The Energy sector looks poised for a sustained rally and may outperform earnings expectations. If this happens, it would greatly boost earnings and, by association, profit margins in the S&P 500. But just how much of an impact would a sustained rally in oil prices have on margins in the index?
Energy sector to blame for tumbling S&P 500 margins
Barclays analyst Jonathan Glionna sought to quantify this effect. He noted in a June 14 report that oil prices have skyrocketed 80% since January, and if this continues, earnings within the Energy sector would finally turn the corner. The impact from a sustained rally would be quite significant, depending on its size, he said. According to Glionna, Energy contributed 11% of the profits for the S&P 500 in the second quarter of 2014, while now, it contributes nothing. In 2014, the S&P 500’s profit margin was 9.9%, while now it is 8.8%, mostly thanks to the low oil prices.
Barclays’ commodity strategists are expecting Brent crude prices to reach $41 per barrel in the third quarter and $52 per barrel in the fourth quarter. Using these prices and an average price of $45 per barrel for the rest of the year, he estimates that the S&P 500’s profit margin would expand 40 basis points between now and the end of the year, bringing it to 9.2%.
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Oil price estimates all over the map
Consensus estimates on oil prices vary quite widely. Goldman Sachs analysts warned this week that the recent gains will stall and described the price recovery as “fragile” in a report released on Wednesday. They expect the recent problems that have boosted oil prices to dissipate and a surplus situation to return. The firm’s analysts believe that oil prices must remain between $45 and $50 per barrel over the next few months in order for supply to fall to a deficit, reports CNBC.
In contrast, a report from Oilprice.com states that we can expect “much higher oil prices” as the low price cycle comes to an end. Dan Steffens reports that a typical cycle lasts two years and that the current cycle started in July 2014. He cites the many situations that have boosted prices recently—the same ones Goldman expects to end soon.
They include the 590,000 per-day reduction in oil production last month, unrest in Nigeria, lower OPEC production, a 1.6 million barrels per day increase in demand, and the recent Canadian wildfires. Steffen also points to estimates from Raymond James, which projects $60 per barrel WTI oil in the third quarter and $75 per barrel in 2017. He also notes that Morgan Stanley upped its long-term Brent oil price to $80 per barrel.
Still room for margin expansion at lower oil prices
But even if Brent crude prices come up short of their estimates, the S&P 500’s profit margin still stands to gain Glionna reports that if crude slips back to $35 per barrel this year, the S&P 500‘s net profit margin would expand 20 basis points. The analyst admits that it may seem as if the Energy sector can’t recover at such a low price, but he adds that even with a $35 per barrel price, profit margins among oil companies should rise because the massive amounts of impairments recorded in the sector last year probably won’t come again.
In the most bullish scenario, he explains that at $55 per barrel, the S&P 500’s profit margin should rise 60 basis points.
Stability needed in other sectors
Glionna notes that his estimates for the S&P 500’s profit margin based on a sustained rebound in oil prices depend on stability in the other sectors, but he argues that this is a possibility. Margins in other cyclical sectors have only seen “modest” compression in their profit margins, he explained, and they remain near peak levels. Meanwhile, defensive sectors haven’t seen much compression in their margins, although he notes that this is pretty typical.
He also observed that recently commodity-linked sectors and other sectors have been de-coupled, which he says is unusual.
“The gap between the profit margins of the energy and materials sectors and the industrials, consumer discretionary, and technology sectors has never been higher, according to our 40-years of data,” Glionna wrote. “During normal business cycles profit margins for the energy and materials sectors change alongside other cyclical sectors such as industrials and consumer discretionary. Not this time.