Optimism On Restaurants, Retail And Airlines Based On Lower Crude Makes No Sense

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Includes: PBJ, USO, XRT, XTN
by: Paulo Santos

Summary

There's a lot of optimism and speculation on several sectors due to lower crude prices. This includes restaurants, retail and airlines.

I explain why such optimism is misplaced in spite of these sectors really benefiting from lower crude prices.

It all has to do with how long the oil shock lasts. And for 1-2 years, it simply does not make sense to bid up these sectors much.

We've already seen how lower crude (NYSEARCA:USO) prices have led to massive gains for several industries, including restaurants, retailers and airlines. The thesis goes like this:

  • For restaurants, more money in consumers' pockets will mean more discretionary income. What people save at the pump, they'll spend dining out. The PowerShares Dynamic Food & Beverage ETF (NYSEARCA:PBJ) is up 12.3% since bottoming in October;
  • For retailers, the story is about the same. The SPDR S&P Retail ETF (NYSEARCA:XRT) is up 11.5% since bottoming in October;
  • For airlines, fuel is usually the higher cost or the second highest. Naturally if this cost goes down profits will go up. The SPDR S&P Transportation ETF (NYSEARCA:XTN) - the ETF with the highest airline exposure, since there's no pure airline ETF - is up 28.4% since bottoming in October.

This is actually all true. People might spend more on restaurants. They might spend more on retail. Airlines might get a bounty of profits! And yet it all doesn't matter much.

Why is this so?

It doesn't matter, because over the long term oil is not going to stay here. It will eventually head higher again. Because while all those industries' shares are going higher, you'll notice that E&P and drilling companies are plunging. They are plunging because their profits will be going down the drain. Drillers are plunging because capex to drill is going to take a plunge as well. Drilling will take a plunge because many wells will become uneconomic to drill, namely a lot of those shale wells which have led to massively increased U.S. production.

And therein lies the rub. Production from individual shale wells declines very rapidly (up to 80% declines in the first year of production). If drilling for them stops, U.S. production growth from those shale wells will quickly stagnate and then reverse. The same, in a way, goes for a lot of other exploration - all wells have a decline rate which needs new wells to compensate for, every year.

What this all means is that when you get a plunge in oil prices, it will turn out to be temporary. Sure, maybe when it comes back it won't head to $100. But it will head higher than where it's at right now.

The "oil shock" can last 1 year. Maybe it lasts two. It won't last forever. What this means is that any benefit for restaurants, retailers and airlines will also be temporary. If these companies get a benefit, that benefit will just be the additional profits they manage to get in those 1-2 years. As I've calculated for retail, that would be just 0.3% of the industry's capitalization per year. 2 years would be 0.6%. If the oil shock last just 1-2 years then the overall impact is as close to "nil" as you can get.

For airlines the impact might be larger on a single year, but then the air fares will adjust because every airline will be benefiting. So there even if the oil shock lasts longer, the excess profits won't.

And finally, none of this considers any downside impact from oil on the economy, even though the oil boom has been a boon to the U.S. economy. Capex will be cut quickly. Jobs will be cut quickly. Much quicker than the benefits will be realized.

Anyway, it doesn't much matter. What matters is that the oil shock is temporary and thus the benefit is limited to excess profits over how long the oil shock lasts. Yet these stocks are trading as if the benefit is here forever and thus you can get sectorial multiple expansion from it. The truth is you can't, and so at some point the gains will be surrendered.

Conclusion

The oil shock is temporary, yet the stocks on the sectors that are expected to benefit are trading like it will last forever. It won't, the same reason that leads the oil sector down will provide for lower crude production, and with most new production coming from shale, the reduction in production will be quicker than in the past.

All this means that the oil shock will last 1-2 years at most, and thus the benefit for the sectors which gain from it is limited as well. It's irrational to bet on those sectors as if the benefit will last forever.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.