Oil's assault on S&P 500 earnings poised to stop at US$20 a barrel

DEC 23, 20152:45 PM

[NEW YORK] Among other things, the 66 per cent plunge in oil since June 2014 has been a disaster for Standard & Poor's 500 Index earnings, sucking the life out of energy companies while failing to ignite consumer spending. One analyst says that cycle has run its course.

Even a plunge in crude to Wall Street's worst case level of US$20 a barrel is unlikely to do additional harm to S&P 500 profits, according to Gina Martin Adams of Wells Fargo Securities LLC, who says a stabilisation at that price would probably unleash a windfall of consumer spending that has so far proven elusive.

Unthinkable two years ago, oil at US$20 has become a possibility to Citigroup Inc and Goldman Sachs Group Inc, while options traders have started buying contracts that pay out at that price.

"Our assumption is that if oil falls to US$20, it will result in profits during the first half of the year being weaker-than- expected but in the second half of the year being stronger-than- expected," Martin Adams, equity strategist at Wells Fargo, said by phone.

Tumbling oil affects S&P 500 earnings in three ways, two of them bad. It lowers earnings in the energy industry, which makes up 6.4 per cent of the full index, and puts a chill on capital spending.

At some point cheaper oil is supposed to lead consumers to open their wallets. The failure of that to happen has made crude's retreat almost unilaterally negative for corporate profits, which are poised to slide for a third consecutive quarter in the three months through December.

Higher spending by consumers has historically lagged behind big shocks in crude prices by about 19 months, said Martin Adams. Americans delayed using any extra cash when oil prices plunged almost 70 per cent over five months starting in 1985, and again in 1991, when crude tumbled more than 56 per cent, she said. Crude has dropped more than 30 per cent this year and is down by two-thirds since June 2014.

Heading into 2015, some stocks seers expected consumers to start spending their windfall from the pumps and overestimated the benefits from lower oil prices.

One reason their optimism wasn't rewarded is that equities take a bigger cue from business spending, and so much of that is tied to commodities prices, a point Bank of America Corp. made at the start of the year.

As oil continued its slide this year, S&P 500 companies saw the smallest increase in capital expenditures since 2009, according to data compiled by Bloomberg.

At the same time, earning for S&P 500 companies are on pace to contract by 0.6 per cent this year. While profits in the consumer discretionary sector are forecast to rise 10 per cent, energy sector income will contract by 59 per cent, according to data compiled by Bloomberg.

Analysts see further declines for energy next year, with profits slated to slump 7 per cent. The S&P 500 as a whole will see profit growth of 7.1 per cent.

Citigroup's Tobias Levkovich said should oil tumble to US$20, earnings gains in the index may evaporate, as potential unexpected consequences include further disruption in gas-and-oil production and company bankruptcies.

"S&P 500 profit growth was flat this year, as other parts of the economy filled the gap in growth," created by energy companies, Levkovich, Citigroup's chief US equity strategist, said by phone.

"But if you get to US$20 a barrel, you're probably going to see greater economic difficulties, and therefore it wouldn't fill the gap." While the another 50 per cent drop in oil would weigh on stocks and profits during the first half of 2016, consumer spending in the second half would fuel growth in industrial production and in the automobile and technology industries, according to Martin Adams. Materials companies would also benefit from lower input costs, she said.

Costs at the gas pump are already the cheapest since 2009. That helped lift gross domestic product in the third quarter, with household purchases propelling demand. Wal-Mart Stores Inc., whose shares have tumbled 30 per cent in 2015, is positioned to outperform next year because its core customers - who earn about US$35,000 a year - spend a bigger share of their income on fuel, according to Nomura Securities in a note this month.

"What happens when oil prices move as rapidly as they have is you get a transition period," Martin Adams said. Consumers "need to plan and react to the new price deck. You get to that point of stability, and then the economy moves forward."

BLOOMBERG