Impact Of A V-Shaped Recovery In Oil Prices On The Home Improvement Names

A rather talked about topic recently has been the dynamics in oil, the price of which witnessed a steady decline over the past year. A host of reasons that altered market forces has contributed to this development. While weak economic activity and a shift towards other fuels in oil importing nations such as China has reduced demand, supply continued to remain strong. For one, the continued turmoil in Iraq and Libya (biggest oil ports) ceased to impact production. Further, Saudi Arabia refused to reduce supply and compromise market shares, which contributed to a large extent to the lower prices. However, the oil producers in North Dakota and Texas stole the show, who started extracting oil from shale formations to uncover close to 20,000 new wells in the past 4 years. This boosted America’s oil production by a third to 9 million barrels a day, one million short of Saudi Arabia’s output, resulting in a steep over 50% fall in prices from $115 a barrel in June last year to less than $50 more recently. ^[1]

While plummeting oil prices led to losses for some, it led to massive gains for others. Among the gainers have been the U.S. home improvement names, Home Depot (NYSE:HD) and Lowe’s (NYSE:LOW), as Americans with higher disposable incomes undertook home renovations. In the past five years alone, the stock price of the companies grew more than 200% to outdo the growth in the Dow Jones index. However, a question worth considering is whether a sharp increase in oil prices in the near future could put an end to the glory days for the home improvement giants.

We have a price estimate of $100 for Home Depot’s stock, which is slightly below the current market price.

Our complete analysis for Home Depot’s stock

We have a $55 Trefis price estimate for Lowe’s stock, which is below the current market price.

See our complete analysis of Lowe’s here

Why Will Prices Rebound?

Let’s start by discussing the plausibility of a sharp recovery in prices. The Organization of Petroleum Exporting Countries (OPEC) has forecast a price estimate of $110 by the end of the decade and that of $177 by 2040. According to them, demand will increase by at least a million barrels per day through 2019 fueled by higher oil consumption among developing nations, even as the developed world continues to resort to more sustainable sources of energy. In order to meet this demand, OPEC members are expected to invest approximately $40 billion, while non-members are expected to invest $300 billion each year until the decade end. In order to incentivize this kind of investment, prices ought to rise correspondingly. ^[2] Yet another theory comes in from the supply side where Saudi Arabia, one of the top oil producers, anticipates the declining oil prices to put high cost producers out of business, which will in turn curb supply to exert an upward pressure on prices. One way or another, there is no doubt that prices will eventually be on their way up, although when this will occur is still uncertain. However, assuming that OPEC’s forecast holds i.e. oil prices hit the $110 mark by the end of the decade, we look at the impact this could have on the present dynamics in the American home improvement industry.

Impact Of The Oil Price Increase On Home Depot And Lowe’s

Since the majority of Home Depot and Lowe’s revenues come from the U.S., we focus mainly on the impact of the oil price recovery on the U.S. economy. Personal disposable incomes in the U.S. currently stand at $13,260 billion. According to Trading Economics estimates, this figure is expected to increase to $18,154 billion by the end of the decade. ^[3] The U.S. Energy Information Administration suggests that energy expenditure has historically accounted for roughly 4-8% of disposable incomes. ^[4] Assuming an increase to about 7% in energy expenditure as a proportion of disposable income by the end of the decade from about 5% presently, we get an almost doubling of energy expense at an estimated $1,403 billion. As Americans pay more for fuel going forward, expenditure on home improvement is bound to suffer to some extent.

According to U.S. Census Bureau data, home improvement spending in 2014 averaged at $149.5 billion, which accounts for approximately 1.3% of disposable incomes. ^[5] Assuming that this figure goes down to approximately 1%, the figure it was in 2011 when the spot price of Brent averaged at $111.26 per barrel, home improvement spending reaches an approximate $181.5 billion. Although we expect only minor postponement in maintenance activity, consumers may choose to cutback on remodeling spending. Hence, we expect the oil price recovery to impact the painting and flooring segment for Home Depot and Lowe’s the most. Assuming 15% of total home improvement spending goes towards painting and flooring activity, we estimate spending in the category to reach $30 billion by the end of the forecast period as opposed to our predicted $35.30 billion.

Given the lower level of home improvement spending and the higher operational costs an increase in oil prices is bound to exert, we expect changes to margins as well. According to Home Depot’s 2014 earnings transcript, lower fuel prices drove approximately 18 basis points of gross margin expansion. ^[6] Assuming an 18 basis point margin contraction on account of fuel prices rebounding by 2020, we arrive at an approximate $2 billion fall in EBITDA for Home Depot and that of $1 billion for Lowe’s. Incorporating these effects, we see an approximate 13% downside to our current price estimate for Home Depot and that of 5% for Lowe’s.

See our complete analysis for Home Depot in the scenario of a V-shaped recovery in oil prices

See our complete analysis for Lowe’s in the scenario of a V-shaped recovery in oil prices

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1. Why the oil price is falling [↩]
2. Why Oil Prices May Shoot Back Up [↩]
3. United States Personal Disposable Income Forecasts [↩]
4. Consumer energy expenditures are roughly 5% of disposable income, below long-term average [↩]
5. Expenditures for Residential Improvements and Repairs [↩]
6. Home Depot’s (HD) CEO, Craig Menear on Q4 2014 Results – Earnings Call Transcript [↩]