With fuel costs dropping and prices for fuel-efficient models softening, Kelley Blue Book outlined what dealers need to do now if their inventory is stocked heavily with compacts.

KBB’s manager of vehicle valuation Alec Gutierrez recommends dealers purge extra fuel-efficient models and replenish them with stable crossovers.

“With fuel prices falling and values of fuel-efficient vehicles on the verge of a correction, many dealers are finding themselves with excess inventory no longer commanding a premium,” Guiterrez shared in the July Kelley Blue Book Market Report.

“Many dealers stocked up on subcompact, compact and hybrid cars during the past several months to satisfy the demand of consumers hedging against rising fuel prices,” he continued. “Dealers also overestimated the willingness of consumers to pay a premium for these vehicles as they continued to buy them even as values approached original MSRP.”

Since values for these vehicles peaked a few weeks ago, Gutierrez acknowledged that some dealers now find themselves in a bit of precarious situation.

“Kelley Blue Book field analysts are reporting that many dealers are struggling to unload compact, fuel-efficient vehicles at auction and are being forced to take losses to clear out excess inventory,” Gutierrez noted.

“In California specifically, the Toyota Prius has been particularly difficult to sell at current inflated prices now that carpool lane use stickers have expired for hybrid vehicles,” he added.

What should dealers do?

“Dealers with an excess inventory of fuel-efficient vehicles are better off unloading these vehicles sooner rather than later, since Kelley Blue Book analysts are expecting values to remain soft through the rest of the year,” Guiterrez suggested.

“Dealers that seek out a ‘wait-and-see’ strategy can expect their inventory to decline nearly 2 percent for every month that a used subcompact, compact or hybrid car sits on the lot,” he warned.

In trying to maximize sales of excess fuel-efficient vehicles, Guiterrez also conceded that there are no easy answers.

“While fuel-efficient vehicles are depreciating more than any other segment today, the entire market is relatively soft and it is expected to remain soft moving forward,” he surmised.

“As gas prices continue to fall, trucks, SUVs and crossovers will likely be the safe bet for dealers looking to purchase vehicles with stable values,” Gutierrez added.

KBB indicated that values for trucks and SUVs may be down 5 to 6 percent since Jan 1, but they are expected to stabilize through the end of the year.

That trend forecast brought Gutierrez to his other suggestion — finding crossovers to fill inventory slots previously taken by compacts.

“Although values for crossovers have declined approximately 2 percent in the last four weeks, they have been relatively stable through most of 2011,” Gutierrez stressed.

“With gas prices on the decline, we expect the risk of significant declines through the rest of the year to be relatively low,” he went on to say. “Crossovers provide excellent fuel economy and are practical, making them a very attractive choice for both dealers and consumers in today’s market.”

Fuel-Efficient Vehicle Values Staring at 15-Percent Correction

Before Gutierrez arrived at his inventory recommendations, the KBB analyst went into an extensive discussion about why fuel-efficient vehicle prices are sinking.

After 20 weeks of consecutive gains, KBB discovered values for gas-sipping vehicles peaked in May in response to a decline in fuel prices. The company said during the last four to six weeks, values of compacts and subcompacts declined approximately 1 to 2 percent, along with the overall market.

“However, Kelley Blue Book’s valuation team expects the overall used-vehicle market to decline no more than an additional 3 to 5 percent between now and the end of the year,” Gutierrez shared. “With fuel-efficient used vehicles reaching their peak in demand and price, larger drops are expected in this segment.

Throughout the first half of the year, KBB reiterated that it has reported remarkable strength among values of fuel-efficient subcompact, compact and hybrid vehicles. From January through May, analysts determined fuel-efficient vehicle values increased 20 to 25 percent, far surpassing the overall used-market average increase of 5 percent during the same time period.

Gutierrez attributed the steep increase to a trio of reasons:

1. Gas prices increasing from $3 on Jan. 1 to $3.97 per gallon on May 15.

2. Supply constraints of new fuel-efficient vehicles resulting from the earthquake in Japan.

3. Continued supply constraints of good-condition vehicles due to reduced leasing and trade-ins.

“In addition to some much-needed relief at the pump, it appears as though Japanese manufacturers are expected to have their production facilities back to 100 percent capacity by September, which is earlier than originally anticipated,” Gutierrez surmised.

“With gas prices continuing to decline and Japanese vehicle and part production recovering, demand for fuel-efficient vehicles is waning, and as a result, dealers are becoming more reluctant to pay premium prices for these vehicles at auction,” he continued.

“While depreciation has been relatively mild so far, based on changes in gas prices and issues with supply, Kelley Blue Book believes a significant 15 percent correction is likely by the end of the year,” Gutierrez went on to forecast.

To reinforce that expectation, KBB looked back at the wholesale market in 2008 when gas prices hit $4 per gallon. Again, three reasons came up as to why KBB thinks drops are ahead during the next few months:

1. Performance during the first half of the year in both 2008 and 2011 are trending very similarly, increasing 21 percent in response to rising gas prices.

2. Values of 3-year-old fuel-efficient vehicles are significantly more expensive today than they were in 2008. Reduced leasing and trade-ins since 2008 have shrunk supply of these vehicles, while a weaker than expected economic recovery has kept demand strong for these budget-friendly vehicles.

3. Most importantly, a severe, 40-percent gas price decline occurred from July through December 2008.

“As gas prices dropped from $4.10 per gallon nationally in July 2008 to $1.60 by year-end, demand for gas-sipping vehicles evaporated,” Gutierrez insisted.

While there are many similarities between today’s market and that of 2008, Gutierrez also pointed out there are key differences that have allowed KBB to determine that there will be “little need to panic” during the latter half of year.

Again, KBB highlighted three reasons why dealers can take some comfort:

1. The level of economic uncertainty in 2008 was significantly higher than it is today. The unemployment rate was climbing fast into the end of the year, and the financial sector was in a free-fall with seemingly no end in sight.

2. Fuel prices declined significantly in the latter half of 2008, ending the year at $1.60 per gallon, while oil fell from a high of $140 per barrel down to $30 by year-end. Today, oil has only dropped from a high of $115 down to around $95, while fuel prices remain at $3.50 per gallon today.

3. Used vehicles were in abundant supply in 2008, while today the industry faces a shortage of good-condition used vehicles due to the severe downturn in new-vehicle sales, leases and ultimately trade-ins. This should act to limit the downside potential for fuel-efficient vehicle values.

“Kelley Blue Book believes that while a correction may be looming, we do not expect to see a repeat of the 40-percent decline in values that took place during the second half of 2008,” Gutierrez emphasized.

“Rather, Kelley Blue Book predicts that the correction will be more like 15 to 20 percent,” he continued. “With values inflated 20 percent since the beginning of the year, we are likely to surpass the drops of both 2009 and 2010, although we will not repeat the heavy drops of 2008.

The key factor determining the July to December drop in fuel-efficient vehicle values will be fuel prices and where they finally stabilize,” he added.

More Commentary about Fuel Prices on Downward Trend

KBB pointed out gas prices already have declined 40 cents per gallon since mid-May, and analysts believe there is a strong likelihood of additional softness moving forward.

“While fuel prices have performed similarly to the last run-up in 2008, they peaked earlier this year and are widely expected to continue to decline through summer,” Gutierrez noted.

Like in the rest of the report, KBB shared multiple reasons for a assessment with its final one being several factors that are likely to continue to push down both gas and oil prices moving forward.

1. President Obama recently announced that the United States will release 30-million barrels of oil from strategic reserves. “This should provide some temporary relief, but when we consider that the U.S. consumes approximately 18-million barrels of oil per day, this is not likely to have a lasting impact,” KBB conceded.

2. Saudi Arabia announced plans to increase oil production to 10-million barrels per day starting in July. “Even if they don’t fully live up to their commitment, an increase in production from a major player such as Saudi Arabia should provide relief to any supply concerns,” KBB said.

3. The International Energy Agency (IEA) recently announced that they would release 60-million barrels of oil from member nations’ strategic reserves at a pace of 2-million barrels per day, 30 million of which will come from the United States.“This should provide further relief to the increased supplies being provided by Saudi Arabia,” KBB indicated.

Gutierrez stressed the severe gas-price drop in 2008 was the result of rampant speculation coupled with the near-total collapse of the U.S. economy.

“We may not be able to predict the bottom of the market, but we do expect prices to drop through summer, and as fuel prices continue to decline, values of fuel-efficient used vehicles will drop,” he stated.

“While oil prices and subsequently gasoline prices will continue to fall based on increased supplies, a 15 percent decline will not send the industry into the tailspin experienced in 2008, when near 40 percent declines were seen across the board,” Gutierrez concluded.