Oil at $100 A Barrel Would Cause Pain, But Likely Not Recession

Location: New York
Author: John Piecuch
Date: Monday, July 31, 2006
 

With crude oil past the $70 per barrel mark, war raging in Iraq and Lebanon, and demand for petroleum products surging because of the fast-growing Indian and Chinese economies, a group of analysts and economists from Standard & Poor's Ratings Services gathered in New York on July 27 for a teleconference to ponder the possible effect of even higher crude prices. What would the effect be on corporate credit if oil were, for instance, to spike to $100 per barrel?

Standard & Poor's is not predicting that crude will reach that price. But in light of heightened worldwide demand, war, and political instability in some major oil-producing nations, we believe it is prudent to consider what might happen if some action on the world stage pushes oil to that level. Although automobiles, airlines, and some parts of the retail industry would clearly be hurt, what would amount to a 40% increase in oil prices would, surprisingly, not presage economic disaster.

"Oil at $100 a barrel would damage consumer spending and slow the economy, but it wouldn't stop it," said Standard & Poor's Chief Economist David Wyss. He figures that a spike in oil prices of this dimension could shave 1.5 percentage points off real U.S. GDP growth by the end of next year, bringing growth down as low as 1%. That is not drastic enough, by itself, to throw the U.S. into a recession.

One of the major sectors to feel the loss of discretionary income as consumers spend more for gasoline and for oil or natural gas to heat their homes would be the retailers and restaurant chains that cater heavily to low-income customers.

"Any potential spike in oil costs to $100 per barrel will likely hit retailers such as fast food chains and discounters the hardest," said Standard & Poor's credit analyst William Wetreich. "Large-ticket sales such as electronics, appliances, and home furnishings may also feel more impact from a spike in gas prices."

The effects of historically high oil prices are already being felt.

"Consumers are making fewer trips to Wal-Mart and focusing their spending on lower margin food items," said Mr. Wetreich, who noted that Wal-Mart's same-store sales in June 2006 rose only 1.2%. Still, despite this current low rate of growth, Wal-Mart Stores Inc.'s 'AA' credit rating appears secure. Target Corp., which has a somewhat more affluent customer base and is rated 'A+', appears to be weathering the current economy better, but is still feeling some effects.

The retailers more likely to have ratings affected in a high-price oil environment are some of the 25 speculative-grade restaurant companies that do not have the financial muscle of those two huge retailers to offset declining business. Of these 25, 11 already have negative outlooks and another three-- Arby's Restaurant Group Inc., Buffets Holdings Inc., and Landry's Restaurants Inc.--are on CreditWatch with negative implications. High-end retailers would be the least affected, as high energy costs will have less impact on their customers.

Unquestionably, higher oil prices would punish some industries. With consumers factoring in current gas costs when they buy a car, General Motors Corp. and Ford Motor Co. have already seen sales of moneymaking SUVs slide in the first half of the year. Sales of full-size pickup trucks, a rare bright spot for the domestic carmakers, appear to be at least waning as well.

"With all these negative events occurring without $100 oil, it seems clear that $100 oil would add a much sharper point, and perhaps a faster pace, to these challenges," said Robert Schulz, Standard & Poor's automotive analyst.

Likewise, the long-beleaguered airlines would also face serious consequences if oil prices rose sharply and stayed there. Most are too financially weak to undertake hedging of fuel costs, and they are still struggling with fuel costs that have climbed 140% since 2003.

"A fuel price rise to $100 a barrel oil would drive costs beyond what could be recovered in higher airfares," said Standard & Poor's airline credit analyst Philip Baggaley. "The airlines would be caught in a squeeze, with costs going up and passenger demand faltering in a slowing economy."

Of course, some industries, such as oil, would generally prosper from higher prices and would see no negative credit effects--although one result could be more M&A activity in the sector. The diverse chemical industry would also likely retain its health overall, with the pressure of higher oil prices muted by the fact that the sector is in the high point of its cycle, which should last into 2007.

"With business strong, even commodity petrochemical producers are well-positioned in terms of financial risk," said Standard & Poor's credit analyst Kyle Loughlin. Still, he cautions that operating margins are likely to contract beginning this year, as higher oil and natural gas costs represent a strong headwind for petrochemical producers.

What might push oil prices to rise so high is an open question, but one of the most immediate possibilities would be a supply interruption from a major producer. Iran is one country where, for political reasons, that might happen.

"Iran is a wild card," said Standard & Poor's credit analyst John Thieroff. No one can foresee how long such an interruption from Iran--or anyplace else--would last. And duration would be a key factor in determining its effect. But we believe that a spike to $100 per barrel for a moderate time span would not irreparably harm the economy, and the scope of significant negative credit ramifications would be limited.