Rising oil prices are great for OPEC and oil exporters, for US shale producers and their capex plans (or at least, stock buybacks plans), and for those long energy equities. They are less great for everything else, and carry a long list of adverse consequences chief among which is that rising oil/commodity costs pressure margins and result in weaker consumer spending. In short, they transfer wealth from oil importers to oil exporters, and benefit stocks at the expense of the economy.
It is this trade off that is becoming a major concern to Goldman’s clients according to the latest Weekly Kickstart from Goldman’s David Kostin, who writes that higher oil prices “should have only a minor impact on aggregate S&P 500 EPS” as the boost to Energy EPS is “offset by margin pressures and weaker consumer spending.”
The Goldman chief equity strategist also reminds us that his bank’s energy team is bullish on oil in the near term (largely on geopolitical considerations), turning more neutral over the longer-term:
“Brent crude oil has surged to $75/bbl from $45 in 2017. Our Commodities team expects oil prices will rise to $83 during the next three months before falling to $75 later in 2018.”
Meanwhile, when it comes to the impact of rising oil prices on energy stocks, the answer is also nuanced, because while energy companies have rallied by 11% in the last three weeks, sharply outperfmorming the S&P 500’s +1% gain amid improving cash flows and capex discipline, the risk is that “decelerating economic growth poses a risk to the sector, and positioning and valuation are less compelling than many expect.“
Some more details on each of those items, starting with why Goldman expects oil prices to rise over the next 3 months before fading 12 months out:
The synchronized upswing in global growth has been a dominant focus of investors for the past year and has boosted oil demand. At the same time, lower production from OPEC, Venezuela, and American shale has restrained supply. Based on tracking data, inventories have normalized and are tracking below their 5-year averages. Our colleagues forecast a 12-month Brent price of $75, but see upside risks given the strong fundamental backdrop and elevated geopolitical tensions among Middle East producers. The futures curve suggests a similar path for oil and indicates that Brent will trade at $69 in 12 months.
Going back to the chief concerns voiced by Goldman’s clients, namely the impact of oil prices on the S&P and the broader economy, Kostin believes that these will be negligible, with the upside summarized as follows: every $10 increase in the average price of oil would add roughly $1 to S&P 500 EPS; this however is offset by higher energy input costs which weigh on the profit margins of firms in other sectors. Furthermore, as Joe Lavorgna recently pointed out, each one cent increase in gasoline prices reduces household purchasing power by $1 billion.
Higher oil prices should have a minimal impact on aggregate S&P 500 EPS. Our macro model suggests that every $10 increase in the average price of oil would add roughly $1 to S&P 500 EPS. Energy companies are the clear beneficiaries of higher oil prices. Historically, Energy EPS growth has outpaced changes in crude oil given high operating leverage. On the other hand, higher energy input costs weigh on the profit margins of firms in other sectors. Energy input costs equate to 1.6% of US private industry revenues. Higher gasoline prices also reduce the disposable income of consumers and weigh on spending. However, the headwinds from higher oil prices could take longer to affect earnings than the direct boost to Energy company profits.
That said, should the oil surge continue, there will be blood, and Kostin notes that transportation and consumer stocks appear most at risk from rising oil prices.
Fundamentally, energy inputs comprise the largest share of revenues for the transportation and paper products industries. With investor focus on record high S&P 500 profit margins, incremental commodity inflation could pose a risk to firms in these industries. At the stock level, GS analysts have identified 35 stocks with at least 15% input cost exposure to oil and oil derivatives. From a share price perspective, consumer-facing industries such as Consumer Services and Retailing have exhibited the strongest negative sensitivity to oil prices.
Here Kostin makes another notable observation: while energy sector equities have been closely correlated with crude oil prices, during the past year energy returns and oil prices diverged to their widest gap since the Financial Crisis. This is shown in the chart below. Kostin attributes this perplexing underperformance of energy to investor preference for secular growth stocks in 2017, which also resulted in the expectations of a ceiling to long-term oil prices that would limit the growth prospects of Energy companies. Another question is what happens next: do energy stocks rally and “catch up” to their correlation implied fair value, or does oil plunge.
To be sure, Goldman remains optimistic on the outlook for energy companies, with Kostin noting that “higher oil prices and improved capex discipline have combined to improve Energy company fundamentals. Our equity analysts forecast S&P 500 Energy companies will grow EPS by 110% in 2018 compared with consensus growth of 81%.”
Even here, however, one observes some peculiar changes from the traditional expansionary process: in contrast with past periods of rising oil prices, companies are tempering plans for capex and focusing on improving free cash flow and cash return to shareholders according to Goldman, which quotes managements teams who have noted that backwardation justifies a more muted capex response.
Our analysts forecast growth in Energy cash flow from operations of 51%, capex growth of 13%, and FCF growth of 207% in 2018 (see Exhibit 3). Energy buyback authorizations have totaled $7 billion YTD, more than twice the amount at the same time last year, and consensus expects 5% dividend per share growth in 2018 after no growth last year.
That said, risks to the bullish thesis remain, chief among which is the danger of decelerating economic growth which “could pose a risk for the sector going forward.” Kostin writes that while oil demand has benefited from strong global GDP growth, the bank’s US and global Current Activity Indicators have decelerated to 3.4% and 4.6% respectively from 4.9% and 5.2% in February.
And although growth remains healthy, a sharper deceleration in economic activity than investors expect could pose a risk to the oil demand outlook and the high-beta Energy sector.
The big wildcard, of course, is when will the cartel crack again, as it inevitably will: “an increased supply response from oil producers could dampen investor sentiment about the sustainability of the rally.” As a result, while energy stocks have rallied alongside crude oil prices, “the sector’s outperformance vs. the S&P 500 may reverse if crude oil prices stall later in 2018 as our Commodities analysts expect.”
Kostin concludes with a surprisingly frank warning to oil bulls, pointing out that whil energy sector positioning and valuations are favorable, but less attractive than most investors believe.
Here, he notes that whereas client conversations often turn to the perceived underweight positioning of mutual funds and hedge funds in Energy stocks, the most recent fund filings suggest more neutral positioning. The statistics:
At the start of 2018, hedge funds carried a 112 bp net overweight in the sector relative to the Russell 3000, although the tilt was the smallest it has been this cycle. Similarly, large-cap mutual funds carried a modest 58 bp overweight.
Finally, on fundamentals, as earnings improved in recent months, energy stock valuations have become less expensive, but today the sector trades close to its typical relative valuation to the S&P 500 during the past 10 years across a number of metrics.
Goldman’s conclusion is that while “current crude oil price dynamics and recent stock momentum create an appealing shorter-term opportunity for tactical investors”, those looking for sustainable, longer-term price appreciation should look elsewhere.