“Give me a one handed economist! All of my economists say ‘on the one hand…on the other’”
Harry S. Truman, 33rd president of the United States of America
Unless you’ve been living under a rock for the last six months, you should be familiar with the recent declines in oil prices. The precipitous fall of crude oil, pictured below (figure 1) has major implications for the Canadian economy, as petroleum is not only represents a major component of household spending, but also an input to many industries. Lower crude prices results in less pain at the pumps for consumers, and higher profits for producers (excluding those who produce oil)- unanimously good news right? As President Truman griped, that answer would be all too easy for an economist.
According to the Bank of Canada (“BOC”), oil extraction accounts for three percent of national GDP, and roughly fourteen percent of exports. The prospective impacts of this negative price shock have been beaten to death in the media; How will this impact housing prices? What does it mean for the federal budget? Are declining oil prices a good or bad thing for Canadian consumers? What’s with the surprise interest rate cut? Far from the “unanimously good news story” described above. What gives?
The purpose of this post is to provide some insight into what economic theories predict the impact of a lower energy prices will be on the broader macroeconomy, and my broader thoughts on impacts for consumers and retailers. For additional background on the decline in crude prices, and credible forecasts on what the future has in store, please reference the U.S. Energy Information Administration (“EIA”) analysis section.
Let’s quickly recap the both the supply and demand side dynamics that are fueling this commodity collapse.
On the demand side, the BOC states “It would be hard to exaggerate the importance of the integration of China, India, and other emerging economies into the world economy. The economy of China alone doubled in size between 2007 and 2013…with rising living standards, Chinese households have been able to afford cars and other products that consume energy.” They suggest that China still has a long way to go as far as urbanizing their population to North American standards. This suggests continued growth in demand.
ECON 101: demand = higher prices, right?
As vital as China has been to global economic growth, the global economy has continued to disappoint in the wake of the 2008 financial crisis. Growth has persistently missed forecast, and more alarmingly is trending down (see Figure 2).
Figure 2. Canadian forecast growth vs actual growth
Source: Bank of Canada, “Drilling Down- Understanding Oil Prices and Their Economic Impact
Compounding the effect of slowing growth, the BOC also points to private indebtedness being at historic highs, reducing debtor’s ability to service their debts. This trend is especially true in Canada, where historically low interest rates have fuelled Canadians to take on increasing levels of debt, while income growth has fallen flat. One interesting observation in Figure 3, is the divergence in household debt between the United States and Canada. While US consumers have de-leveraged significantly since the economic downturn in 2008, Canadians have continued to pile on debt.
Despite significant “headwinds” on the demand side, the BOC primarily attributes the decline of crude prices to supply side dynamics. Particularly the BOC points to the shale revolution that has taken place over the last six years, which has gone from virtually non-existent in 2008, to contributing nearly 4,000,000 barrels a day. The BOC highlights, “It’s only a slight exaggeration to say that, when oil is worth $100 per barrel, there is oil everywhere.” The market response to high prices in Canada has been significant.
Figure 4. Total oil production (Oil sands vs. Conventional Oil)
It should be noted that although higher prices led to greater investment and discovery, much of these new sources have relatively high extraction costs. Now that prices have fallen below the all-in production costs for these new sources, companies will begin to scale back their investments.
So there you have it, a high level introduction to what is driving the collapse of oil prices. But now for the interesting bit- What does economic theory predict?
In a 2009 article published to the Journal of Monetary Economics, Paul Edelstein (Decision Economics), and Lutz Kilian (University of Michigan) ask the question: How Sensitive are Consumer Expenditures to Retail Energy Prices?
The paper identifies four key mechanisms through which unanticipated energy price changes impact consumer spending. They explore this concept in the framework of positive price shocks, but the reverse logic holds true, “We demonstrate that linear models are consistent with the symmetric behaviour of real consumption in 1979, when energy prices increased sharply, and in 1986, when energy prices declined sharply.”
1. Higher energy prices reduce discretionary income, which they have coined the discretionary income effect
The BOC highlights this effect in their recent address, “The positive effect will work it’s way through the economy via two channels, it will give consumers more disposable income, second, it will reduce input costs and encourage production in sectors other than oil”. Anecdotal evidence of this effect can be found by examining holiday retail performance in resource driven Calgary, which saw the third highest growth in the country in holiday spending.
2. Changing energy prices may create uncertainty about the future price of energy, causing consumers to delay purchasing irreversible consumer durables, deemed the uncertainty effect
The importance of this effect is exemplified by the recent rate cut by the BOC, to encourage consumer spending in the face of lower oil prices and other deflationary pressures.
3. When purchase decisions are reversible, consumption may fall in response to energy price shocks, as consumers increase their precautionary savings
Similar to above, the surprise rate cut recently announced by the BOC cannot be underemphasized as an indicator for how the BOC views these effects. Simply put, if the BOC believed that effect 1, dominated effects 2 and 3, there would be no need for any monetary policy intervention.
4. The consumption of durables that are complementary in use with energy (like cars) will decline more than other durables
Interestingly we have seen the reverse trend hold true in light of the recent declines in oil prices. Trucks have turned out to be the big winners in the automotive industry. Anecdotally, Escalade sales are up 55% YoY.
The structure of the study is actually quite simple. Using an empirical framework, the details of which we will gloss over (for those interested, it can be found here), Edelstein and Kilian identify the effects on purchasing power by estimating how the major components of real consumption respond to changes in energy prices. They define the major components of real consumption as durables, which have long useful life (houses and refrigerators), non-durables, which have relatively short useful lives (cosmetics and food). For the purpose of their analysis, Edelstein and Kilian break out vehicles from durable goods (to isolate the marginal effect of #4 above.
So what is the key takeaway?
The authors challenge conventional wisdom that a fall in energy prices will only have weak effects on output and employment, since increases in demand are offset but reallocation of changing spending patterns. This traditional view results in asymmetries, where increases in energy prices result in sharp economic contraction, however declines in energy prices are not met with any significant economic expansion. The authors suggest that changes in consumption are too large to be explained by changes in discretionary income alone. They attribute excess response to changes in precautionary savings, and changes to the operating cost of energy using durables (vehicles). Across their dataset, Edelstein and Kilian find that a 1% increase in energy prices is associated with a real decline in consumption of -0.15% a year later (statistically significant at the 95% confidence interval).
Aside from this more technical analysis on the impacts of falling oil, on consumer spending, one of the more relevant (and recurring) questions on marketers minds (specifically in eCommerce) is how low oil prices will impact shipping rates? Intuitively, most assume that lower fuel prices result in lower costs for shipping companies, ultimately resulting in lower prices for customers. As seen below, there is some merit to this logic, since fuel represents one of the largest components of Operating Expenses.
But in keeping with the theme of the two-handed economist, this is not the complete picture. Both UPS and Fedex charge what is known as a “fuel surcharge” which lives as a component of revenue. This means that lower fuel prices also result in lower revenue for logistics companies.
Basically it’s a premium the shipping companies apply to their fuel costs in their pricing structure. Fedex describes these charges:
The FedEx Express® fuel surcharge is based on the spot price for jet fuel and it applies to all FedEx Express services except FedEx International Premium™ (IP1) and FedEx® International Express Freight (IXF).* FedEx has adopted a fuel surcharge calculation method for FedEx Express services based on the fuel price published monthly by the U.S. Department of Energy.
The FedEx Ground® fuel surcharge is based on the rounded average of the national U.S. on-highway average price for a gallon of diesel fuel. FedEx has adopted a fuel surcharge calculation method for FedEx Ground services based on the fuel price published monthly by the U.S. Department of Energy.
The FedEx Freight® intra-Canada fuel surcharge is based on the weekly Canadian national average wholesale price for diesel fuel and it applies to all FedEx Freight LTL & TL shipments within Canada. FedEx has adopted a fuel surcharge calculation method for FedEx Freight services based on the fuel price per litre published weekly by Natural Resources Canada.
So on the one hand, lower input costs should reduce overall costs for logistics companies, on the other, lower fuel costs also lowers top line as well. The Associated Press summarizes: “Due to falling oil prices, UPS expects less revenue from fuel surcharges. But cheaper fuel will lower a major cost. Those lower fuel costs may also stimulate consumer spending as Americans pay less at the pump, which would also help UPS, said Chief Financial Officer Kurt Kuehn in an interview.”
So which effect will dominate?
Well, if you know the answer to that, then you could quite possibly be the next CFO at UPS.