mix (+2bp to +9bp). Indirect impacts will include a more moderate natural rise in inflation-indexed costs (primarily wages and rents; +7bp). As regards the stocks in our universe, we favour those exposed to the USA, Ahold (Neutral; target price €16) and Delhaize (Neutral; target price €80), and non-food retail stocks, Metro (Buy; target price €33), Carrefour (Buy; target price €35), GROUPE FNAC (Buy; target price €65) and DARTY (Buy; target price 90 p).
Higher consumer spending, via trading up for the food retail segment
As our Natixis economists have shown, household consumption should benefit if oil prices remain low for some time. If the oil price remains at current levels for the next three years, they calculate that it will add 1 percentage point to growth in household consumption in the USA and euro zone combined over the three years. They also note that pump prices in the euro zone have adjusted more rapidly in Germany and Spain than in France and Italy, so they think that the lower oil price will benefit consumer spending more in the first two countries than in the last two (+1.5 points in Germany and Spain vs. +0.7 point in France and Italy).
Moreover, it appears that consumer spending on food, household equipment, rents, water and residential energy should benefit most if oil prices stay low for a long time. These are mostly consumer staples, so the news if particularly good for lower-income households which consume more when their income is rationed less.
In the food retail segment specifically, although there is no proven price/volume elasticity, we often note that any additional disposable income (especially via lower prices) results in trading up. The consumer will spend his/her extra disposable income on better-quality, more upmarket products. For example, in France in 2014, food deflation came to ~-1.2% for consumer goods as a whole but this was more than offset by a trading-up effect of ~1.5%.
Overall, and all else being equal (flat gross margin rate, flat fixed operating costs), we calculate that an extra 0.5% of consumer spending would push food retailers’ EBIT margins up by 10bp.
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Lower logistics costs driven by lower transportation costs
Logistics costs, and particularly the cost of transporting goods, should benefit from lower petrol prices. According to data published by Ahold, logistics costs represent on average ~3% of a retailer’s sales. We estimate that a third of these logistics costs are linked to transportation (i.e. 1% of a retailer’s sales).
Chart 21:
Breakdown of a retailer’s operating costs Breakdown of transportation costs in France (%) (incl. logistics costs) as a % of sales
Sources: Natixis, company data (Carrefour)
Based on data from the CNR (Conseil National des Routiers), petrol accounts for 25% of transportation costs (i.e. 0.25% of sales).
So we calculate that a 20% drop in petrol prices will, thanks to lower transportation costs, boost a food retailer’s EBIT margin by 4bp.
Natural cost inflation will be moderated, particularly staff and rental costs
We believe that the steep and lasting drop in oil prices will indirectly bolster retailers’ P&L accounts as natural cost inflation, usually estimated at between 2% and 3% / year, will be moderated. Our economists estimate that energy accounts for 8% to 10% of a developed economy’s overall consumer price index. So lower energy prices considerably moderate, or even lower, the inflation indices used to calculate rental growth rates (ICC and ILAT in France) and minimum wages (SMIC in France, adjusted on the basis of a consumer price index and purchasing power gain index).
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Chart 3: Correlation between ICC (construction cost index) and Brent
Sources: INSEE, Datastream
Chart 4: Year-on-year trend for the SMIC (minimum wage) since 1990
Source: INSEE
Wages and rents account for ~11% of a food retailer’s operating costs (cf. chart 2). If we assume that sales grow by 1% lfl, that wage and staff costs are stable in absolute terms, and that other operating costs show natural inflation of 2%, then the impact on a food retailer’s EBIT margin would be 7bp.
Accretive impact on food retailers that sell petrol
Retailers that sell petrol at the pump will see their EBIT margins expand as the price of oil falls. Retailers often consider petrol to be a loss leader, prompting them to sell it at cost price and generate zero margin. So lower petrol prices, at constant volumes, should have a positive business-mix effect. The prominence of petrol in the sales mix varies considerably from one retailer to another depending on the format it operates: petrol is often sold in hypermarkets or even supermarkets. Depending on the share of petrol sales (between 5% and 15%) and the extent of the decline in pump prices (between 10% and 20%), we estimate the impact on a food retailer’s EBIT margin at between +2bp and +9bp.
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Stock picks: exposure to the USA with Ahold and Delhaize, and to the non-food retail segment with Metro, Carrefour, GROUPE FNAC and DARTY
Given the information given above, we think the following retailer categories will benefit the most from lower petrol prices:
− Retailers operating in countries were the oil price in local currency has fallen the most (e.g. USA).
− Retailers heavily exposed to the non-food segment (and thus the most likely to benefit from a rebound in private consumption).
− Retailers whose petrol sales account for a large share of their sales mix (e.g. hypermarkets).
In light of this, our top picks on the oil theme are:
− Ahold and Delhaize owing to their US exposure (respectively 60% and 70% of their EBIT).
− Metro and Carrefour which generate respectively 50% and 25% of their sales in the non-food segment. Note that Carrefour’s EBIT margin will also get a boost from its petrol sales as they account for ~5% of its total sales.
− GROUPE FNAC and DARTY should benefit from a rebound in consumer spending driven by lower oil prices and thus higher purchasing power.
Oil prices have not fallen steeply enough to trigger credit rating upgrades
Our equity analysts estimate that EBIT margins will get a boost of at most 30bp if oil prices remain low for a long time.
This is certainly a substantial potential boost to margins, but not enough to trigger credit rating upgrades for the food retail stocks in our universe. Retailers’ EBIT margins have been trending downwards since 2005: they averaged more than 4% in 2005 but are now only in the region of 3%. As margins have deteriorated, so have ratings.
Chart 22:
2014 EBIT margin vs. 2005 2014 credit rating vs. 2005
This margin expansion, of 30bp at most, will not be enough to improve credit ratios to levels that would trigger rating upgrades. In the cases of Auchan, Metro and Tesco, their adjusted FFO/ND ratios would have to improve by 10 points to trigger any rating upgrade (cf. chart below).
The only two issuers with credit ratios above the minimum levels required to maintain their ratings are Casino and Carrefour and, all else being equal, we think the only potential candidate for an upgrade could be Carrefour. However, if it wants to return to S&P’s “A” category, it would need a good track record in terms of same-store sales growth and margin expansion in all the markets in which it operates, particularly Spain, Italy and China. Moreover, with interest rates so low and market access so easy for corporate issuers, we think it would not be in Carrefour’s interests to get upgraded and it will probably prefer to use its additional financial headroom to make acquisitions or increase its shareholder returns.
In Casino’s case, there is little scope currently for an upgrade given its complex financial structure with lots of minority interests limiting the amount of cash transferred up to the level of Casino SA.
Chart 23: Adjusted FFO/ND ratio at end-2014, minimum FFO/ND ratio required for the rating to be upgraded or maintained
Media: Support for consumer spending and thus for advertising stocks Oil prices have plummeted by more than 50% since summer 2014 and the resulting disinflation should increase purchasing power and thus boost household consumption of non-energy goods and services. There is a very close correlation between household consumption and the advertising market (R² of 89% since 2001). Advertisers only advertise when they have the prospect of selling their goods or services. European TV stocks should benefit most from this, particularly Pro7Sat1 (Buy; target price €46). We also advise investors to take up positions on Publicis (Buy; target price €82) owing to its US exposure.
The European and US advertising markets should benefit significantly
Based on the estimates of Natixis’ economic research analysts, we think there is a high degree of elasticity between oil prices and household consumption in the euro zone as well as the USA (which is more dependent on oil). Our economists say that if oil prices remain at current levels for the next three years, instead of rising back to $75 by end-2016 as per our core scenario, then household consumption will be 1 percentage point higher in the USA and euro zone combined over the three years. Pump prices in the euro zone have adjusted more rapidly in Germany and Spain than in France and Italy. So we can assume that low oil prices will benefit consumer spending more in the first two countries than in the last two (+1.5 points in Germany and Spain vs. +0.7 point in France and Italy). In the French market, for example, we see household consumption growing by 1.3% in 2015, i.e. twice as fast as in 2014 (0.6%). Conversely, advertising markets in oil-producing countries (Russia and the Middle East) should be less buoyant as low oil prices will have the opposite effect on their purchasing power.
European TV stocks should benefit the most
All stocks exposed to the advertising market will benefit from this jump in consumer spending: ad agencies, TV, outdoor advertisers, etc. But we expect European TV stocks to benefit the most as they harbour considerable leverage (80% fixed costs): every extra 1% of growth has a positive impact of about 4% on their EPS on average in Europe (vs. ~1.5% on average for TV agencies). The benefits will, of course, vary from one market to another depending on each specific competitive landscape, but the momentum is favourable and could prompt upward revisions to earnings forecasts if oil prices remain low for some time.
The guidance targets issued during the full-year reporting season confirm this momentum. Pro7Sat1, for example, emphasised that the year had got off to an excellent start in Germany. This was confirmed by the two Spanish TV groups (Atresmedia and Mediaset Espana). Note that these two markets are quasi-duopolies (with the two leaders commanding a combined market share of ~90%), enhancing the impact on prices and bolstering the leverage effect.
So Pro7Sat1 is our top pick in these circumstances and we also recommend buying Publicis given its positioning in the US market, which we expect to be particularly dynamic in 2015 (52% of Publicis’ revenues in 2015 following the acquisition of Sapient).
Construction & Concessions : good news for Motorways and Airports A broadly positive impact on the Concessions sector. Winners: Motorway and Airport operators, particularly ADP (Buy; target price €110). Loser: Groupe Eurotunnel (Neutral; target price €10). Broadly neutral impact on the Contracting (Construction) sector (but negative in regions such as Africa).
Low oil prices are good news for the Concessions sector. First of all they will favour airport operators (a boost to air traffic + more disposable income for passengers making purchases in airport boutiques) as well as airport operators (a boost to motorway traffic). The loser, on the other hand, is Groupe Eurotunnel (the surge in the yield fuelled by the Marpol regulations will perhaps be smaller than expected in 2015). Low oil prices have a broadly neutral impact on the Contracting (Construction) sector. But watch out for certain regions (e.g. Africa), where clients’ financial capacity depends on the oil price. Note that Africa represents estimated annual sales of €2bn for Vinci, i.e. 5%e of its total sales, and close to 25%e of Salini Impregilo’s sales.
Airports: ADP the winner
Lower oil prices benefit airlines (depending on how their oil-price swaps are structured) as they lower their costs and ultimately, enable them to tap into more traffic… and this in turn benefits airport operators. Lower oil prices, i.e. cheaper fuel, also mean more disposable income for passengers and therefore greater purchasing power in airport boutiques. Our top pick in this segment is ADP. All else being equal in our SOP models, an extra 1-point of traffic growth in 2015 vs. our current estimates would push our target prices up by +2.0%e for ADP and by +1.7%e for Fraport.
Motorways
There is no doubt that lower fuel prices boost motorway traffic, which is fundamentally positive for Atlantia, Eiffage, Vinci and Abertis. All else being equal in our financial models, an extra 1-point of traffic growth in 2015 vs. our current estimates would boost our target prices by +2.0%e for Atlantia, by +1.3%e for Eiffage, by +0.9%e for Vinci and by +0.6%e for Abertis.
GET the loser
Low oil prices favour GET’s rivals, i.e. ferry operators, as energy costs account for 30%e of their opex. This scenario would give ferries a little leeway to adopt more aggressive prices and thus limit the positive impact on GET that the Marpol regulations should have as of 2015. GET’s management says that Marpol will indeed benefit GET but only in the longer term.
Food-HPC: strong sensitivity to oil, especially for Unilever The fall in oil prices is favourable to the Food-HPC sector both on the stock market and operationally. Admittedly, the fall in raw materials costs may compress the price effect and therefore organic growth rates, but between the positive impact on consumption and the benefit to margins, the effect of oil prices remaining low would be positive. A scenario of a durably low oil price could trigger a favourable cycle of modest growth and soft inflation, which would strongly rebalance the relationship between growth and profitability and support the current high valuation levels. Unilever (Neutral; target price €40) is in our view THE oil stock in the sector.
The stock market correlation between the relative performance of Food-HPC stocks and oil price has been sharply negative since at least 2007.
Chart 24: Performance of the MSCI Staples Europe index relative to the Euro Stoxx 50 (right) and oil prices (left)
Sources: Natixis, Datastream
This negative correlation derives from both stock-market and fundamental factors.
On the stock market, in times of falling oil prices, investors switch to defensives at the expense of cyclicals. Indeed, leaving aside geopolitical factors, a fall in the oil price is a sign of slowing economy, particularly in emerging countries. European Food HPC groups, which are 50% exposed on average to emerging countries, are affected by this macroeconomic slowdown, but less so than cyclicals. In addition, the current fall in the oil price is fuelling deflation fears, which underlie the ECB’s accommodative policy and therefore the switch to stocks offering solid yields.
The fundamental reasons are to do with the fact that a large share of raw materials costs are themselves correlated to oil prices. The risk of deflation is present in the minds of most investors but the positive impact on margins of lower costs should not be overlooked, even though part will be passed on to consumers, and nor should the indirect effect on purchasing power and therefore growth, especially in mature countries. All told, while a low oil price compresses the organic growth outlook via the price effect, we believe that the net impact on earnings is positive.
Unilever is the group most sensitive to oil due to its product mix. The stock is admittedly seen as an emerging country play, but in stock market terms its shows a sharply negative correlation with oil prices. This is due to the sensitivity of its costs to raw materials prices directly and indirectly linked to oil. A durably low crude price could therefore offer more potential.
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Food for fuel: Agricultural raw materials? or oil?
The biggest and most visible operating impact of low oil prices concerns raw materials costs. But the indirect impact on consumer spending, and therefore on organic growth, as well as the resulting impact on underlying inflation (fixed costs), is also positive.
Contrary to what one might think, the groups in our universe mainly transform raw materials that are correlated to oil either directly or indirectly.
Packaging and petrochemicals are strongly dependent on oil prices even though there is often a lag of 3 to 6 months as with PET, due to the storage effect.
− But there are also agricultural raw materials, and particularly oilseed plants (soybeans, corn and palm oil), the prices of which are increasingly dependent on oil prices since the emergence of biofuels. This is the famous ‘food for fuel’ issue, which has emerged since 2007, the principle of which is simple: the higher the oil price, the more competitive the biofuels industry and the stronger the demand for oilseeds. In Indonesia, palm oil is used to fire power stations. In the USA, 40% of corn production is destined for biofuels and 60% for animal feed.
Raw materials purchases represent 20% to 40% of the sales of European Food-HPC groups and those whose prices are directly and indirectly correlated to oil represent on average 30% of the raw materials purchases of European Food-HPC large caps. Unilever is the most exposed with 51% of its raw materials purchases correlated to oil, by our estimates. We include here vegetable oils, petrochemicals, PET and other plastics.
As a % of sales, raw materials purchases correlated to oil account for up to 20% of sales for a group like Unilever. Although the strength of the USD against the € and emerging country currencies reduces the impact of raw materials gains, the saving on purchasing costs is theoretically considerable and the gross (and theoretical) impact on the operating margin is even greater. A fall of 10% in purchasing prices correlated to oil has a gross impact of +200bp on Unilever’s underlying operating margin, which represents a 14% increase in underlying operating profit.
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Table 31: Breakdown of raw materials purchases as a % of sales: as a % of sales, Nestlé and L’Oréal are the least sensitive
% of sales Unilever Danone Nestlé Henkel Reckitt Beiersdorf L'Oréal Average
Net of the deflationary effect, the impact is positive
A consensus formed at the end of 2014 and at the start of the year around the idea that deflation was the main risk for the sector. This consensus is based mainly on the idea that: 1/ the fall in commodities prices will squeeze organic sales growth rates due to the fall in the price effect; and 2/ that from a stock market standpoint, this is not favourable insofar as organic growth is a key indicator for investors.
− We do not subscribe to this idea although this does not mean that we dismiss the risk. The negative impact of deflation on organic growth is a “false problem”. What would be the value of higher organic growth, if it were only achieved thanks to a price effect that would be nothing other than the exact corollary of stronger inflation? Organic growth is one of the key performance indicators, but it is just an indicator. We are more concerned with EPS, operating profitability, operating FCF and the ROIC, and organic growth is just one of the ways to assess a group’s quality and long-term survival.
− The fall in commodities prices will probably in large part be passed on in selling prices but the impact is sufficiently large for it still to have a positive and visible effect on margins. The following example is just theoretical but it can quickly show that there is no incompatibility between a rise in margins and the passing on of the fall in commodities prices in consumer prices. Purchases correlated to oil account for on average 10% of the sales of European Food-HPC groups. An average fall of 20% in the price of purchases correlated to oil (after factoring in the fall of the € vs. the $ and hedging impacts) has a theoretical average impact of 200bp on the operating margin. Passing on 90% of the fall in selling prices nevertheless leaves a net gain of 20bp for margins.
− The appreciation of the USD from creates a competitive environment that is unfavourable to massive price cuts. North American groups (P&G, Mondelez, Colgate, PepsiCo, Coca-Cola, etc.), the main global rivals to European groups, are faced with a strong $, which is hurting their earnings. P&G recently said that the $ was going to reduce EPS by 12% over its fiscal year and that it would offset part of this impact via pricing (mainly in emerging countries) and via cost
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savings. Although this is a mistake in our view (consumers don’t care about the impact of the $ on P&G’s EPS), this policy might be favourable to a limited fall in prices and enable European groups to either retain a larger share of the raw materials gains or reinvest in prices with better-than-expected leverage on volumes (market share gains).
− The positive leverage on volumes should not be overlooked. Oil prices have a direct impact on consumer spending, as our economists show. And the marginal return on volumes varies from 30% to 65% for higher value added products, and even 80%/90% for products such as perfume.
Lasting effect?
The fall in oil prices obviously has a cyclical effect on purchasing costs and indirectly on consumer spending. But the positive effect of low oil prices on the European Food-HPC sector could be more durable on two conditions:
− If European groups make good use of part of this raw materials gain to tactically capture market share. Faced with US rivals forced to exercise greater cost discipline to offset the impact of the $ on their EPS, it could be a good time for them to be a little more aggressive commercially speaking.
− If the continuing low level of oil prices were to open up a cycle of modest growth/soft inflation. In concrete terms, when organic growth rates were 8% to 10% in emerging countries, how come levels of operating profitability didn’t skyrocket? In reality, between one-third and half of this growth created only very little (or artificial) value since it merely reflected just the passing-on of inflation in raw materials costs in prices. In addition, this very same inflation in raw materials costs drove high-single-digit underlying inflation in fixed costs in certain emerging countries. The impact is not neutral in that fixed costs represent nearly 30% of sales.
Unilever: the oil stock
Unilever is in our view THE oil stock in the European Food-HPC sector. Durably low oil prices would be clearly favourable to the operating profitability outlook but also the share’s valuation.
As the previous tables show, Unilever is the group whose raw materials purchases are the most sensitive to oil. Its product mix (washing powder, cooking aids, sauces, margarines, cosmetics) combined with its mass market positioning account for the large share of plastics, petrochemicals and vegetable oils in its raw materials purchases. We believe that nearly 50% of its purchases are directly or indirectly correlated to oil. On the stock market, this sensitivity has been clearly identified as illustrated by the negative correlation between its share price and the oil price.
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Chart 25: Unilever’s performance relative to the Euro Stoxx 50 (right) and the oil price (left)
UNA rel perf vs Euro Stoxx from sept07 (RHsc) crude oil Brent in $ (LHsc)
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Capital goods: impact will vary from one group to another The correlation between electrical engineering stocks and oil prices seems to depend more on the industrial markets of the groups in our sample than on their cost bases. From this perspective, certain groups such as Legrand (Neutral; target price €48) appear to be relatively immune to a fall in commodity prices because there is no mechanical correlation with their market outlets and because replacement products account for a large share of their sales mix (about 50%).
Positive close correlation with share prices
There is a positive close correlation between certain electrical engineering stocks and oil prices. It stands at 65% for Prysmian, 60% for Rexel, 57% for Schneider, 55% for ABB and 42% for Legrand since 2004. By way of comparison, integrated oil stocks are most closely correlated with oil prices (about 80%). In electrical engineering, this correlation is much closer with oil prices than with non-ferrous metal prices (28% with nickel for Saft, 25% with copper for Nexans, negative correlation with copper for ABB and Prysmian), even though these metals are essential to their production processes.
Chart 26: Rebased oil price (Brent/$) vs. ABB (CHF) and Schneider (€)
Source: Natixis estimates
Yet there is also a proven historical correlation between Brent and in electrical engineering (T&D) capex in the USA and industrial capex in OECD countries. So an empirical approach suggests that lower oil prices will have a mechanically negative impact on electrical equipment makers’ capex in 2015 in terms of orders and in 2015/16 in terms of billings. Certain groups (ABB, Nexans, Rexel) say there will probably be delays in project phasing.
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Chart 27: Correlation between Brent and electrical engineering capex in OECD and USA
Source: Datastream
Correlation with operating performances mainly concerns market outlets
The correlation seems to depend more on the market outlets of the groups in our sample than on their cost bases. On this basis, the groups most exposed to the oil/gas segment within our universe are Saft (10% of 2014 sales), ABB (10%), Nexans and Prysmian (7/8%), Schneider (6/7%) and then Rexel (4%), which needs to be considered in relation to its exposure to the upstream oil segment. Conversely, certain groups appear to be relatively immune to falling commodity prices as there is no mechanical correlation with their market outlets and they have a large share of replacement products in their sales mix (about 50%), such as Legrand.
Lower purchasing costs might appear to be a potential godsend, but we think it will be very limited because of the deflationary climate. ABB, Nexans and Legrand currently have less pricing power in mature countries and in systems and projects. Oil is used to produce plastics (insulation, casing) but only accounts for a tiny share of purchasing costs compared with non-ferrous metals (especially copper, aluminium and silver). It also seems to account for only a modest share of energy costs for the groups in our sample. Moreover, existing hedges will delay the impact by about 3 to 6 months. Lower costs would be beneficial if selling prices continue to rise, but this seems to be less the case since late 2013. So wage inflation (2/2.5%/year on average) can only be effectively tackled with higher productivity, not with widespread price hikes.
More specifically, market outlets in the upstream/downstream oil segment have very different cyclical profiles depending on the group in question. Almost all the groups in our sample, except for Rexel (a distributor), show an imbalance between their oil-related production costs and their oil-related sales, with Saft, Prysmian, Nexans, ABB and Schneider having the biggest imbalances. Most market outlets are in the upstream oil segment, both onshore and offshore. Production cycles are relatively long, especially in offshore (6 to 15 months). So lower oil prices will not have an immediate impact; they will initially cause book-to-bill ratios to contract in 2015, assuming oil prices remain in the region of $50/60/bbl.
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Table 32: Operational exposure to oil and gas markets
Utilities: very low impact Oil prices remaining low over the long term should, all other things being equal, have minimal consequences for European utilities. The gas segment would nonetheless be the hardest hit. Within our coverage universe, the companies most affected would be GDF Suez (Neutral; €18.5 target price) and, to a lesser degree, E.ON (Reduce; €11.75 target price) and Gas Natural/Fenosa (Neutral; €21.3 target price).
Generally speaking, the prices of the main fossil fuels (oil, gas and coal) are moving independently of one another save in special cases. We have therefore assumed in our scenario that low oil prices over the long term would not directly impact the prices of other fossil fuels (coal and natural gas).
When it comes to electricity generation, Europe does not have many oil-fired power plants in operation today due to technological (obsolescence) and environmental considerations (carbon intensity). Even if they became more cost competitive in relation to gas- and coal-fired units, it would not affect their position within the European mix. Moreover, because of structural changes in the European sector since the start of the decade, the coal price is now the main driver of wholesale prices.
Environmental services specialists (Suez Environnement and Veolia Environnement) are only directly exposed to oil prices through costs at their waste management and energy services businesses (Veolia Environnement; via Dalkia International). But energy costs are subject to pass-through mechanisms at these businesses, meaning rises and dips in costs are more or less automatically passed through to final customers without affecting operators’ margins. On the other hand, the positive impact of an uptick in GDP on industrial output would have a positive effect on industrial waste management volumes.
The recent fall in the oil price will have a direct impact on operators in the gas segment in 2015, though effects will vary greatly in magnitude and even in direction depending on the businesses and geographic areas exposed. Operators with exposure to oil exploration and production and sales of liquefied natural gas (LNG) in Asia (sale prices indexed to oil prices) will be the hardest hit. Among the companies we cover, the impact will mainly be felt by GDF Suez (estimated €900m EBITDA impact in 2015) and, to a lesser extent, E.ON and Gas Natural/Fenosa. Where GDF Suez is concerned, continuously low oil prices would take away a margin growth catalyst (assuming a barrel price applied by the group of $67 in 2016 vs. $60 in 2015). This would probably lead the group to speed up implementation of its existing strategic plan, which involves reducing the portion of revenue exposed to commodity risk, notably by scaling back hydrocarbon-related investments (exploration-production, LNG activities).
Hotels, Leisure & Catering: positive to varying degrees Cruise and tour operators stand to gain most from the fall in oil prices. To a smaller extent, duty free, hotels and contract catering groups should also benefit. Our top picks are Carnival (Buy; target price 3,600p) and TUI (Buy; target price €17.5).
The oil price decline is positive for the Hotels, Leisure & Catering sector. Groups stand to benefit in different ways, 1/ directly on their cost base for groups that buy fuel (Cruise and Tour operators) and 2/ via consumers’ increased purchasing power (Hotels, Duty Free and Contract catering).
Cruise & Tour Operators: main beneficiaries
Fuel is one of the biggest cost items for cruise operators (ca. 20% of their operating costs). Carnival and Royal Caribbean are thus excellent vehicles to play the fall in oil. In its last update and based on Brent prices of $63, Carnival was looking for a fall in its fuel bill of $475m in 2015 (vs. a total fuel bill of $2bn in 2014). On the whole its sensitivity is as follows: a $10 fall in oil prices accounts for $0.13 /share (i.e. ca. 5% on 15e EPS). As for Royal Caribbean, its sensitivity is ca. 3% on EPS for a 10% variation in oil prices.
Tour operators with their own aircraft fleets should benefit from the fall in oil prices. TUI operates a fleet of 136 aircraft and Thomas Cook 88. We estimate that the impact should be contained in 2014/15 (virtually-nil for the winter season and slightly positive for the summer) in light of the groups’ fuel hedging policies. Moreover, the groups estimate that they should be able to pass on part of the savings to customers. Therefore, although this will have a globally positive impact in 2015, we believe that 2016 holds most of the potential for nice surprises (fiscal year beginning on 1 October) if oil prices remain sustainably low.
Duty Free, Contract catering and Hotels: Also positive
The oil price decline will support motorway and air traffic figures. Autogrill and Elior are exposed to this traffic via their contract catering businesses. Dufry and World Duty Free also stand to gain.
To a lesser extent, hotels will benefit as some of the additional traffic will have a knock-on benefit for hotels.
Automotive: a positive effect that must be qualified Sustainably low oil prices are globally positive for the automotive sector even though certain side effects must not be overlooked. For car manufacturers, beyond partially supporting demand, this situation should result in a richer sales mix (which will be more tangible in North America than in Europe) and improved operating costs (energy and logistics), partly compensated by various perverse effects (lower return on fuel efficiency investments, pressure on certain emerging markets). While it is difficult to identify the real winner/losers in the current climate, Daimler (Buy, target price of €91), in light of its trucks exposure, might stand to gain most.
For Auto parts suppliers, beyond gains tied to potentially higher automotive demand or a richer mix, the clearest gains will be made on commodities and their retention rate after renegotiations with their car manufacturer clients. Faurecia (Buy; target price €48) and Plastic Omnium (Buy; target price €30) could thus stand to gain most, given the larger share of plastic in their raw materials purchases.
Last, tyre manufacturers could benefit from more upbeat trends on the replacement market owing to richer mix trends and to a smaller extent, a potential increase in distances travelled. Even so, remember also that this climate has perverse effects on pricing conditions which will probably play more in favour of low cost players, at the expense of premium ones. On the whole, it is difficult to single out any real winners in the short term on this segment, Nokian Tyres (Reduce; target price €20) stands to lose most, owing to its strong exposure to Russia.
Indirect impact on demand, more significant on the mix
The impact of sustainably low oil prices on automotive demand is not easy to determine. We believe the relationship is essentially indirect, reflecting the reallocation of implied purchasing power gains in the purchase of new vehicles. This factor is far from being the main driver for automotive demand which is more sensitive to other variables such as interest rates (70% of purchases in Europe and 90% in the USA are financed via credit or leasing), the unemployment rate and demographics. This supportive factor will probably be a marginal, perhaps even ineffective support in countries where demand is already stimulated by tax breaks (e.g. the PIVE plan in Spain). Moreover, price sensitivity to oil will be more tangible in the USA given the low share of taxes in fuel prices (10/15% vs. 60/80% in Europe). At this stage of the cycle, given the level of profitability reached (high for premium players, recovering for broadline), any additional growth in demand will be felt more on the mass market segment (Peugeot, Renault, Fiat Chrysler Automobiles) where capacity utilisation rates are much lower than in the premium segment.
The theoretical impact on demand could be more significant in the trucks segment, owing to the development of rail freight and a greater investment capacity on the part of transportation companies, whose profitability is sharply influenced by fuel price trends (this line item accounts for a good third of their operating costs). The combination of low oil prices and low interest rates post-QE might speed up the recovery in demand for trucks in Europe, beyond current forecasts that are underpinned by replacement needs after the recent crisis (5% increase expected by Volvo, +0% to 5% by Iveco, vs. Natixis estimate of +3% for the segment > 16T). This also applies to the US trucks market which is still remarkably upbeat despite the clear recovery in 2014 (+14%). This climate should benefit Daimler whose trucks business accounts for 21% of 2015e EBIT as well as Volkswagen whose trucks division, undergoing restructuring, accounts for 14% of 2015e OP.
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OE suppliers should, unsurprisingly, be supported by greater manufacturing momentum but it is difficult to identify one particular winner. Among tyre makers, and beyond the continued impact on OE sales, there is a strong correlation between distances travelled and growth in the replacement tyres segment. But although it does exist, it is much weaker when it comes to fuel prices, including in the USA where, as indicated previously, the weight of taxes is much lower than in Europe. Amid this, it would appear that beyond a fall in fuel costs, the macroeconomic climate remains predominant, which means we prefer Michelin as it is more exposed to North America (30% of sales). Last, in the long term, manufacturers should benefit from an improved mix in favour of SUVs that have bigger sized tyres. Moreover, the group has the most exposure to the trucks segment (31% of sales) compared with other manufacturers, particularly in North America.
Beyond the impact on demand, keeping oil prices low should skew the sales mix in favour of larger vehicles that consume more fuel. This trend has already been observed in the USA where fuel prices have fallen to around $2/gallon (a level not seen since spring 2009), thus boosting sales of light trucks and SUVs that now account for 55% of demand (historic peak of 60%) versus 42% in June/July 2008 when fuel prices culminated at $4/gallon. As this segment is the most profitable, this trend promises improved margins, and the Detroit 3 (Ford, GM, FCA) will be the main beneficiaries. In Europe, the situation is patchier due to tax breaks for more low-key vehicles (e.g. eco penalty in France).
Perverse effects
The fall in oil prices has an impact that is not only positive for the automotive sector. Indeed, its impact is negative for emerging economies that are highly dependent on commodities and hydrocarbons in particular. This is notably the case of Russia where the recent difficulties, exacerbated by international sanctions and the collapse of the rouble, have led to automotive demand plummeting (-20% to 30% expected in 2015 after a 10% fall in 2014). Nokian Tyres is undeniably the stock that is most sensitive to crude price fluctuations, as its share price is strongly linked to oil prices (see our report 13/01/15 Still too early). Renault is also widely exposed to the Russian market, both directly (7% of its sales) and via Avtovaz that will not be fully consolidated before 2016. The group’s challenge will be to avoid sinking into the red and offset the shortfall in Russia with solid operating leverage in Europe, as it brilliantly managed to do in 2014.
Moreover, a lasting fall in fuel prices might mean that consumers have (even) less interest in alternative powertrains (full electric, hybrid, plug-in hybrid) which are still significantly more expensive than conventional (internal combustion) engines. This could push back the prospect of a mass development of these technologies, making it more difficult to generate returns on the heavy investment made by the global automotive industry (>50% of R&D efforts are tied to these issues) under increased pressure from environmental regulations. This situation calls for an in-depth examination by US and European regulators as to the upcoming stage of tightening of CO2 emission standards (further decrease of 18/28% expected in Europe between 2020 and 2025, more than 50% reduction in the USA between 2016 and 2025) which threatens to widen the gap between consumer demand and manufacturers’ offering.
What about operating costs?
The industry as a whole stands to benefit from the impact of lower oil prices on its procurement costs (particularly via indexing clauses with suppliers) as well as on energy and logistics spending. Car makers do not seem to have factored in particularly favourable assumptions in their 2015 guidance, probably owing to what is still a highly competitive climate. We do not see as much of a distinction on this theme, which should however play more in favour of broadline manufacturers (Peugeot, Renault, FCA, VW) given the currently weak profitability on their automotive businesses.
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Among parts suppliers, the players with most exposure to plastics, such as Plastic Omnium and Faurecia, should come out on top amid the current climate as they estimate that they will be able to preserve between 20 and 30% of the gains after negotiations with car manufacturers. Bear in mind that for the most part, this pertains to complex plastics and consequently there is not a perfect price correlation with crude oil.
Last, at tyre manufacturers, we still think that such an environment is challenging as the current context of low commodities prices plays in favour of low-cost players at the expense of premium players such as Michelin, and could heighten pricing pressure, thus squeezing the gains made on raw materials costs.
Brent vs. Eurostoxx 600: an econometric analysis In order to supplement the views of our equity analysts, we use an econometric analysis to look at the long-term and short-term relationships between the sector sub-indexes making up the Euro Stoxx and several market variables, including the oil price. The results yielded by this analysis enable us to determine a basket of sectors that benefit from a durably low oil price environment. These are Industrial goods & services, Personal & household goods, Food retailing, Media, and Travel & leisure.
Analysis of the impact of oil shocks on the different sectors of the equity indexes is generally carried out via factor models. These quantify the sensitivity of yields to variations in clearly identified economic and financial factors, including oil prices. For our purposes, these models have a major disadvantage: they are based on variations in statistical data (yield, growth rate). Most of our study is based on a strong hypothesis, namely a stagnation in oil prices or, put differently, a variation close to zero over a time horizon of a few years. This is why it is impossible to use factor models and why we used another statistical technique, cointegration.
Understanding cointegration requires a degree of familiarity with some statistical concepts, in particular stationarity. To be stationary, a series has to meet three conditions, namely a constant average, finite variance and last covariance between two periods t and t+h that is solely a function of the difference in the time h. To summarise, a series is stationary if its average, (finite) variance and covariance are time-independent. This is generally not the case for variables such as GDP, consumer spending, the oil price, etc.
The advantage of the theory of cointegration lies in the fact that a large number of financial and macroeconomic series are not stationary. Consequently, the use of standard regression methods could then result in two problems, namely fallacious regressions and the fact that certain asymptotic laws (in particular those that test significance) would no longer be valid, de facto skewing the evaluation of the test statistics. We therefore chose to focus on error correction models. Indeed, error correction models make it possible to model the adjustments that lead to a long-term equilibrium situation. These are dynamic models that factor in both the short-term and long-term changes in variables.
To this end, we seek to determine whether there exists a cointegration relationship between the Euro Stoxx, its component sectors and different market variables. The market variables that we consider are the following: Brent, US and European 3-month deposit rates, and the EURUSD. All of the variables are logarithmic with the exception of interest rates, which are levels. The period studied is from January 1999 to the present day, except for the real estate sector, for which the data begin in 2001.
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If there are one or more cointegration relationships between the variables, then the series must necessarily not be stationary. Consequently, we must first determine whether the series are stationary or not. Several tests exist, each of which has its advantages and disadvantages, but we opted for the ADF (Augmented Dickey-Fuller) test. Given the test statistics as well as the critical values associated with them, we observe that all of these series are non-stationary with or without constant and trend.
The test is then carried out on the differenced variables. This is therefore the yield for equity indexes, Brent and the EURUSD since the series are logarithmic. It turns out, after analysis of the test statistics, that the entire differenced series is stationary with or without constant and trend (Table 1). We may therefore conclude that the logarithmic series or level series for rates are integrated of order 1 (I(1)). Therefore, the whole point of the concept of cointegration is that can link non-stationary variables in a relationship that is stationary.
Table 33: Test statistics and P-value for the ADF test
The next step is to find out whether there is a cointegration relationship within each of the non-stationary series sets. To this end, two approaches may be used. The first is the Engle and ranger method, which consist of first estimating the long-term relationship, then subsequently the error correction model. The disadvantage of this approach is that it cannot distinguish several vectors of cointegration where they exist. In order to get around this difficulty, we prefer the second method proposed by Johansen: a multivariate approach (i.e. where several variables are included) to cointegration based on the maximum likelihood method.
We therefore apply the following procedure. First, we use different criteria, namely the information criteria of Akaike (AIC), Hannan-Quinn (HQ), Schwarz (SC) and the Final Prediction Error (FPE) in order to determine the number of lags in the VAR modelling the variables. According to the principle of parsimony, we choose the smallest lag among those that minimise each of these criteria. However, we verify that the VAR residuals are not autocorrelated via a Portmanteau test and incrementally increase the degree of the VAR as long as the null hypothesis is rejected. Second, we determine the number of cointegration vectors using the trace test proposed by Johansen. We observe that at the level of 1% we have ONE cointegration relationship for all the equity indexes.
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Table 34: Number of lags selected, test statistics and critical values of the trace test
Now we have to identify the long-term relationships between variables, estimate using the maximum likelihood method the VECM model and perform the usual validation tests, namely verify that the coefficients are significant and that the residuals are indeed white noise.
The cointegration relationships given by the Johansen method are presented in the first part of the table below. The final columns represent the coefficient associated with the long-term equation in the estimate of the VECM and the p-value corresponding to the test on the residuals (Table 3).
If we take the example of the Healthcare sector, we have:
With 𝑍𝑡−1 a stationery series representing the estimated residual of the long-term relationship in the VECM.
We observe that the null hypothesis of white noise from the residuals in the VECM is rejected for media at 1%; at 5% it is not rejected for the oil & gas, chemicals, food retailing, real estate and travel & leisure sectors. Analysis of the coefficients leads us to eliminate certain sectors. Indeed, if these coefficients of course have to be significant, they also have to be negative otherwise there would be no phenomenon of returns.
Consequently, although the correction is fairly weak over one month, we choose to focus on the following sectors: Healthcare, Industrial goods & services, Personal & household goods, Insurance, Chemicals, Food retailing, Media, Travel & leisure and last Financial services.
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Table 35: Cointegration relationships and associated coefficients in the VECM, P-value of the Ljung-Box test
Sectors1 BRENT IR USD 3M IR EUR 3M EURUSD Coefficient Coint Eq P Value (Ljung-Box)
The idea is therefore as follows, the higher the Brent price, the more it penalises these sectors. Conversely, a low Brent price favours them.
We now analyse the VECM coefficients associated with the short-term momentum. The first table below shows the coefficients associated with the returns (or variations) from the explanatory variables lagged by one month and the second table the coefficients associated with the returns from the sectors and from Brent for lags ranging from 2 months to 4 months.
As regards the variables lagged by one month, we note that the coefficients allocated to Brent are all negative but are only significant for Industrial goods & services, Household equipment, Food retailing, Media, and Travel & leisure. These sectors should therefore benefit from a low level for Brent via the long-term equation and also from any fall in Brent via the short-term dynamic. It is worth noting that this short-term effect (negative and significant coefficients) shows up again a little later, with a lag of four months. These results confirm the recommendations of the various analysts as given above.
Equity strategy: how to play lastingly low oil? The sharp fall in oil prices is broadly positive for equity markets. The bulk of its impact stems from the resulting improvement in macro growth prospects. What scale are we talking about? Eurostat econometric calculations, corroborated by our economists, suggest, based on a 50% slide in prices since June 2014, a growth supplement of 0.4% for GDP in volume in year one, 1% in n+1, 1.2% in n+2. Hence, though the positive impacts are clear, we also see that the full effect will only be felt in the context of maintained low prices over a relatively long period (2 to 3 years).
Table 37: Impact of a 10% fall in the oil price on real GDP (annual averages)
% Year 1 Year 2 Year 3 France 0.01 0.02 0.05 Germany 0.16 0.33 0.37 Italy 0.07 0.25 0.36 Netherlands 0.03 0.08 0.10 Spain 0.04 0.21 0.25 Euro zone 0.08 0.19 0.24 Source: Eurosystem Staff Calculations
We have seen that our economists validate this assumption. In fact, this scenario of lastingly low oil has prompted them, alongside the fall for the euro/$ and inside five months, to raise their growth forecasts for the euro zone in 2015 from 0.8% to 1.7%. Our EPS growth estimate model, based on simple regression between GDP in volume (main variable) and EPS growth (secondary variable), suggests that this upward revision brings EPS growth to 13% this year versus 7.0% expected before, which is of course favourable to the valuation for equities.
Based on current market data4 these items point to a Stoxx index on a target 12m fwd PE of 15.8x (14.1x at 24/2/2015)… i.e. an increase of some 12% (ex-dividend) on current levels.
How to play low oil? Long (H1) sectors negatively correlated to the price of crude (consumption and operating costs)
Basically, the fall for crude can be boiled down to a massive transfer of wealth from oil producer countries to energy intensive company and households.
What sector consequences? We have downgraded Integrated oil and Oil services from Market performer to Underperformance. Unsurprisingly, the power of the downward adjustment to prices upsets economic equilibria for the oil and oil services sector. For Integrated oils, the downward adjustment to capex risks being insufficient to maintain a level of cash flow compatible with the present level of high pay out (> 55% in 2013). To avoid selling off these assets on the cheap, disposals have slowed, even come to a halt. Finally, it looks doubtful that the solidity of balance sheets (with gearing not over 33%) will be tapped to continue with a generous shareholder return policy. Fundamentally, the sector is engaged in a negative spiral: declining profitability, upcoming cuts to investments and dividends.
Aside from the negative message for the Oil sector as a whole (Integrated oil and Oil services), we have sought how to take advantage of this lasting scenario of weakness for oil
4 Cost of capital of 7.2% (Natixis equity calculation), 49% pay out for the Stoxx index, ROE of 8.1%,and sustainable growth rate of 4.1% (g= RR * ROE)
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prices. At end-2014, we examined the 6 month correlation between Brent and sectors. We have introduced two levels of analysis: 1/ stock market examination (monthly logarithmic return for Brent and sectors) and 2/ the impact on operating margins (net adjustment to the operating margin over one month in the consensus and logarithmic return for Brent).
How to profit from these adjustments on the stock market? Basically, it is in the interests of the investor to sell sectors positively correlated to the Brent price: Integrated oil, Oil services, and, to a lesser extent, Electricity players and Staples (a decline for oil implies downward pressure on commodity prices).
Conversely, sectors with a negative correlation should be bought and the most evident gambles are to be found in sectors for which oil (and its derivatives) represent a substantial proportion of operating costs: Airlines (watch out however for the possibility of a price war5 which would promptly cancel the benefits of the slide in jet fuel prices), Chemicals (=), Capital goods and Building materials (Cement notably). The sectors which will benefit from extra business (positive impact on GDP growth, supplementary purchasing power) are also desirable: Environment, Non-food retailing, Hotels & leisure and Banks (via an increase in loan distribution).
Lastly, the slide for oil equating to a supply shock, cyclical Consumer goods are to be picked as they profit from the extra purchasing power conferred: Cosmetics (Outperformance), Luxury goods (Market performer), Media (Market performer), Car makers (Outperformance) and Car parts suppliers (Market performer).
Fundamentally, our long call on European equities remains intact: we are playing a return to earnings growth in Europe (+13% based on 1.7% GDP growth in volume terms in the euro zone), at a time when the cost of capital will remain low for a long while (7.2% vs. a historical average of 9.1%) because of the unconventional monetary policy being implemented. It is true that the overall climate is conducive to an overweighting of equities, but we would warn investors against any kind of non-discriminatory approach. Buying growth does not mean buying it at any price.
The factors behind the supply shock ($ and oil prices) benefit European economic growth quite a lot more than they benefit global growth. The latest forecasts established by our economists put euro zone growth at 1.7% (in volume terms) in 2015 and 2016 (i.e. an upward revision of 0.5% in the space of 2 months!) without any similarly substantial upward revision to global growth projections (2.6% vs. 2.5%).
This constitutes a solid argument in favour of European cyclical stocks (and the financial sector) and against sectors most exposed to global growth, especially as the latter are trading on historically high relative multiples. We would support this argument further by emphasising the relative stabilisation of the euro / dollar exchange rate. This could be good news for European equities, especially as regards flows from the USA. Moreover, flows from the USA generally imply investments in value themes. But should we be concerned about one of the main earnings growth drivers being made obsolete? No, because base effects established by the recent appreciation of the dollar have by no means been exhausted (most of the positive impact materialises 18 months after the decline), and the beneficial effects on company accounts are only just beginning to filter through.
5‘For Ryanair, the slide for oil favours price wars’, Reuters, 2 February 2015
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Table 38: Summary of criteria to play oil weakness
Correlation 6M sectors Correlation 6M OM sectors Note
What consequences for the credit market? The underperformance of $ debt vs. € debt since September 2014 is to a great extent attributable to the fall in oil prices, as the weight of this sector in $ credit indexes is much greater than that in € IG indexes and even more so in HY indexes. Low oil prices would trigger a sharp rise in energy sector leverage in $ HY and a rise in the default rate on the $ HY market of 1.3 points. From an econometric standpoint, the $ HY market already prices in such a big rise in the risk of default that it offers an incentive to increase long positions on this market, despite the oil risk. In IG debt, the Oil risk premium is also much greater in $ IG spreads than in € IG spreads. In the medium term, convergence between these risk premiums may therefore be played on IG Oil & Gas debt.
Allocation between € and $ debt: overweight the € in the short term on the IG segment
Since the acceleration in the fall in oil prices, € and $ credit indexes have not moved in the same way. The chart on the left below shows that the € non-financial IG credit market showed little change throughout the period August 2014 to January 2015, while $ non-financial IG debt suffered strongly in the same period (45bp widening in spreads against swaps). The chart on the right below intuitively confirms that the widening of $ credit spreads vs. € is inversely correlated to oil prices - if we exclude the recent period, which has seen a tightening of credit spreads in both the US and Europe, driven in particular by the ECB’s announcement of QE on 22 January (despite the fact that corporate debt is excluded from the programme).
Chart 28:
Asw spread of € iBoxx Non-Fin indexes vs. $ € - $ spread differential on
This underperformance by $ credit markets since the fall in oil prices is largely due to the over-representation of the energy sector in $ credit indexes compared with € credit indexes: the chart below left shows that the Energy sector accounts for 17% of the iBoxx US$ HY index, while just 1% of iBoxx € HY non-financial outstanding debt stems from this sector! The exponential growth
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in shale oil drilling in the US in recent years has engendered a broad debt market in this sector to finance the heavy investment – with relatively high leverage ratios. All told, US HY credit indexes include $185bn in HY debt denominated in $, with a strong concentration on BB and B- ratings (cf. the chart below right). This peak is a cause for concern, insofar as it corresponds to unsustainable leverage levels, assuming that the EBITDA generated by these companies in 2015 will be strongly affected by durably low oil prices.
Chart 29:
Share of the Oil & Gas index in € and $ credit indexes
Based on this observation, it is easy to see how a lastingly low oil price level is likely to result in a continuation of the underperformance of $ credit markets relative to € credit markets, in that the default rate in the US energy sector will have a substantial impact on the average default rate for dollar-denominated debt, which will not be the case for the market in debt in €.
What default risk on Oil & Gas HY debt in $?
In order to determine the impact of a rise in the default rate on HY debt in $, we estimated the impact of the fall in oil prices on the leverage ratios of the main $ HY issuers in the Energy sector. In a scenario of a fall in the Brent price from $99 in 2014 to $52 in 2015, we assumed a fall of 60% in EBITDA on average for the sector, generally similar to that observed for the European majors in the same scenario. These leverage ratios for Energy sector $ HY issuers are weighted by the share of these issuers’ outstanding debt in the index.
In order to estimate the increase in the risk of default in the sector, we modelled the probability of a default within the next 5 years by an Oil & Gas $ HY issuer depending on the associated leverage ratio. Based on the 61 companies with the highest outstanding debts in the sector, we obtain an average leverage ratio of 4.6x at the end of 2013.
Moreover, assuming stable net debt for the issuers (the decline in operating cash flow being offset by reductions in capex), average $ HY sector leverage would rise from the current level of 4.6x to 11.6x! In terms of the probability of a default in the next 5 years (weighted by outstanding debt per issuer), the impact of this scenario would be an increase of 15 percentage points, or 2.5 percentage points at the scale of the $ HY index as a whole. In terms of the risk of default at one year, this
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increased leverage in the Oil & Gas sector would potentially represent a rise of 0.5 of a percentage point in the US HY default rate.
However, this assumption looks relatively optimistic, insofar as the risk of default is in reality a rare and binary event. If, on the other hand, we assume that leverage above 11x (which corresponds roughly to a CCC or lower rating in the Oil & Gas sector) automatically triggers a default, then the chances of a default in a scenario where oil prices remain at $52 per barrel would be 24x greater than those currently observed in the Oil & Gas sector of the $ HY market. Over a 3-year time horizon, this would push up the $ HY default rate by 1.3 percentage points.
This may not look like much compared to the default rates historically observed in the HY segment (cf. the chart below left), but compared with the most recent levels reported by Moody’s (1.91% for the US HY, 2.05% for the global HY at end-January 2015), an increase of 1.3 points in the $ HY default rate would be substantial.
In particular, a scenario in which all the Oil & Gas defaults materialise before the end of the year would push the $ HY default risk up to 4.3% at the end of 2015 (cf. the chart below right), assuming that our core scenario of a default rate of 3% holds true excluding the Oil & Gas sector.
Chart 30:
Historical trend in the HY default rate according to Moody’s Impact of an oil stress test on $ HY default risk
Stress tests on Oil & Gas(assuming stable default rates
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Is this risk of defaults in the Oil & Gas sector priced into $ HY spreads?
Is this risk priced into the $ HY market? To determine this, we applied a stress test with a default rate of 4.3% on the $ HY market to our forecasting model for $ HY spreads (cf. charts below). This showed strong divergence between the spreads observed and our model. We estimate the sensitivity of the $ HY index to a 1 point increase in the default rate at 35bp for OAS spreads. This would imply a theoretical spread for the $ HY index of OAS+449bp at the end of 2015, taking into account not just a default rate of 4.3%, but also a rise in the VIX to 17% by the end of the year. As the chart below on the right shows, $ HY spreads already price in this risk premium.
Chart 31:
Historical $ HY spreads Impact of an oil stress test on $ HY spreads
Consequently, exposure to the $ HY segment has become attractive, even factoring in a worst-case scenario of oil remaining at $52/bbl until the end of the year.
In the medium term, should investors take up positions on the $ IG debt market?
The charts below show, at 26 February last, the risk premiums observed in the Energy sector in € on the left and in $ on the right, by rating category. We can see that the risk premium is low on the € IG credit market, except for BBB+ and BBB- rating categories. However, these are biased by a large share of issues by Pemex in the BBB+ category and by Gazprom and Petrobras (probably not for much longer, since after Moody’s downgrade of Petrobras to Ba2 on 24 February with the rating remaining on review for downgrade, a one-notch downgrade by S&P or Moody’s would put the Brazilian corporate in the junk category), hence an emerging risk. For the other rating levels, it must be acknowledged that the risk premium for the Energy sector on the $ credit market is around 40-50bp for AA- to BBB+ ratings and 150bp for BBB- rating, which is much higher than what is observed on the € credit market.
We would therefore gamble in the medium term on a convergence of sector risk premiums between € and $, i.e. an outperformance of the Energy sector in $ vs. €, at least for the IG compartment (which will be less affected by the resurgence of defaults to be expected in this same scenario in the HY category).
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Chart 32:
€ non-fin credit spreads by rating according to sector $ non-fin credit spreads by rating according to sector
Indeed, while the underperformance of $ debt relative to € debt has been visible in all sectors since September 2014 (cf. charts below), the most marked negative differential on the $ credit market does indeed stem from the Oil & Gas sector (cf. chart below on the right).
Chart 33:
Credit spreads by sector Contribution to the change in the iBoxx indexes (€ and $)
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