Diageo: Will A Rebound In Oil Prices Cause A Hangover?

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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 around $50 more recently. [1]

While plummeting oil prices led to massive gains for some, it led to losses for others. For Diageo however, circumstances were different, given its varied geographical presence. While the fall left consumers in some markets with higher disposable incomes to spend on alcohol, many oil exporting markets suffered widespread economic turmoil to pull down demand drastically. So far, the decline in oil prices did not do much for Diageo’s performance, as witnessed by the recent half year results, where operating profits declined 11% and volumes declined 2%. Trefis examines whether a possible rebound in oil prices will leave Diageo’s glass half-full or half-empty.

Trefis has a $119 price estimate for Diageo, which is slightly above the current market price.

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See Our Complete Analysis For Diageo Here

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. For our analysis, we assume OPEC’s forecast holds, i.e. oil prices hit the $110 by the end of the decade.

In this situation, the markets we would first turn to are oil-exporting countries such as Russia and Venezuela. Russia and Venezuela have faced the worst of the fall in oil prices as both countries derived the majority of their dollar income from oil exports. Furthermore, their high reliance on imports even for basic goods has contributed to high inflation in both countries, with rates reaching as high as 68.5% in Venezuela and 17% in Russia early this year. This contributed to widespread currency depreciation, with the Russian ruble falling almost 80% against the U.S. dollar and the bolivar sliding almost 88%. While on the one hand, the high price of necessities choked off alcohol demand, the depreciating currency further contributed to losses for Diageo. According to the company’s half-year earnings report, exchange rate movements for the year ending June 2015 are expected to adversely impact net sales, operating profits, and net finance charges. While net sales and operating profits are expected to decline by  £120 million ($180 million) and £85 million ($127.50 million) respectively, net finance charges are expected to go up by £10 million ($15 million).

Assuming approximately 70% of the fluctuation in exchange rates was a consequence of the drop in oil, we get a loss of $126 million in net sales, $89.25 million in operating profits, and an increase of $10.5 million in net finance costs. Allocating 40% of this to Diageo’s Latin America operations and 50% to Africa and Eastern Europe operations, we anticipate net sales to increase by almost $113 million in these regions by the end of the decade as oil prices rebound to mitigate unfavorable exchange rates movements. Furthermore, improving economic conditions in these regions could further perpetrate volumes, which are expected to increase by almost 10 million equivalent cases (i.e. standard nine-liter cases) in these regions by the decade-end.

The rebound in oil prices is expected to improve prospects in oil-exporting markets, although an almost doubling of prices is bound to drag down purchasing power of consumers in other markets. Whether this will impact alcohol demand considerably or not is a matter of contention. While alcohol demand may not decline much on the whole in response to this, Diageo’s premium pricing policies may further come into scrutiny especially in markets like the U.S., where the alcohol manufacturer is already battling intense price competition. Furthermore, Diageo’s already premium pricing will preclude them from raising prices further and hence, unable to pass on the higher costs to its consumers, we expect margins to decline by at least 10 basis-points. In conclusion, we anticipate a meager 5% downside to our current price estimate for Diageo, where part of the loss in revenues in markets such as Europe and North America, are offset by improving prospects and favorable exchange rate movements in markets such as Latin America, Africa, and Eastern Europe.

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

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Notes:
  1. Why the oil price is falling []
  2. Why Oil Prices May Shoot Back Up []