“Falling oil prices” is ruling the headlines nowadays, a paradigm shift from oil prices hovering around $100 per barrel for the past few years supported by surging global demand, particularly in China.
Oil prices have been falling due to the classic tale of supply -- demand imbalance. New oil sources have contributed significantly to the global supply. In the United States, companies began using techniques like fracking and horizontal drilling to extract oil from shale formations.
In fact, Unites States is currently the world’s biggest oil producer, overtaking Saudi Arabia and Russia. Moreover, resumption of significant Libyan production acted as a key factor in putting downward pressure on the prices.
Simultaneously, weak economic activities along with a shift to cheaper and cleaner alternatives have led to lower demand. Oil demand in Asia and Europe began to weaken particularly due to the slowdown witnessed in China and Germany.
Given the scenario, the onus was on OPEC (Organization of Petroleum Exporting Countries), the world's largest oil cartel which controls nearly 40% of the world market, to make an effort to cut back production in order to push prices back. However, at the much awaited meeting in Vienna in November, OPEC decided to maintain the current production output target of 30 million barrels a day. In reaction to this, oil prices went into free-fall and eventually hit a five-year low on Dec 16, dipping below $60 to $53.60 a barrel.
Since June, the price of crude oil has plunged more than 40% from over $100 a barrel to under $60. Not overlooking the fact that oil is a necessity, in every form, the next question that crops up is – what effect will this falling price have on other industries and the consumers?
Win-Win Situation for Plastic Companies
While falling oil prices have created mayhem for industries like energy, the plastic packaging industry is well positioned to capitalize on the situation. Falling oil prices will not only provide a cost tailwind but will also boost demand due to the increasing disposable income at the customer level.
Increased Disposable Income Means Higher Volumes
The macroeconomic environment has been challenging for the packaging industry in the past few years due to weak consumer spending. Moreover, economic uncertainty in the Eurozone and raw material and energy price inflation also had a negative impact on packaging producers.
Now, cheaper oil means lower gasoline prices, which have fallen to $2.47 per gallon, the lowest since 2009. The EIA (US Energy Information Administration) projects that the US drivers will spend about $550 less on gasoline in 2015 than in 2014, assuming prices stay low. This, along with an improving employment scenario, will lead to a positive turn in consumer spending patterns and consequently, packaging demand.
Lower Cost Will Translate to Increased Margins
Companies engaged in plastics are among the biggest beneficiaries of falling crude prices, being derivatives of crude oil polymers. Approximately 5% of the worldwide oil production is used to make plastics. Worldwide production of plastics is currently estimated at 265 million metric tons and still growing.
Oil represents a large input cost to produce the materials used in the Packaging industry. Lower oil prices would lower the transportation costs for the industry. Resin, a derivative of oil, makes up almost a major portion of the cost of goods sold of the packaging companies.
Polypropylene and polyethylene account for the majority of their plastic resin purchases. Plastic resins are subject to price fluctuations, including those arising from supply shortages and changes in the prices of natural gas, crude oil and other petrochemical intermediates from which resins are produced.
The correlation between polyethylene prices to crude oil is 95%. Polyethylene prices fell 3 cents per pound in November and are expected to fall 4 cents to 5 cents per pound in December. Generally, a $10 per barrel decline in oil translates to 4 cents per pound decline in polyethylene prices. This will lead to meaningful margin expansion for plastic packaging companies.
Resin accounts for 35% of cost of goods sold of Bemis Company, Inc. and Sealed Air Corp. (SEE - Free Report) , Sonoco Products Co. (SON - Free Report) will also benefit given that 6% of its cost of goods sold is tied to resin and plastic film. Another company that will stand to benefit from this is Berry Plastics Group, Inc. (BERY - Free Report) , which is reportedly one of the largest global purchasers of plastic resins, more than 2 billion pounds annually.
In case of rising raw material costs and increased fuel surcharge, manufacturers tend to hike prices and pass on to customers. But in the wake of lower oil prices, they are much slower to respond. Moreover, the demand for plastics is currently strong, which, along with increasing discretionary income is lessening the pressure on companies to cut down prices for their products.
Therefore, until the volatile crude and gasoline markets begin to settle, consumers are not likely to see any markdowns. This will ensure margin expansion for the plastic packaging companies.
Bet on These Plastic Packaging Players
Given expectations of significant savings on raw-material costs and prospects of increase in volume due to falling oil prices, the share price of companies like Sealed Air, Berry Plastics, Bemis, AEP Industries Inc. have witnessed significant price increase in the past 12 weeks.
The EIA expects global oil inventories to continue to build over the next year, exerting downward pressure on oil prices. EIA projects that Brent prices will reach a 2015 monthly average low of $63 per barrel for each month from March through May, and then increase through the rest of the year to average $73 per barrel during the fourth quarter.
It is thus prudent to invest in the Plastic Packaging and Containers industry, where revenue and earnings are expected to increase next year, thanks to lower costs as a result of reduced oil prices.