Investment Research US Consumer and Corporate Behavior in a Low Oil Price World Ronald Temple, CFA, Managing Director, Portfolio Manager/Analyst David Alcaly, Research Analyst Since the extraordinary decline in oil prices that began in mid-214, analysts and commentators have focused much of their attention on who wins and who loses from cheaper oil. What has not been a subject of much analysis, however, is timing when the impact of lower oil prices will actually appear in the economy. This question is of great importance to the United States, which is both a large oil producer and a net importer. In this paper, we examine how and when sustained lower oil prices may affect US consumer and corporate behavior. Consumers have already seen dramatically lower gas prices at the pump, but we believe higher spending is unlikely to occur until the second half of 215. Corporate cuts in the US energy industry, on the other hand, are being announced now, and their impact will be felt as they are implemented. Considered together, we believe that the decline in energy prices is a substantial net positive for the US economy, but we also recognize that the benefits and damage may not appear in the economy at the same time.
2 Introduction In the December Lazard Insights, The Evolving Global Oil Market, we evaluated the factors contributing to plummeting oil prices and outlined the implications of a low oil price world. In a series of Letters from the Manager since, our investment teams have discussed the specific implications for investors in the Middle East and North Africa (MENA), Australia, real estate, and emerging markets debt. In this paper, we examine how and when the decline in oil prices may affect consumer and corporate behavior in the United States. It is commonly observed that two of the biggest economic impacts of sustained lower oil prices should come on the positive side from new consumer spending due to savings at the pump, and on the negative side from capital expenditures (capex) and job cuts by companies in the oil supply chain resulting from sharply lower cash flows. Winners and losers are thought to break down along the same consumer and producer lines (Exhibit 1). prices were to recover. While they are not discussed in this paper, we also believe that state and local governments in oil-producing regions will take even longer to adjust, both because their budgeting cycles are not designed to respond rapidly and because, with the exception of Alaska, tax revenue likely will be affected more by weaker local economies than by lower oil production taxes. Consumer Spending At the current average retail price for regular gasoline of $2.33 per gallon, 1 consumers stand to save roughly $83 $1,2 per household on gasoline over the course of a year (Exhibit 2), or about $15 $125 billion cumulatively. The impact of this windfall on the economy depends on how much of it is spent rather than saved. 2 Exhibit 2 Lower Gas Prices Could Result in Significant Savings for Households Exhibit 1 Winners and Losers from Lower Oil Prices (USD/Gallon) 3.8 Average Gasoline Price Winners Losers Countries Net importers Net exporters 214 Average Industry Sectors Petroleum or related inputs Exposed to consumer discretionary spending Petroleum or related outputs Exposed to the oil production supply chain 2.9 2. Estimated Consumer Savings Price Drop vs. 214 Average ($/gallon): 1.8 Implied Consumer Savings ($B): 15 125 Implied Savings per Household ($): 83 1,2 Feb 14 Apr 14 Jul 14 Sep 14 2.33 Dec 14 Feb 15 The timing of the gains and losses from oil prices is less obvious. This consideration is particularly important for the United States, a net importer of oil that is also one of the world s biggest oil producers. We agree with the consensus that low oil prices should be a net positive for the overall US economy, with differing regional and sectoral impacts. However, we disagree about timing and believe current expectations about how quickly these impacts will be felt are unreasonable. We believe the most substantial portion of increased consumer spending is likely to become apparent three to four quarters after prices began to decline. This implies that the expectations for a spike in consumer spending in the first half of 215 might be premature. In fact, we believe there is a strong case to be made that the bulk of consumer spending benefits will come in the second half of 215 as household savings accumulate and people begin to see lower fuel prices as a longterm rather than a short-term change in expenses. We believe imminent corporate cuts are more widely anticipated because of recent announcements, which have come quickly and are severe. They should be followed by more gradual signs of wider economic impact, as cuts are implemented and local economies suffer. The speed and depth of these announcements can partially be explained by the quicker capex cycle for shale oil production, which also implies that capex could be ramped back up more rapidly than in the past if oil As of 23 February 215 Note: Chart shows the drop in average retail prices for regular gasoline. Consumer savings calculation is based on spending on all grades of gasoline and fuel oil. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Energy Information Administration, Bureau of Economic Analysis, Census Bureau, Bureau of Labor Statistics, Bloomberg, Haver Analytics, Lazard It is important to note that consumer spending on gasoline and other fuel contributes to GDP. As a result, if consumers save rather than spend their entire windfall from lower gasoline prices, GDP measured in dollars, as opposed to volume, could actually decline. When the benefits of lower fuel prices are instead spent on other goods and services, there is a stronger multiplier effect than if these benefits had been spent on fuel. This elevated multiplier effect means the new spending ultimately has an even greater impact as increased business revenues resulting from this spending are in turn spent and work their way through the economy. Much of the discussion of the economic impacts of lower oil prices has focused on headline consumer savings, leading to recent disappointment that retail sales have yet to show dramatic improvement (Exhibit 3). Part of the problem is that it is inherently difficult to separate the impact of new spending from the broader dynamics of an improving economy. Moreover, retail sales figures do not capture all consumer spending and are themselves affected by the lower prices at the pump. While the Department of Commerce does report retail sales at gasoline stations as
3 Exhibit 3 Retail Sales Have Not Responded Dramatically to Lower Gas Prices* (%, MoM Change) 1.2.6. -.6-1.2 1994 21 a separate series, the percentage of gasoline purchases from sources other than gasoline stations has risen to 13.8% of total volume as companies like Kroger, Walmart, and Costco sell increasing volumes of gasoline. 3 As a result, even core retail sales figures are not as clean as they might appear. Beyond measurement challenges, two other factors should be taken into account: 1. the possibility of a lag in how consumers respond to changes in expenses that are more price inelastic; and 2. the timing and accumulation of savings. We see this lag as shaped by a number of factors that influence consumer behavior, including: the propensity to spend new disposable income, which is highest among low-income consumers; the economic and employment outlook; 28 * Retail sales include food services but exclude autos, building supplies, and gas stations; month-over-month % change, 3-month rolling average (SA). As of 31 January 215 Source: US Department of Commerce, Haver Analytics 215 views on the duration of low gas prices, especially since new volatility in prices (which were relatively stable in recent years) increases uncertainty, creating a bias for saving; and the lasting psychological impact of losses incurred in the global financial crisis, as well as the related need to continue deleveraging and rebuilding household balance sheets. Our view is that while consumers immediately recognize their savings at the fuel pump, they are unlikely to immediately commit to redeploying their incremental disposable income in a long-lasting way. For example, if an individual saves $2 on gas, she might splurge on a movie or a restaurant meal or might choose to save the money. She is unlikely, however, to commit to monthly payments for a durable goods purchase under the assumption that the savings on fuel will be recurring. Over time, as the energy savings are perceived to be more permanent, then we would expect an individual to redirect her savings in a more long-term way, leading to increased consumption of other goods and services that initiates the virtuous cycle of multiplier effects we anticipate. If we take into account the damage done to consumer balance sheets, income statements, and confidence by the global financial crisis, it is appropriate to expect consumers to be more reluctant to spend all of their savings right away. In fact, in a recent fourth quarter earnings call, Visa CEO Charles Scharf indicated that consumers to date have been saving about 5% of the energy windfall, using another 25% to pay off debt, and spending only 25% on other goods and services. He also said that he anticipated that accumulated savings would eventually be spent in discretionary categories. We believe improving sentiment, continued job gains, and an accumulation of savings could come together in the third or fourth quarter. Notably, US gasoline consumption peaks during the summer driving season, and the combination of summer vacations followed by the back-to-school shopping season provides ample opportunity for increased discretionary spending. We should also note that by late 215, many consumers will begin to see their credit scores recover from the financial crisis. Credit scores typically take about 7 years to recover after a foreclosure and 7 1 years to recover following a bankruptcy, depending on its type. 4 Over the course of 215, more than one million households could see their credit scores recover as the extreme financial stress of 27 29 recedes into history. Combined with lower fuel prices, stronger job gains, and still low interest rates, this could be particularly powerful in driving increased spending. We illustrate the accumulation of savings per household in Exhibit 4, in which we chart monthly year-over-year changes in actual US consumption of fuel oil and motor gasoline multiplied by retail prices through January 215. We extend the calculation to the end of 215 using consumption and prices as projected by the US Department of Energy, Exhibit 4 Household Savings Projected to Peak in Spring and Summer 215 (YoY Change, USD Spend Per Household) 4-4 -8-12 Actual EIA Projection (USD) 4. -16 2. Jun 14 Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Gasoline [LHS] Fuel Oil [LHS] Avg Gasoline Retail Price [RHS] As of 31 January 215 Note: Calculated as (consumption x retail price) / number of households. Consumption data is not limited to households. Price and consumption projections are those of the Energy Information Administration. Savings are not evenly distributed among households. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: US Energy Information Administration, Lazard 3.5 3. 2.5
4 Exhibit 5 Exploration and Production Capex Cuts Could Be Similar to 1986 Down Years (%) 1986 1987 1991 1992 1998 1999 22 29 215E North America Capex -39-8 3-18 -4-27 -17-32 -35 International Capex -18-4 23 8 14-14 9-6 -15 Total Capex -31-6 15-2 7-18 -1-15 -21 Lazard estimates as of 17 February 215. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Historical data from Barclays which sees pump prices rising slightly but remaining near current levels. The calculation is rough, but it nonetheless demonstrates that meaningful savings only began in recent months. As shown in the chart, we expect savings to be substantially larger in the spring and especially the summer, with cumulative savings reaching significant levels during this period. Assuming prices do not sink further, year-over-year savings should decline as we approach the anniversary of the initial energy price decline in the fourth quarter. In summary, we believe the shift in spending from lower oil prices to other goods and services is likely to be delayed longer than in prior supply-driven price cycles due to the circumstances of the current economic environment, potentially until the third or fourth quarter of 215. The benefits will extend into 216 assuming fuel prices do not rebound, but that contingency largely depends on the pace and degree of capex reductions by oil producers and the subsequent effect on prices. Oil Supply Chain Cutbacks In contrast to the more nebulous task of evaluating and projecting consumer behavior, we have already seen immediate and substantial announcements of capex cuts by energy companies in response to the oil price decline. Based on historical experience and assuming oil prices remain near current levels, we believe the 215 cuts could reach 35% versus 214 capex, which represents a significant drop in historical terms (Exhibit 5). Only five times previously has the oil price plunged more than 3% in a six-month period. Four of these instances coincided with global weakened demand for oil, during the US recessions of 199 91, 21, and 27 9, and the Asian crisis in 1997 98. The fifth, in 1985 86, is most similar to current circumstances and was precipitated not just by weak demand growth due to price spikes in the 197s, but also by supply factors rising production from non- OPEC sources and a reversal of policy by Saudi Arabia, which ramped up production to gain market share (Exhibit 6). 5 Following the 1985 86 price decline, North American exploration and production capex dropped by nearly 4%, according to Barclays data. Our estimate of a 35% capex cut in 215 represents a small further decline from already announced spending cuts, which have been rapid and severe in the first quarter to date, averaging 3% for US producers Exhibit 6 Major Oil Price Declines Since 1983 (USD/Barrel) 14 15 7 1/9 4/91-47.% 5/1 11/1-32.2% 1/85 4/86 1/97 4/98 7/14 1/15 35-58.% -33.5% -55.2% 6/8 12/8-68.6% Jul 83 Jan 94 Jul 4 Jan 15 US Recession Avg of WTI, Brent, and Dubai Spot Prices As of 31 January 215 Note: Price drop percentages are for the deepest six-month drop in an average of the monthly average WTI, Brent, and Dubai spot prices. Source: Bloomberg and 34% for Canadian producers based on Goldman Sachs tracking through 19 February 215. Announcements in recent weeks included: ConocoPhillips, slashing spending plans twice in a month, including a 3% cut to worldwide capex; Pioneer Resources, surprising the market with 45% year-over-year capex cut; and Apache, announcing that it would reduce 215 spending by 55%. The timing of these announcements, roughly two quarters after the oil price began its plunge, is also in line with past experience. Historically, a decline in rig counts, which foreshadows new drilling, lags falling oil prices by about one quarter, while private fixed investment in oil & gas wells and mining & oilfield machinery lags prices by about two quarters. Indeed, rig counts have begun to fall off dramatically (down 39% from the 1 October 214 peak as of 27 February 215), 6 but upstream private fixed investment was still increasing at the end of 214. Similarly, direct employment in upstream oil & gas production had yet to decline significantly by the end of 214 (Exhibit 7). The severity and speed of these announcements is in part due to the rapid growth of shale oil production in recent years, as its capex cycle is shorter than for other oil production, especially large, complex multi-year projects offshore. To be more specific, a significant portion of oil shale well production is generated in the first two years, and production rates can decline 7% in the first year. 7 The time to initiate production is
5 Exhibit 7 Rig Counts Have Started to Follow Oil Prices Lower... (USD/Barrel) 6 45 3 15 WTI Crude Oil Inflation-Adjusted Spot Price [LHS] Baker Hughes US Oil & Gas Rotary Rig Count, Pushed Back 3 Months [RHS] 1983 1991 1999 27 215 (Rigs) 3, As of 27 February 215 Note: The rig count series is for both oil & gas rigs, which extends back further than the equivalent series for oil rigs alone and captures the 1985 86 price drop. Source: Baker Hughes, Bloomberg, Haver Analytics...While Upstream Fixed Investment Lags the Oil Price by Two Quarters... (%, YoY Change) 16 WTI Spot Price Upstream O&G Private Fixed Investment, Pushed Back Two Quarters 8-8 1986 1993 2 27 As of 31 December 214 Source: Energy Information Administration, Bureau of Economic Analysis, Haver Analytics 2,25 1,5 75 214...And Oil & Gas Employment Has Yet to Significantly Decline (% MoM Change) 3-3 27 29 211 As of 31 December 214 Source: Bureau of Labor Statistics, Haver Analytics Upstream Oil & Gas Employment Total Oil & Gas Employment 213 215 also short, allowing producers the flexibility to adjust capex plans quite quickly (aside from investments that have been contracted in advance), both as prices plunge and as they recover (provided prices do not stay down so long that spare capacity shifts out of the supply chain). Balancing quicker reaction times, many of the initial cuts in shale capex have been focused on less efficient and more costly new development, and some of the capex reductions will come via lower prices and margins in the supply chain, making impacts more gradual than headlines suggest. This view is consistent with the consensus that while US oil production growth will slow, a decline is unlikely to occur at least until the second half of 215 or even later, depending somewhat on whether prices remain low for an extended period of time or enter a V-shaped recovery. Notably, when natural gas prices and rig counts fell in 212, gas production did not. Nonetheless, recent announcements clearly signal the beginning of deep cuts to investment and employment, which we expect to be felt throughout the oil production supply chain as they are implemented. However, the broader negative impacts on regional and local economies will take longer to be felt even if sentiment might be affected sooner. In summary, we believe the scale and timing of recent rig count declines and capex cut announcements are in line with historical experience and their economic impacts are likely to be felt in coming quarters. Based on historical experience, oil production capex could ultimately sink by 35% or more. However, capex cuts for shale oil production can be reversed more quickly if prices rebound. Conclusion The potential effects of the recent plunge in oil prices have been the subject of much discussion, in particular the benefits for consumers and consumer spending and the negative impact on oil producers and the oil production supply chain. Despite wide anticipation, we believe consumer impacts will become most apparent in the second half of the year and producer impacts in coming quarters, assuming oil prices do not rapidly rebound. We estimate consumer savings of roughly $83 $1,2 per household and producer capex cuts of roughly 35% in 215, with wider effects as new consumer spending circulates throughout the economy and lower oil producer spending hurts the industry supply chain and local economies reliant on oil production. However, both direct and indirect effects will take time to be felt. On the positive side, consumer behavior is likely to gradually factor in more permanent savings and a stronger economic outlook, but it will take time for sustained consumption patterns to change as the majority of savings will accumulate in the spring and summer. On the negative side, recent rig count declines and capex announcements signal the beginning of actual cutbacks, based on historical experience. Taken together, we view the decline in energy prices as a substantial net positive for the US economy, but we also recognize that the costs of capex reductions will be uneven and may not perfectly match the timing of the benefits from consumer spending.
6 References 1 As of 23 February 215. Source: Energy Information Administration 2 The upper end of the range is calculated using Personal Consumption Expenditure information from the Bureau of Economic Analysis s National Income and Product Accounts. The most recent release was the advance estimate for 214, published on 3 January 215. The lower end is calculated using household expenditure information from the Bureau of Labor Statistics s Consumer Expenditure Survey (CE). The most recent CE data tables are for 213 and were made available on 9 September 214. 3 215 Retail Fuels Report. National Association of Convenience Stores. February 215. Spittler, Malcolm D. and Peter D Antonio. Retail Sales Through The Looking Glass: Down is Up. 12 February 215. 4 As of 13 February 215. Source: Fair Isaac Corporation, MyFICO.com 5 Global Economic Prospects, January 215: Having Fiscal Space and Using It. World Bank Group. January 215. 6 As of 27 February 215. Source: Baker Hughes United States Crude Oil Rotary Rig Count data via Bloomberg 7 Jayaram, Arun and Mark Lear. Investing in E&P. Credit Suisse, 1 April, 214. Important Information Published on 14 September 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 7 April 215. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives, and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. LR2519