THE second quarter of this year was the most profitable ever for Big Oil: the six largest Western oil companies reported a 40% jump in profits, to a combined $51.6 billion. Exxon Mobil, the biggest of them all, banked $11.7 billion, the highest-ever quarterly profit reported by an American firm, beating its own record. But nobody expects a repeat of such feats of capitalism in the quarter soon ending, thanks to the tumble in the oil price from its peak of $147 in July. And given all the recent talk about levying windfall taxes on them, the oil giants may think that is just as well.
However, anyone tempted to hope that falling energy costs will mean higher profits for other American firms should think again. To the extent that oil prices are falling because of slowing global growth—the likeliest explanation, despite the flap earlier this year about the role of speculators—then they are likely to be an indicator of falling profits across the board. As oil prices tripled between 2002 and 2007, aggregate corporate profits doubled. Both reflected strong global demand, points out David Rosenberg, an economist at Merrill Lynch.
He says the recent decline in energy prices is a “symptom of demand destruction” that has dire implications for overall profitability. Mr Rosenberg has just written a gloomy report identifying “four horsemen” that will do their worst to American corporate profits: thinner profit margins; paying down debt as tighter financial conditions take their toll; lower energy prices; and a combination of slowing growth outside America and a stronger dollar. He predicts 7% falls in profits for firms in the S&P 500 both this year and next.
Until recently corporate profits have held up fairly well, even in America—except in financial services, where profits have been wiped out by the subprime-mortgage crisis and the credit crunch. Overall profitability for the S&P 500 was down by 31% on a year earlier in the fourth quarter of 2007, and by around 27% in the first half of this year, the second-worst three-quarter performance since the second world war, notes Martin Barnes of Bank Credit Analyst, a research outfit. (The worst was during the recession in 2001.) Yet, excluding financials, profits in the rest of the S&P 500 were actually up by 4.6% in the year to the second quarter of 2008.
This relative health was largely due to high energy prices, which benefited energy firms such as Exxon Mobil. They now account for 20% of S&P 500 profits, up from around 5% five years ago. Profits have also been buoyed up by strong demand from overseas, especially emerging markets. Domestic-based American non-financial firms have seen their profits decline at an annualised rate of almost 14% during the past six quarters, says Mr Barnes. But the profits of overseas subsidiaries of American non-financial firms have risen for 22 consecutive quarters, typically showing double-digit annual gains; they now account for 50% of the total profits.
Already countries that represent half of American exports, including big trading partners such as Japan, Canada, Germany and France, have posted at least one negative quarter of GDP growth, says Mr Rosenberg. As the global economy slows, the boost from abroad seems likely to weaken. Add to that the fact that the dollar has been rising like a homesick angel ever since The Economist’s Big Mac Index pronounced it too cheap in July, and it seems certain that this will be a disappointing quarter for many internationally leaning American firms. Moreover, several economists predict that the recent rise in the dollar is the start of a long-term trend.
“American companies are simply not prepared for this,” says Wolfgang Koester of FiREapps, a provider of software for managing currency risks. “They took the free ride on the falling dollar, and by and large are not hedged against its rise.” The more the dollar rises, the more it will help foreign firms that export to America, which have had to work hard in recent years. For instance, Airbus, Europe’s aviation giant, has struggled because it relied on dollar revenues to cover its euro costs.
If the dollar stays where it is until the end of the year and global growth in industrial production slows to 2% from 4.5%, the growth in overseas profits of American firms would slow to 2.5% in 2009 from 21% this year, Mr Barnes calculates. If the dollar were to rise by another 5% in trade-weighted terms, and global growth were to fall to zero, overseas profits would drop by 7%.
Mr Rosenberg is gloomier than most economists because he expects America’s GDP to shrink over the coming year, whereas the consensus is that it will continue to grow, albeit modestly. Wall Street’s equity analysts, by contrast, predict an increase of more than 20% in S&P 500 profits in 2009. They assume that the fortunes of financial-services firms will improve and America’s economy will grow. But profit growth of over 20% is typically associated with a rise in GDP of around 4.5%, and it has never occurred with GDP growth of less than 3.2%, which is roughly twice the consensus forecast for next year, says Mr Rosenberg. He suspects that equity analysts, who are having one of their least accurate years ever, are too busy trying to forecast profits for this quarter to correct their outlook for 2009.
Although Exxon Mobil can live with earning profits at a slightly slower rate, a growing number of firms are struggling to turn any sort of profit or even to bring in enough money to pay their debts. Moody’s, a rating agency, recently raised its forecast of defaults on high-yield corporate bonds to 7.4% over the next 12 months. The actual default rate over the past year is 2.65%—and 4% at an annualised rate so far in 2008—up from a low of 0.96% in 2007. The number of debt issues that are distressed (ie, are yielding at least 1,000 basis points more than Treasury bonds of a similar maturity) has soared to 27% of those in the main Merrill Lynch high-yield index, up from 1% last year.
The list of troubled firms has now extended far beyond the housebuilders and building-supplies firms that were the first casualties of the subprime-mortgage crisis to include retailers, casinos, publishers and cable-TV companies, points out Martin Fridson, a veteran observer of corporate bonds. Companies with distressed debt now include such household names as Delta Air Lines, Clear Channel, Toys “R” Us and Reader’s Digest. There would already have been more high-profile bankruptcies, points out Mr Fridson, except that at the peak of the credit bubble some of today’s more troubled firms managed to borrow “covenant lite” debt that makes it harder for creditors to demand their money back. But that seems likely to delay only briefly the arrival of the Grim Reaper.