“The plunge in oil prices is unambiguously good for the US economy”
– Virtually every “pundit” with a business suit, who collected a $200 CNBC appearance in the past 3 months
A week ago we showed that, using Gallup polling data, the crude crush has clearly led to a “spending surge” among US consumers: whereas a year ago all US consumers spent $96 per day, this December, with crude and gasoline prices roughly half off, Americans spent a self-reported whopping, drumroll, $98 per day.
Worse, as is well-known the biggest marginal beneficiary of low gas prices are not wealthy US consumers, for whom the elasticity of gasoline (and crude) prices is irrelevant, but poorer households, those making under $90,000 a year. It is here that the spending spree was an even more unprecedented $1 more, from $84 a year ago to $85.
That’s the good news.
The bad news is that contrary to conventional wisdom, as even Bank of America and Goldman now admit, sliding crude prices will have an increasingly more negative impact only not on economic growth but S&P earnings… something we said from day one.
Here is Bank of America becoming increasingly less cheery:
Despite conventional wisdom, investors seem to be on edge, with the 10-year yield below 2% and equities stumbling. Global disinflationary fears are growing, with concerns that the US will not be able to decouple from weakness abroad. And despite the benefits of cheaper gasoline, reports of a recent shale default and cuts to energy capex are putting the focus on downside risks. In our view, those risks are contained.
In our Year Ahead piece, we highlighted the downside risks to the energy patch from falling oil prices. At that time, based on our 2015 oil forecast of $90/bbl, we saw around 0.1%-pts of risk to GDP. But continued declines in the oil price suggest mounting risks. Here, we gauge the downside risk to growth if oil stays at $50/bbl. Already, rig counts have fallen to 1482 in the first week of January from a high of 1609 in October last year (Chart 1), suggesting declines in exploration/drilling outlays.
Although that 8% drop appears modest relative to history (we saw a 60% decline in the 2009 recession), Chart 1 shows that there’s about a four-month lag in the response of rig counts to weaker oil prices, so there’s likely more pain to come. Indeed, our Oil Services team sees a near 15% decline in rig counts in 2015. It’s important to note that the relationship between oil production and rig counts is non-linear. As our Commodity Strategy team points out, early reductions in rigs don’t necessarily imply falling output as operators may initially shift resources to more economic wells, keeping production intact. As prices fall further, the decline in rigs may eventually trigger greater curtailments in production. Thus, we see a notable lag of several months in the response of production to weaker prices.
The good news is that oil and gas extraction accounts for only 1.8% of GDP directly, suggesting a small hit to the overall economy. For example, if energy production were to fall by 10% in 2015 (just shy of the 14% decline in the recession) the decline in production would slice 0.2% off of GDP.
Needless to say, oil is not only 10% lower than the $50/bbl price when this note went to print on Friday, but is about 50% below BofA’s 2015 oil forecast. So… what were we talking about again?
And then there is BofA recalling that Investment is a very distinct component of GDP.
With the oil price falling, capital budgets in the energy sector have come under renewed pressure. According to Census Bureau’s Annual Capital Expenditure Survey, roughly 90% of energy capex is allocated to structures investment – namely outlays for exploration and wells. Spending there tracked an annualized rate of $140bn in the first three quarters of 2014, a sum that accounts for a whopping 30% of total non-residential private fixed investment in structures (Chart 2), or about a 1% of GDP.
In our view, there are important downside risks to the outlook for capital spending. Already, a number of energy firms have announced cuts to capital budgets recently, expressing caution in an environment of falling energy prices. If we use history as a guide, there are five notable periods of decline in energy capex since the early-80s coinciding with falling energy prices.
Based on the magnitude of the capital spending decline in response to falling energy prices historically (Table 1), we think that if the oil price in 2015 averages $50/bbl (marking a 50% decline relative to 2014), energy sector capex could fall by 40%. That’s about 1% of downside risk to non-residential structures, all else equal, or a hit of 0.3%-0.4% of GDP.
Or, one could just read what we warned back in November when we explained that the “Imploding Energy Sector Is Responsible For A Third Of S&P 500 Capex.” We are happy that Wall Street has finally caught up with what our readers knew 2 months ago.
And then there is Goldman, where the first Mea Culpa came from equity strategist David Kostin who said:
Reduced energy capex will also hurt profits in other industries. In contrast, lower oil is a positive for the US consumer, but likely not enough to offset the Energy sector drag on overall market earnings.
The direct negative effect of lower oil prices on Energy earnings is clear. Energy firms account for 8% of S&P 500 market cap and 11% of earnings, and EPS have a strong historical relationship with the commodity. Given this historical relationship and oil futures prices, Energy earnings are likely to drop by more than 50% year/year in 2015. This fall would result in an S&P 500 earnings drag of roughly $65 billion, or more than $7 of EPS vs. 2014.
Better get that multiple-expansion thesis going then. Oh wait, it was Goldman which two months ago said Multiple Expansion Is Over. Well then…
But it gets worse, because according to Goldman the biggest driver of stock upside in 2014 and also in 2015 – stock buybacks– is about to be punched in the face.
Buybacks are also at risk. Energy accounts for 9% of S&P 500 buybacks, in line with their market cap weight. In the past decade, Energy firms have increased the share volume of repurchases during periods of falling crude prices and stock valuations, but buybacks have nonetheless declined in dollar terms. A decrease in Energy buybacks proportional to the fall in oil would represent a $35 billion headwind to the aggregate $107 billion (+18%) growth we forecast for S&P 500 buybacks in 2015. However, the slow start so far in 2015 is not unusual: January is typically quiet, accounting for just 3% of annual repurchase activity, while February sees double that amount.
In short: dear BofA and Goldman, welcome to the red pill party.
To summarize what we have said since September, here is Bloomberg:
Forecasts for first-quarter profits in the Standard & Poor’s 500 Index have fallen by 6.4 percentage points from three months ago, the biggest decrease since 2009, according to more than 6,000 analyst estimates compiled by Bloomberg. Reductions spread across nine of 10 industry groups and energy companies saw the biggest cut.
Earnings pessimism is growing just as the best three-year rally since the technology boom pushed equity valuations to the highest level since 2010. At the same time, volatility has surged in the American stock market as oil’s 55 percent drop since June to below $49 a barrel raises speculation that companies will cancel investment and credit markets and banks will suffer from debt defaults.
One big market risk from lower oil is the prospect that it will freeze energy-related capital spending, according to Savita Subramanian and Dan Suzuki, strategists at Bank of America Corp. Earnings in the S&P 500 may be as much as $6 a share lower than analysts forecast this year should oil stay below $50 a barrel, they estimate.
“Either there is nothing to worry about and crude is going quickly back to $70 plus, or we have entered an earnings down cycle for an appreciable portion of the market,” said Michael Shaoul, who helps oversee $10 billion as chief executive officer of Marketfield Asset Management in New York. “Idon’t see much room for a middle ground and I don’t think the winners will cancel out the losers.”
Precisely. And to complete the humorously circle, here is some more delayed comprehension comedy:
“My initial thought was oil would take a dollar or two off the overall S&P 500 earnings but that obviously might be worse now,” Dan Greenhaus, the New York-based chief strategist at BTIG LLC, said in a phone interview. “The whole thing has moved much more rapidly and farther than anyone thought. People were only taking into account consumer spending and there was a sense that falling energy is ubiquitously positive for the U.S., but I’m not convinced.”
Yes, Dan, in retrospect everything is much more obvious. And thank you Dan for finally SHIFT-F7ing “unamobgiously good” and teaching us the übiqutiously positive” synonym. Even if Wall Street’s value-added is boosting one’s SAT vocabulary, we will take it…
Written by Tyler Durden-Zero Hedge