Will Rise In Crude Oil Prices Impact Equity Markets?

Will Rise In Crude Oil Prices Impact Equity Markets?

Crude oil prices are on a boil and are up by more than 30 per cent in one year. Even if the crude oil price is way lower than the all-time high at $ 145 per barrel made in July 2008, it stands higher by almost 127 per cent from its multi-year low of $ 26 per barrel made in February 2016.

Crude oil is important for the world economy, and more so for the Indian economy. India is one of the largest importers of crude oil globally and has been consistently among the top four importers globally, just behind the US and China. India imports approximately 157.5 crore barrels of crude annually, and if we calculate the damage that a single dollar increase in the price of crude can cause, it comes to around `9,500 crore, assuming the exchange rate of `60 to a dollar.

To ascertain the damage, it is equally important to also check if the US dollar is strengthening or weakening against the Indian rupee. If the rupee strengthens, the damage will be limited even if crude oil price appreciates. For India, a situation where the crude oil prices increase along with strengthening of the US dollar will be painful.

The price jumped in anticipation of an extension of the OPEC-led production cut, which is due for expiry next March

Speculation is rife that the crude oil prices may touch $ 70, and if that does happen and crude oil manages to stay above $ 70 for several months together, it will start showing its impact on macroeconomic indicators in India. The forex reserves will be under pressure and the current account deficit will widen which, in turn, will make foreign investors cagey on Indian economy's growth story. If such suspicion on the growth potential of Indian economy persists, the foreign investors may decide to accelerate their redemption from Indian equity markets, which are already witnessing selling pressure from the offshore investors. Indian economy has already suffered slowdown owing to demonetisation and GST implementation, both of which were reform measures perceived to be good for the economy in the long run.

Brent crude oil touched an all-time high of $ 145.31 per barrel in July 2008

The valuations are rich for the global equities and, in particular, for the Indian markets. Nifty P/E stands at more than 26 and it will be foolish to believe that Indian markets cannot trade below P/E of 26 .

Rich equity valuations along with the expected higher crude oil prices do not augur well for the equity markets. The foreign investors may take a negative view on equity markets in India as India is one of the top importers of crude oil and the equity valuations are rich. In spite of abundant liquidity, equity prices may face correction and the damage will depend on how much, how fast and how long the crude oil prices spiral up.

Now the million dollar question is — "Will crude oil prices stay above $ 70 in CY18?" Says Prathamesh Mallya, Chief Analyst- Non-Agri Commodities & Currencies, Angel Commodities Broking Pvt Ltd. "Crude oil prices have risen fast and fallen fast, which in turn has led to increased volatility in the asset due to host of surrounding factors, such as disturbances in production in Iraq and uncertainty in the Saudi Arabian kingdom, while increased production and rising inventories in the US have led to sharp fall in oil prices in recent weeks.

The correction in oil prices will extend in the weeks ahead with the immediate target of $51 for WTI, while MCX oil price will fall lower towards `3400 per barrel.

I think the increase in oil prices will have its own multi-layer effect on the balance of payment and current account deficit. Besides, oil is just not the sole deciding factor for correction in any asset class."

If crude oil prices continue to remain higher, we can safely assume that equity prices will remain subdued, despite visibility in earnings growth.

Among various reasons cited on why crude oil prices can stay higher is the launch of one of the biggest IPOs world has ever seen. Aramco IPO is expected to happen in 2018. Higher crude oil prices will be in the interest of Saudi Arabia, as the Aramco IPO is touted to be valued at $ 2 trillion.

Higher oil prices could mean more problems for India, which imports more than 80 per cent of its crude oil requirements

Apart from the wide speculation on the IPO and the political uncertainty in Suadi Arabia, there are some signals which suggest that it will not be easy for crude oil prices to sustain above $ 70 per barrel, provided it first manages to touch $ 70 and cross the magic figure successfully.

WHY HAVE OIL PRICES BEEN SO VOLATILE IN THE RECENT PAST ?

The US production of shale oil and alternative fuels increased • Recent volatility in foreign exchange rates, which drove up the value of the dollar by 25 per cent in 2014 and 2015. • OPEC did not reduce output to put a floor under prices until November 30, 2016

CONCLUSION :- If we consider the historical journey of crude oil prices, it has been extremely volatile, to say the least. In March 2006, Brent crude was selling at around $ 60/b and in July 2008 it touched $ 145/b. In 2014, it touched $ 100/b and in January- February 2016 it plummeted to its 13-year low of $27/b (rounded off) only to more than double at the current level of $ 65/b.

Whether or not the crude oil will return to its historical levels of $70 to $100 per barrel, only time will tell, but suffice to say that it will depend on how many shale oil producers go out of business in the US, what steps Iran takes to cut production along with OPEC and how fast the economy grows.

The demand for oil, producers' behaviour and the impulse for overproduction have defined how crude oil prices behave in the past decade or so. While the supply was dictated by the under-investments and the limited availability of frack crews since 2015, it does look like the situation on the ground will start changing in 2018.

High crude oil prices are good for oil exporting countries, however, high crude oil prices slows down economic growth of oil importing countries and lowers the demand for the commodity itself. History suggests that there is ‘demand destruction' if high prices for oil lasts long enough as there is always a probability of people changing their buying habits. It has happened previously in 1979 oil shock. The demand eventually declines and the supply catches up in the long run, thus keeping crude oil prices in check.

In 2008, market speculators pushed the oil prices higher, assuming that there will be shortage in future supply and that China's demand for oil would overtake supply. It turned out that the speculators were wrong and the oil prices fell sharply.

Investors, while remaining cautious in the equity markets, should not be overly worried about the crude oil price rise. In the long run, the impact subsides and the basic fundamentals of the economy start impacting the corporate performance. Seasoned investors will know that the interplay between higher oil prices and impending possibilities of over-supply and under-supply will continue, but that will not derail the long-term momentum in equity prices globally.

A stronger currency would limit the pass-through from higher prices of imported oil

The Indian oil basket price has increased by nearly 22% since early September to $61.6 per barrel. The price of gasoline averaged across four cities (Delhi, Mumbai, Chennai and Kolkata), however, shows zero increase. The reason -- Central and certain state governments cut tax duties on gasoline and diesel in October. What's more, the rupee is set to appreciate to 61 per dollar by March 2018, on strong capital inflows and favourable trade seasonality, according to BE's forecast model. A stronger currency would limit the pass-through from higher prices of imported oil.

The concerns that a tight fiscal position means limited space to finance tax cuts on oil are misplaced. True, low RBI dividends, lower telecom revenues, and a likely shortfall in the government's ambitious asset sale programme already mean the deficit is in danger of overshooting. But this does not necessarily mean higher market borrowing for the government:

Funds earmarked for GST revenue shortfalls of state governments, surplus cash balances with the RBI, and draw-downs from small savings deposits could all be used to finance any shortfall.

High tax buoyancy in 2H as growth recovers above 7% and GST teething issues are addressed should support stronger revenue growth.