The Impact of Lower Oil Prices on Industrials: Looking Beyond the Obvious

by Steven Elms, Head of Industrials, EMEA, Treasury & Trade Solutions, and Sameer Sehgal, Head of Trade, EMEA, Treasury & Trade Solutions, Citi

The consequences of the halving of oil prices in recent months are more complex than generally thought. The motivations and business strategies of industrials clients must be scrutinized to ensure that appropriate treasury solutions, trade finance and support are made available, according to Steven Elms, head of industrials, EMEA, TTS and Sameer Sehgal, head of trade, EMEA, TTS.

The dramatic fall in the price of oil, which has more than halved since June 2014, has potentially profound implications for industrials companies. All corporates in the sector – which spans sub-sectors as diverse as automotives, aviation and aerospace, shipping, logistics, paper and packaging, heavy machinery, cement, power technology and construction – are impacted by the price move. However, the implications for each sector vary.

At a basic level, lower oil prices will reduce input costs and working capital requirements for large energy users, such as airlines, freight and shipping, chemical, plastics, heavy manufacturing, and any business with high transportation costs. As a result, these companies will benefit. In contrast, companies that are directly involved in, or dependent on, the oil and gas sector will come under pressure, including oil services companies, and heavy industrial manufacturers supporting oil exploration and production.

However, the actual impact of lower oil prices on different industrials sectors is likely to be more nuanced: the decisions made by individual industrials companies will be determined by a number of factors other than the oil price – important though that is. For example, in the aviation sector the trend in recent years has been towards greater fuel efficiency (partly because of high oil prices). As a result, many airlines began to renew their fleets, resulting in growth in aircraft manufacturers’ order books.

The decline in the oil price might – at first glance – be expected to reduce the imperative to improve fuel efficiency, and encourage airlines to continue to operate less efficient aircraft for longer, potentially damaging the prospects for aircraft manufacturers. However, the move towards more fuel-efficient aircraft is not only driven by oil prices: regulatory requirements and corporate responsibility strategies to reduce aviation emissions also play an important part

Furthermore, there is a solid economic argument for airlines to continue to improve the fuel efficiency of their fleet by purchasing new aircraft. The falling oil price is expected to stimulate global economic growth: the International Monetary Fund (IMF) estimates that, all other things being equal, world GDP will be 0.3%- 0.7% higher in 2015 because of lower oil prices [1]. In addition, a lower oil price puts more money in consumers’ pockets. Higher economic growth and consumer spending will result in increased air traffic. For airlines seeking to take advantage of this opportunity, it makes sense to use the cash dividend of lower oil prices to fund new fleets: aircraft that are more efficient will offer greater potential to increase margins in the future.

Implications for treasury

From a treasury perspective, there is also an important rationale to continue to improve aircraft fuel efficiency – one that can also be applied to other transportation companies. While many observers believe that the price of oil will remain low in the near future, volatility is expected to increase. Hedging during periods of high volatility is expensive. By focusing on fuel efficiency, airlines (as well as shipping companies or other large-scale users of fuel) can reduce their exposure to oil price volatility and their hedging costs.

All industrials will have to carefully work through the implications of lower oil prices on their operational and treasury models. And, as in the case of airlines, the decisions they make may not be the ones that appear most obvious. For example, the auto sector has also focused on improving fuel efficiency, especially through increased use of technology and lightweight materials, in recent years. The fall in oil prices has spurred a short-term increase in US sales of trucks and SUVs, which tend to use more fuel. However, consumer demand for electric vehicles has continued to grow faster than any other segment. Meanwhile, regulatory pressure to lower emissions continues unabated in many markets. As a result, auto producers are expected to continue to invest in fuel efficiency.

Given the high costs associated with new automotive technology, new trade financing products may be necessary to facilitate development. There will be greater emphasis on financing solutions that meet sellers’ requirements and capture the full product lifecycle from research and development to sale. For example, suppliers want to explore tooling financing options that provide them with stable sources of funding from development to final sale to automotive companies.

For industrials that gain from the fall in the price of oil, there is likely to be increased appetite to improve treasury efficiency in relation to cash and liquidity management and trade finance. As revenues, margins and the business outlook improve, companies will seek to deploy cash effectively (especially given continuing record low rates) and treasury budgets could rise to help achieve that goal. Projects, including treasury management system and enterprise resource planning rollouts, or the creation of payment factories or shared service centers, could be accelerated. Growing industry competition for sales will lead to increased need for differentiation: solutions such as supply chain finance (SCF) and portfolio finance may become more attractive, as a result.

[1] Seven Questions About The Recent Oil Price Slump, Rabah Arezki and Olivier Blanchard, iMF Direct blog, December 22, 2014

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In sectors where the fall in oil prices is unequivocally negative for business – such as oil or gas services – a decline in capital expenditure, including on treasury projects, is likely. Credit downgrades among heavy industrial manufacturers supporting oil exploration and production are expected as major projects are cancelled. Such companies will consider new opportunities to capture flows. For example, there may be increased interest in working capital solutions that address accounts receivables. Corporates are also looking at SCF as a way to target fuel suppliers and relieve the pricing pressure on them created by the oil price fall.

Consequences for countries

As well as impacting different industrials sectors and individual companies, the halving of oil prices also has major consequences for countries’ financial strength. For oil-importing countries, the fall in prices is advantageous and should improve their balance of payments.

As importantly, lower fuel costs should provide a spur to faster economic growth (and therefore increase tax revenues) and may also offer an opportunity to reduce fuel subsidies, which are often a sizeable part of government spending in emerging market countries. As a result, governments should have additional resources to invest in infrastructure projects. That should increase demand for trade finance solutions, including Export and Agency Finance (EAF) financing, accounts receivables finance, SCF, trade loans, and bid/performance bonds.

For oil exporting countries, lower oil prices will weaken their external and fiscal balances. The IMF suggests that large buffers and available financing should allow many oil exporters, especially in Gulf Cooperation Council countries, to avoid sharp cuts in government spending. Nevertheless, such countries – and especially non-GCC oil exporters – are expected to scale back infrastructure development plans as they seek to balance their budgets against a backdrop of sharply lower revenues.

Adapting to change

For banks serving the industrials sector, the fall in the oil price in recent months requires a rapid readjustment. All other things being equal, a halving of the oil price results in a halving of flows related to oil, which has a major impact on bank revenues and necessitates a redoubled effort in terms of origination. Loan portfolios associated with oil and other commodities are likely to shrink. As importantly, banks need to reassess their trade finance product portfolio to ensure that it meets the widely varying needs of industrials as they adapt to the new oil price environment.

Citi’s broad range of trade finance solutions and unrivalled global network will enable it to respond to the fall in oil prices effectively. By listening to our clients and seeking to understand their business strategies, we can continue to meet the diverse needs of its industrials clients in this new environment.