Markets: Oil and Investments
New York: December 13, 2004
By John R. Stephenson

For those of us who follow the markets, the big stories of late have been the slide of the U.S. dollar and the price of oil. Long-time market observers will recognize that when the commodity complex rallies, the stock market tends to do poorly and vice versa. Over the last few weeks we've witnessed something we haven't seen for a while - falling oil prices. Maybe it is the higher than anticipated crude inventories or possibly the view that terrorism is on the wane, but no matter, oil is down in price and the markets have taken notice.

The impact of oil on the markets and the economy is simply huge. No other commodity is as closely watched and as important to our economic well being. From automobiles to plastics, from chemicals to jet aircraft, we are totally dependent on oil to keep our lives and economies functioning smoothly. In days when oil has fallen, the stock market has rallied. The opposite is also equally true. Would a reduction in the price of oil be enough to sustain a rally in the market? Maybe not over the long haul, but certainly it would benefit the market in the short term. And with oil prices sliding to a 3 month low, investors are salivating about the possibility of a potential boost to the purchasing power of consumers. But if oil prices do fall, what are the industries that are likely to benefit the most from cheaper oil?

With the price of oil hovering around $40 a barrel, there are a number of sectors, which stand to benefit from lower energy prices. A fall of $10 a barrel increases world GDP by 0.3% and U.S. GDP (gross domestic product) by 0.4%. Regionally, the impact of falling oil prices is highest in non-Japanese Asia where oil consumption as a percentage of GDP is more than triple that of other regions. It is our view that investors who want to benefit from falling energy prices will need to focus not only on the companies and sectors that have a large exposure to energy, but also on the sectors which exhibit some strong pricing power (margins are likely to increase more dramatically with falling energy costs).

Figure1: Regional Oil Consumption as a % of GDP

Source: BP, CSFB research

The price of oil is widely followed by market participants because, not only is it the fuel of the modern economy enabling the transportation of people, goods and services, but it is also used as a feedstock for so many of the products that we consume. Almost everything that we can think of in a modern world utilizes oil or natural gas in the manufacturing process. We heat our homes with oil (or natural gas) we use energy in the production of chemicals, plastics, tires and in the production of pulp and paper.

The sectors that are likely to benefit from a fall in energy prices include the commodity chemicals sector and the aluminum and cement sectors (respectively 50% and 25% of their direct costs are energy related). The cement industry should do particularly well in a declining oil price environment since demand remains strong and there are significant capacity constraints in the industry. Within the chemical sector, the commodity chemical group (ethylene and chlorine producers) has the greatest pricing power of the chemical group and should benefit the most from falling energy prices. Metals and mining are also strongly positively impacted by falling energy prices (15-20% of costs) as they are large energy users. Within the metals and mining sector, the aluminum manufacturers are strongly impacted by falling energy prices (25-30% of costs) followed by steel producers (15-20% of costs) and then producers of coal and iron ore.

While it is our view that there is still significant upside in energy equities (largely because the long term estimates for energy prices remain too low) we believe that investors should also consider stocks that will do well in weak energy markets -by targeting companies that utilize oil or natural gas in large quantities as a feedstock to their process. The best opportunities for investors lie with companies that are energy intensive and yet have enough pricing power to maintain their margins when oil prices are falling. The sectors that present the best combination of strong energy usage and strong pricing power are the cement and commodity chemical manufacturers.

Figure 2: Stocks with Energy Exposure

Source: MSCI, Factset, CSFB Research