Economic News & Analysis - April 12, 2012Oil prices and profits: Three ways to look at energy prices
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
The PPI for finished goods was flat for the month of March, dragged down by a 1% decline in the prices for finished energy goods. Before drawing any conclusions from this data, it’s important for investors to look at the various stages of processing.
The PPI measures the prices received by producers, but the Bureau of Labor Statistics (BLS) has indexes for numerous stages of processing, breaking it down to the crude level, the intermediate level, and the finished stage. (In fact, the BLS news release leads with the finished goods index because the PPI for finished goods typically passes through into the Consumer Price Index, though the pass-through is never perfect.)
Measurement at these stages of processing can point to expanding or contracting profit margins for various businesses. For example, in March 2012, the year-on-year change in prices received for crude goods declined 2.5%, while for intermediate goods, prices received increased by 0.7%. For finished goods, prices received increased by 2.8%. The discrepancies among these numbers could point to compressing profit margins at the earliest stages of processing.
The energy indexes are particularly interesting—and this ties back to an earlier Economic News and Analysis piece I wrote on gasoline prices and consumer spending. Year on year, the price received for gasoline increased 7.1% in March, though residential gas declined 8.8%. At the earliest stage of processing—the “crude materials for further processing” category, that is—natural gas prices declined 36.5%, while crude petroleum prices increased 7.2%. These major swings in prices can cause profit margins to swing wildly as well, benefiting some companies and hurting others.
Three ways to look at movements in energy prices and profitsI like to look at how movements in energy prices can affect profits from three perspectives. The first is the “energy intensity” of the overall U.S. economy (see Chart 1). Since the 1973–1974 oil price spike, the U.S. economy has been able to generate gross domestic product (GDP) more energy-efficiently. As of the end of 2011, the U.S. used more than 61% less petroleum and natural gas and more than 52% less energy in total for every dollar of real GDP than it did in 1973. This means that aggregate corporate profits and aggregate economic activity are less sensitive to changes in energy prices today than they have been over the past 40 years.
Chart 1: Energy consumption per real dollar of GDP has declined over the past 40 years
The second way to assess the effect of energy prices on different industries is to look at the input/output tables produced by the Bureau of Economic Analysis. These tables are supposed to reveal how interrelated different areas of the economy are by showing how output from one industry is required as an input to another. In these terms, every industry has become slightly less dependent on the oil and gas extraction industry since the oil price increases of 2008. This trend should help “desensitize” corporate profits from changes in oil prices. And if oil prices stay high, the shift toward the use of other energy sources and more energy efficiency will continue to accelerate.
The third way I look at how oil prices affect corporate profits is to measure, statistically, how sensitive profits are to oil prices. What I find is that for every 1% increase in oil prices, corporate profits actually increase by 0.83%. This is partly because higher oil prices are oftentimes associated with more rapid economic growth. However, there are clearly times when higher oil prices are associated with supply problems, or with potential supply problems, which I think is what is currently happening, as the prospect of supply disruptions coming from the Middle East drives up the price of oil today.
While this could crimp profits by approximately 4%, I think the effect will be short-lived. There is a temporary ceasefire in Syria, and Mahmoud Ahmadinejad, the president of Iran, seems to be losing his domestic support. Now, Iran’s move to cut off oil shipments to Germany may result in even less support for the president’s hostile stance toward the rest of the world. Because the country’s revenues depend on selling oil and the president relies on dispensing largesse from that revenue, Iran’s boycott may backfire on Ahmadinejad. If he is deposed, which I think is likely, oil prices could decline significantly. While it’s possible that tensions could rise before they calm down, I don’t see any long-term threats to corporate profits from the currently high oil prices.