Oil on the boil provides buying opportunity

Performance of the Indian equity market has a positive correlation to oil price performance

In the past few weeks, brent crude oil has crossed the $70/barrel mark and remained there for some time. This is making market participants evaluate the risk on fiscal spending, current account balance, currency and equity markets. Let’s analyse the impact on each of these.

Drivers of higher price

Let’s step back to see why crude oil has gone up 3x in less than 30 months and over 45 per cent in a year.

Firstly, at the back of strong economic growth across the globe, the demand for oil has been robust. It has been growing at 1.3-1.5 mmbpd (million barrels per day) for the past four years. The International Energy Agency expects the demand to grow by 1.4 mmbpd in 2018, 1.2 mmbpd in 2019 and 1-1.2 mmbpd thereafter.

Secondly, the compliance of the OPEC and non-OPEC nations to cut production by 1.8 mmbpd has been above 100 per cent since the beginning. This effort was led by Saudi Arabia cutting production even at the cost of reducing its market share. In fact, it is now pushing for a 10-20 year agreement on oil production control between OPEC and non-OPEC countries.

Thirdly, offsetting the above mentioned cuts, is the increase in crude production by the US since November 2017. The rigs restarted production after the oil price breached $55-60/barrel and remained there. The US has incrementally added 900 kbpd (thousand barrels per day) in the past six months.

Fourthly, as a result of the supply shortfall to meet the increasing demand, the oil inventory in OECD countries — which was 350-400 mmbbl (one thousand and one million barrels) in 2016 — has been drawn down to about 30 mmbbl currently, which may force replenishment going forward

Finally, rising geopolitical concerns has put upward pressure on prices. Venezuela’s financial crunch, coupled with US sanctions, has resulted in a sharp production decline of 0.9 mmbpd from 2.5 mmbpd in 2015.

The re-imposition of sanctions would lead to western oil-and-gas companies curtailing investment in Iran E&P (exploration and production). The event could see an immediate cut of 250-350 kbpd from Iran’s current production of 3.8 mmbpd. The cut could go as high as 800 kbpd as it has happened in the previous event of sanctions that lasted five years until 2015.

Impact on Indian economy

The increasing oil price brings back worries of twin deficit — fiscal as well as current account. On the fiscal front, excise duties to the extent of ₹15 and ₹19 per litre for diesel and petrol, respectively, have buoyed the tax revenues. Being an election year, the hesitation to pass on oil prices to the public may be highly impacting the PSU oil companies. In case the excise duty is cut, the fiscal maths may come under pressure. Overall, the impact on fiscal may be to the extent of 40-50 bps due to oil price rise.

India is a net importer of a billion barrels of oil per year. A $10/barrel move on oil would increase the trade deficit by $10 billion or 34 bps of GDP. At an average price of $70-75/barrel, the Current Account Deficit would be close to 3 per cent of GDP.

Since the funding required would be greater than the FDI flows, the dependency on FPI flows increases, putting pressure on the rupee. However, India has over $425 billion of foreign reserves which should help tide over the volatility

Impact on equity markets

We looked at nine instances since 2000 where oil has gone up more than 50 per cent from its trough (April 2000-June 2016). In this period, Nifty Index in USD terms gave an average return of 30 per cent, beating the MSCI Emerging Market and MSCI World indices, which rose 26 per cent and 10 per cent, respectively.

During the same period, we also looked at 10 instances where oil fell more than 30 per cent, in which case Nifty Index fell 1.4 per cent on an average in USD terms, outperforming the EM and World indices that fell 7.4 per cent and 3.7 per cent, respectively. Hence, it is important to note that the performance of the Indian equity market has a positive correlation to oil price performance.

In the current context of increasing oil prices, there would be news-driven price spurts, but the upside to such spurts could be limited. The Indian economy has become more resilient to the volatility in oil prices compared with five or 10 years ago. Equity markets may, in fact, take it in their stride as earnings growth comes back and global growth holds up. Any correction in markets may turn out to be buying opportunities for investors.

The writer is Co-CIO, Aditya Birla Sun Life AMC.

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