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Fossil-fuel betas put energy risk in its place.
S.L. Mintz, CFO Magazine
December 1, 2008
Only last April, Michael Graff of Graff Trucking predicted catastrophe if diesel prices climbed higher. "I'm at the point where I'm questioning my ability to continue to operate," he said. While the current respite may have dialed back such angst, volatility has not vanished. Nor has the contingent risk to cash flow posed by potential taxes and cap-and-trade quotas on greenhouse gases (GHGs). These lurking costs jostle market values every day.
To date, however, companies have lacked any precise, uniform means to evaluate and manage value-at-risk from energy volatility, future liability from GHG emissions, or other aspects of sustainability. It's been a finger-to-the-wind exercise in which companies have set all manner of targets and deadlines, with no hint of uniformity. Tool manufacturer Black & Decker, for example, reported to the Carbon Disclosure Project (CDP) that it sets no corporate emissions reduction target; instead, its initiatives focus on energy-efficient lighting, improving the use of compressed air and steam, and using high-efficiency electric motors.
To improve its energy profile, airplane maker Boeing seeks a 25 percent improvement in greenhouse-gas emissions intensity (on a revenue-adjusted basis) at major manufacturing facilities by 2012. Wal-Mart has described lofty long-term goals — to rely completely on renewable energy, to create zero waste, and to sell products that sustain global resources and the environment — all aimed at lowering a $2.5 billion bill for fuel and electricity.
This welter of goals, ambitions, and good intentions calls to mind Ronald Reagan's famous dictum: Trust, but verify. Enter the "fossil-fuel beta," a metric that can pinpoint the impact of fossil-fuel prices and contingent GHG emissions liabilities across the value chain. Such a metric could furnish market-based data to support fossil-fuel targets and truly substantive sustainability reports.
The fossil-fuel beta — or FFβ™ — developed for CFO by finance professor Anant Sundaram and the Allwin Initiative for Corporate Citizenship at Dartmouth's Tuck School of Business, estimates exposure of a company's market returns to changes in fossil-fuel prices. This new benchmark zeroes in on one pivotal question: To what degree do corporate policies and hedging strategies help decouple a firm's market returns from fossil-fuel price changes?
The figures presented on the following pages do not address a potential carbon tax or the cap-and-trade cost implications of fossil-fuel consumption. That analysis must wait for improved quality of carbon-use audits; today fewer than half the companies in the S&P 500 provide a detailed public accounting of their GHG emissions, according to the CDP.
However, FFβ introduces an objective, accessible handle on a major component of energy risk. It combines reliable and widely used stock-market data from the Center for Research in Security Prices with fossil-fuel prices from the Bureau of Labor Statistics. The results pose new questions about bottom-line virtues of "natural" hedges that reduce fossil-fuel use and strategies that offset costs.
Using three calendar years of stock-market returns and fossil-fuel price data (through December 2007), the 2008 FFβ roster highlights inequality across a range of S&P 500 companies. Routine regression analysis tracks excess stock returns for changes in fossil-fuel prices at 135 companies in 10 industries. The tables illustrate the impact of a 10 percent fossil-fuel price increase.
Like conventional market betas, FFβs measure percentage changes in expected returns subject to another variable. Positive betas flag companies that tend to mute consequences of higher oil prices or even convert increases to added profits. Negative betas signal earnings more vulnerable to rising fuel prices. "It is not good or bad, per se, to have a positive or negative FFβ," Sundaram says. "But it may be strategically sensible for a company to decouple its core business from fossil-fuel prices in the long run by gravitating to a zero beta." Neutral FFβs can furnish a target for managers who want to insulate core earnings from fossil-fuel price fluctuations. Using the same scale, managers might instead adjust betas to accommodate any risk appetite or energy outlook.
An FFβ expresses the expected change in a company's excess market capitalization for every 1 percent change in the price of fossil fuel. The change in market capitalization divided by the number of shares forecasts an imputed share-price impact of a change in fossil-fuel cost. When combined with consensus analyst estimates of the forward P/E ratio, it produces an earnings-per-share equivalent impact. This equivalent impact does not drive actual earnings up or down in a given quarter, as sales would. Instead, it imputes an energy toll (or bonus) to EPS subject to many other influences.
Take, for example, two package-delivery rivals, FedEx and United Parcel Service. Both spend enough on fuel to affect bottom lines and, hence, market values. UPS reported to the CDP that 6 percent of its 2007 operating expenses assigned $2.8 billion to fuel. FedEx reported a $3.5 billion fuel bill, or 11 percent of its total operating costs. Although both deliver packages, their excess earnings respond differently to changes in fossil-fuel prices.
What did the different sensitivity mean for shareholders of UPS (FFβ 0.0576) and FedEx (FFβ -0.1411)? Enough to nudge earnings in opposite directions by several cents a share. A 10 percent increase in the cost of fuel, Sundaram estimates, would strip the equivalent of 10 cents a share from FedEx. That, in combination with a P/E ratio of 12.2, relinquished an imputed $1.22 in share price, a penalty that a different energy policy might have offset. Conversely, a 10 percent drop in fuel prices should boost earnings in equal measure.
By maintaining a neutral FFβ, closer to zero, UPS delivers 3 cents of implied excess earnings, or 41 cents in share price (applying a P/E of 15.9). This net difference of $1.63 in the stock prices of two rivals resulting from a 10 percent change in fossil-fuel prices highlights why a fossil-fuel beta might help managers frame savvy questions around energy consumption. One explanation might lie in UPS's aggressive pursuit of conservation initiatives, such as more fuel-efficient facilities, minimizing miles flown or driven, and converting 25 percent of its truck fleet to lower-emission vehicles.
Even steeper differences separated rivals in other industries. The imputed market impact of a 10-cent rise on petroleum producer Apache Inc. (FFβ 0.0657) was 71 cents a share; on Valero Energy Corp. (FFβ 0.5351), $3.75 a share. All 13 oil producers in the roster have neutral-to-positive FFβs, an outcome consistent with classical economics, says economist Robert Hansen, director of Tuck School's Allwin Initiative. "This is the likely result of an increase in the demand for energy over this period, combined with rising asset values associated with the energy firms' fossil-fuel reserves."
In retailing, fossil-fuel exposure at Nordstrom (FFβ −0.4953) appeared to surrender $1.82 of market value, while a neutral profile at Wal-Mart (FFβ 0.0228) appeared to add 11 cents, for a net price difference of $1.93.
Nordstrom, in fact, had posted the most negative FFβ grouping in the retail sector as of December 2007, capping negative results in all rolling three-year periods since 1998. The imputed impact on its EPS: minus 16 cents. Citing favorable recent experience as fuel prices slid (when a high negative FFβ should have furnished a benefit), Nordstrom dismisses its 2008 FFβ as "coincidence," but the Seattle-based retailer withholds its analysis.
Sundaram's methodology calculates a neutral beta for Wal-Mart (FFβ 0.0228). Energy consumed by the giant retailer's North American stores, warehouses, and delivery vehicles should have pushed Wal-Mart toward a negative FFβ along with most of its retailing peers. It is possible that undisclosed financial hedges, in combination with natural hedges, braced the giant retailer's earnings against oil-price fluctuation in either direction. A fuel-efficient truck fleet, for example, furnishes a natural hedge that saves millions of gallons of gasoline a year, while rising oil prices may actually boost business by herding consumers toward value-oriented retailers. And Wal-Mart and its subsidiary Sam's Club supply oil at gas stations nationwide. Those factors appear to have combined to create a rare positive FFβ in the retail sector.
Energy costs have long eluded means to manage them. Cost volatility alone warrants a new look at market-based analytical tools. Pressure to go green compounds demand for better data, not least in conjunction with looming cap-and-trade initiatives and related taxes. Besides furnishing a new tool aimed at critical cost control, this first look at a fossil-fuel beta should advance the ongoing energy dialogue. Think of it as just one window on a sustainability landscape still in need of wider exploration.
S.L. Mintz is a deputy editor of CFO. Robert Burnham of the Tuck School provided crucial analytical support for this story.
$2.8 billion UPS: 2007 operating expenses that went toward fuel
$3.5 billion FedEx: 2007 operating expenses that went toward fuel
0.0576 UPS FFβ
-0.1411 FedEx FFβ
$1.63 Expected difference in share price between the two companies based on a 10% rise in fuel prices given the spread between their respective FFβs.
For a look at how the fossil-fuel beta plays out in 10 sectors, click here.