You've got the power

PUBLISHED : Monday, 23 July, 2012, 12:00am
UPDATED : Monday, 23 July, 2012, 12:00am


The world was a better place before the global financial crisis, but it was not perfect. People may now gloss over the fact that, before the crisis, Asia was in the grips of an inflation scare. Oil prices were soaring. As oil is a key cost for almost all economic activity, this drove a rise in general inflation, most notably in the cost of food.

For a brief period in early 2007, Hongkongers could be often seen trucking home bulk bags of rice, as a hoarding mentality crept in amid headlines about an impending global food shortage.

It's worth remembering that era because five years of slow global economic growth and shaky sovereign finances have flipped this situation. Oil prices are diving, delivering a direct bonanza to those countries that are not energy exporters (most of Asia). Put another way, to the extent that spiralling energy costs created anxieties about inflation and the economy five years ago, today investors might take comfort in the fact that the price of oil has dropped by one-fifth in the past five months.

There is a tendency to focus on the negative. People tend to view the decline in energy prices as yet more evidence of a global growth slowdown led by the three pillars of the global economy: the euro zone, China and the US.

But a large swathe of Asia's commodity-intensive industries directly benefit from declining energy and raw material prices. Shrewd investors might be able to get in front of this by buying firms best positioned to profit from declining energy prices.

Consider the fact that jet fuel can be up to half of the operating costs of an Asian airline, while thermal coal makes up to 75 per cent of the costs of coal-fired power plants in China. Raw foodstuffs and packaging compose up to 60 per cent of the total costs of Chinese food and beverage firms.

The relationship between energy prices and corporate profits is often indirect and nuanced. External factors creep in. The relationship changes as the price moves.

For example, falling fuel costs are usually correlated with a slowdown in the wider economy. A firm that experiences lower production costs may simultaneously be grappling with slower sales.

For industries with large sunken costs, such as power producers, this can be a mixed blessing. The firm saves on fuel costs, but then has to cope with a lot of spare capacity.

In another example, regional airlines are now enjoying jet fuel savings but - to the extent that the declines are connected to a general economic slowdown - they are also experiencing falling passenger traffic and declining yields.

Meanwhile, when customers get wind that their suppliers are enjoying cost savings, they demand lower prices. Firms need to have pricing power to resist such requests. Not all firms are equally positioned to reap the windfall.

The trick is to identify the firms with defensive sales and a good ability to convert falling input prices into profits.

China's independent power producers fall into this category. The generation growth of Chinese power plants has been remarkably resilient, up 3.7 per cent in the first half of the year. Meanwhile, spot prices for Newcastle coal (a benchmark) are down by about one-quarter since May, partly because US power plants are switching from coal to cheaper shale gas.

This is all good news for independent power producers on the mainland, for which coal costs are a key determinant of profitability.

The central government sets electricity tariffs, typically below market rates, forcing the power producers to get by on razor-thin profit margins.

The power firms cannot control the price of coal, which tends to crowd out other variables to become the dominant input. Thermal coal makes up about 75 per cent of the utilities' costs.

That means a small drop in coal prices can make a huge difference to the bottom line of the Chinese power producers. A decline of just US$1 for one tonne of coal can boost profits as much as 5 per cent, and analysts believe coal prices may yet fall by as much as US$15 per tonne.

But again, investors need to look closely at each power producer to understand fully the relationship between energy costs and profits.

Many Chinese power producers have thrown away their long-term contracts to switch to spot coal prices, so as to capture the price declines as they happen. Others plants depend on one particular coal supplier, and have therefore committed to providing a price negotiated long ago.

Investors who want to take a view on falling coal costs should look at coastal power producers, which can import coal from anywhere and are therefore better able to take advantage of drops in the global spot price for coal.

Chinese aviation is another bright spot. While the sector's profitability is down so far this year, it is still enjoying passenger growth of about 7 per cent.

Airlines' profits are highly correlated to crude oil movements. This is particularly true for the mainland carriers, which do not hedge their fuel costs. They get a 3 per cent to 6 per cent share-price boost for every US$1 the cost of a barrel of jet fuel falls.

Also, Chinese airlines derive the bulk of their annual profitability between the months of June and September, which is the peak holiday travel period.

Indeed, the months often subsidise losses generated during the rest of the year. It just so happens that the peak this year coincides with a period of declining fuel costs, and this bodes well for industry earnings in the second half.

Regional budget airlines are other bright spot, because they benefit from declining fuel costs, and because the cut-rate pricing model tends to shine during times of economic uncertainty.

Some regional budget airlines have generated double-digit passenger growth this year.

The mainland's food and beverage sector also gets a seasonal sales boost over the summer months, and it likewise benefits from declining energy costs. Rising palm oil and wheat flour prices (because of a drought in the US) have hurt the sector.

But food and beverage profits are most sensitive to other input, such as the cost of sugar, packaging and polyethylene terephthalate (PET), which is used for plastic bottling.

These items make up about half of the production costs incurred by snack and beverage companies. A 1 per cent drop in the price of PET can translate to a profit rise of 1 per cent to 3 per cent for such firms.

The price of PET is down 26 per cent so far this year, thanks to massive oversupply.

China's listed food and beverage firms are market leaders with strong brands. They are able to maintain prices even as their costs come down. The outcome should be fat profits. Clearly, anyone taking a position on these sectors has to take a view on whether oil prices will continue to drop.

After peaking at a price of US$110 per barrel in late February, West Texas intermediate oil (a benchmark) is now trading at US$89. UBS CIO Research forecasts the floor for the trading range for this oil could drop as low as US$69 per barrel in the next three months.

The final icing on the cake is that many of the above sectors offer generous dividend yields, which offers a welcome respite for investors when local interest rates are so low.

Carl Berrisford is an analyst with UBS CIO Wealth Management Research