The impact of lower oil prices on the automotive industry

The fall in oil prices comes at a good time for the automotive industry. Global light vehicle sales recovered nicely from the 2009 recession with China’s fast growing market providing much of the growth.

However, global sales show little improvement over the last year due to a moderating China vehicle market, a weak European recovery, and economic troubles in Eastern Europe and South America. In this environment, lower oil prices will help drive vehicle sales through stronger economic growth for most countries, and by lowering operating costs, making personal transportation more affordable for all consumers.

The light vehicle market already had a strong growth outlook with IHS Automotive forecasting over 760 million sales between 2014 and 2021, a 33% increase over the previous eight year period, and lower oil prices will contribute to even more upside potential. The direct impact of low oil prices alone on vehicle purchases is difficult to quantify, but IHS Automotive estimates sales could rise an additional 5-7 million units over the forecast horizon.

The largest beneficiaries will likely be the US market where lower gas prices will improve consumer confidence quickly, and developing markets like India and ASEAN where lower ownership costs will bring new buyers. However, low oil prices may also lead to government changes in fuel subsidy and tax policies in many countries, so cost savings may not reach consumers fully.

The largest impact from low oil will likely be on the types of vehicles purchased, and the automotive industry may need adjust accordingly. In recent years, many countries have implemented policies to direct consumers toward more fuel efficient vehicles in order to address pollution concerns and reduce dependence on imported oil.

Manufacturers, assuming stronger demand for improved fuel efficiency as a result of these policies, invested heavily in engine and transmission technologies, and have created many product options, offered at a price premium, that improve fuel economy and lower carbon emissions. The expectation was that consumers would invest in these technologies because the higher fuel economy would result in lower operating costs.

However, lower gasoline prices change the return on investment calculation for consumers dramatically, and with oil prices now falling, demand for these technologies will likely fall as well.  Lower fuel prices raise the consumer’s payback period – the time needed to earn back the investment in the fuel saving technology – and many consumers will determine the added cost is not worth it.

As an example, the total annual operating cost as gasoline prices change for a typical mid-sized car, with 24 miles per gallon fuel economy, being driven 12,000 and 20,000 miles per year.  As gas prices fall, annual operating costs also fall.  Car buyers, who are assumed to be “rational”, will calculate their own usage/cost relationship to determine whether a technology investment is warranted.

The prospective car buyer’s investment calculation will be based on many factors, but expected length of ownership will be critical.  A consumer could purchase a midsize car with a hybrid engine, rather than the usual gasoline only engine, for $3,000 more and improve their fuel economy 25%. The chart on the right reveals the payback period in years for this investment.  For a consumer driving 12,000 miles per year, and gas prices at $3.50 per gallon, it will take 8.7 years to pay back this investment from fuel savings, already a substantial amount of time for most car buyers. At gas prices of $1.00 lower, the payback period increases to over 12 years – far too long for all but the most high-mileage drivers.

The more miles driven each year, the shorter the payback period, but even for these high use consumers the investment choice becomes “less rational” as gas prices fall. For countries with higher priced gasoline such as Europe or Japan, the change in the payback period from falling prices is less dramatic, but still negatively impacts the return on investment. So, we can expect far fewer consumers willing to pay for fuel efficient technologies. Electric vehicle sales, which are generally the most expensive technology/fuel efficiency investment relative to basic gasoline engine options, will likely suffer the most.

Vehicle size will likely be impacted as well.  In a lower oil price environment, more consumers will choose larger sized vehicles over smaller sizes. Knowing this oil price/vehicle size relationship, there may be some trouble on the horizon for the industry.  Besides investments in improved fuel economy, the industry has also been focused on building smaller sized vehicles in many markets in order to meet expected consumer demand and government regulations for fuel efficiency and lower emissions.

The expectation was for oil prices to continue to rise leading consumers in most mature markets to demand smaller, more fuel efficient vehicles. However, consumers will likely prefer larger products than currently forecasted the longer oil stays as low levels. The industry has a long lead time from product conception to the showroom floor, generally 3 – 5 years for many manufactures, so planning decisions for new vehicles may need immediate re-evaluation.  Overall, new low oil prices may require adjustments to longer-term product plans, but will also benefit the industry through stronger sales and lower ownership costs by reducing the cost of personal transportation.

Author: Michael Robinet is the Managing Director of Automotive Consulting and Tim Armstrong is Vice President at IHS Automotive.

Image: A picture shows a charging station in front of a Mercedes electric car. REUTERS/Thomas Peter