DSIJ Mindshare

A Drop of OIL

Crude oil prices have been slipping in the global markets, with economists and investors standing by cheering this fall. Changes in the crude market have rewritten old equations afresh. How long will the tumbling of the barrels sustain?Shrikant Akolkar finds out

Crude oil is the most important commodity that fuels the world economy. Changing crude oil prices make a huge impact not only on the developed economies but also on the developing and under-developed ones. It is no secret that this is the prime reason why oil is at the centre of international politics. No wonders the world has seen several wars being orchestrated in the Gulf region, the wellspring of the world’s oil reserves. 

Crude oil is, for all practical purposes, a measure of global economic growth. This time around, crude has made it to the news on account of a fall in prices. The same ‘black gold’ that once gave the finance ministers of many countries sleepless nights has seen over 10 per cent fall in prices in the first four months of this year. Such a steep fall is the first of its kind in the last 10 years.

After this, many market pundits have become bearish on crude oil. As for India, the fall augurs well to reduce the twin deficits. Inflation would also witness further easing, which would lead the RBI to cut the key interest rates faster. Here, one needs to understand why the price has witnessed such a decline and secondly, where it will stop. Investors would also be seeking a near-term outlook of this energy commodity. But let us first take a look at why crude has fallen.

Structural Change In The Crude Oil Market

Before one dwells on the depth of the fall, it must be understood that the crude oil market is undergoing a few structural changes. Earlier, crude production had been a major business of the OPEC (Organization of the Petroleum Exporting Countries) countries. Besides, the demand for oil has always been higher than the supply, which is why the prices of this commodity rose historically.

Taking a look at the demand-supply scenario, as per the International Energy Association (IEA), the oil supply has outrun the demand in calendar year 2012. The same trend has continued in the first quarter of CY2013. The supply has also been increasing consistently over the last three quarters, which is a major reason for the oil prices seeing a fall. This is no rocket science – the most elementary rule of economics is sufficient to understand this logic.
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US Coming Into Surplus

We are also, in all likelihood, looking at another structural change in the next few years. While the US has been the largest oil importer for over four decades, the scenario is slowly transforming now. The shale gas boom in the oil & gas sector in the US has allowed the country to rethink its oil policy. It is now taking steps to become an energy independent nation rather than relying on others.

According to the annual report of US Energy Information Administration (EIA), the share of net imports in the total petroleum consumption of the country has been consistently declining from 2005 onwards. What is more, the report also envisages that the US could become a net oil exporter country sometime in the future. According to EIA, the crude oil production in USA has been increasing, going from five million barrels per day (mb/d) in 2008 to 6.5mb/d in 2012. This was a direct result of the technology advancements in crude oil production.

Global Growth Outlook: Still In Limbo 

Counterbalancing the higher domestic oil supply in the US is the lower demand for crude oil worldwide. There are many factors underlying this, but the crippled global recovery was the major factor that impacted crude oil prices. The world’s largest economy, US, is still struggling to get back onto its prerecession growth path, while the Euro zone is far from a recovery. 

In fact, the disastrous debt crisis in the Euro region has spread its tentacles to the developing markets, which has led the IMF to lower its growth forecast. In January 2013, this body had forecast global growth for 2013 to be at 3.5 per cent but it has recently lowered this estimate to 3.3 per cent. It has also toned down the expectation for growth in the US from 2.1 per cent to 1.9 per cent, while that in the Euro zone to -0.3 per cent (signifying a contraction in the economy).

The world’s second largest economy China recently overtook the US as the largest oil importer in the world. But the country may not see a huge uptick in growth. China reported 7.7 per cent GDP growth in the first quarter of 2013, below the IMF forecast of eight per cent growth in the economy for the calendar year. Recent data also shows that it is showing some pressure in the manufacturing sector, in which it has traditionally been a force to reckon with. Here the economics is quite simple – slower global growth would result in slower demand for oil.

All these macroeconomic growth fears are translating into a fall in the crude oil prices. Lower growth means that the slowdown in the industries will continue.
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Other Forecasts: EIA, IEA & OPEC

The US Energy Information Administration’s 2020 forecasts estimate that Brent crude oil prices would remain between USD 103.47-107.22/barrel. One should note that the EIA has used both high and low economic growth scenarios to arrive at this price. This implies that crude will remain under pressure even in a high growth scenario. It has also projected that US crude oil imports will decline by 17-30 per cent, and at the same time the crude oil production will rise by more than 31 per cent. The EIA is absolutely bearish for 2013, with an estimate of prices as low as USD 93.17/barrel. The world’s largest economy saying that it will reduce its oil imports will surely impact the crude oil prices.

The short-term outlook of the International Energy Association (IEA) indicates slower demand and higher supply. It has said that, “A weak macroeconomic environment is expected to keep demand growth relatively subdued for the remainder of the year”. This clearly indicates that the oil price would remain under pres- sure for at least a year’s time. The IEA, though, expects oil prices to rise to USD 247/barrel by 2035, which iscontrary to the EIA’s long- term out- look. According to a Bloomberg report, IEA expects Brent crude prices to fall to USD 91/barrel in 2016.

The OPEC is also quite bearish on crude. The agency has lowered the world oil demand growth, cutting its growth estimates by 0.4 mb/d in 2013. It expects the non-OPEC oil supply to keep growing, which means that there will not be any shortage of oil. Bloomberg, in its January 24, 2013 report, has cited that OPEC expects oil prices to remain between USD 85-95/barrel by 2020.

Experts’ View

When the three largest energy agencies are cutting their demand forecast and the crude oil price estimates, surely there it bears paying heed to. Oil experts also have a varying outlook on the commodity.

Speaking to DSIJ, Essar Oil CMD, L K Gupta said, “My personal view on crude oil is quite bearish. There is no problem of short supply of crude. Oil production is rising, which is why crude oil prices are declining”. Hardeep Yadav, CEO, Checkmate Trades, a Gurgaon-based crude oil trading company expresses a contrary opinion, “Oil prices may remain stable between USD 98-105/barrel. If crude oil breaches the USD 90 level, it may also go down to the level of USD 80/barrel on COMEX.”

Besides the demand-supply equation, global liquidity is another factor that sways commodity prices. The ECB, Australian Central bank as well as India’s RBI have cut the interest rates, and this will increase the liquidity in the global economy overall. After some poor first quarter GDP numbers, the US Federal Reserve is expected to continue with the quantitative easing measures. This implies that the global liquidity remains supportive of recovery, which may have a positive impact on crude oil demand in the global markets.

In this regard, Dhananjay Sinha, Equity Strategist and Economist, Emkay Global says, “If you have long-lasting liquidity, then you can’t expect the crude price to keep falling”.
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Impact On India

India is a net oil importer country, bringing in more than 80 per cent of its total requirement through imports. Over the last five years, India’s crude oil production has increased by two per cent while the consumption has increased by eight per cent annually. In FY12, India imported crude oil worth a total of USD 152 billion, which was 32 per cent of its total imports and eight per cent of the total GDP. Naturally, crude oil is a key commodity that is being watched by the government, experts, industries and economists to chart the future course of the economy.

Sinha comments that since crude oil is a prominent import at 33 per cent of the total imports, a fall in crude oil prices would definitely lead to lowering the trade deficit. It will also moderate the yawning Current Account Deficit (CAD), which is expected to be 4.8 per cent of the GDP for FY14 as per the government estimates. “If one is expecting growth in the world economy, then that should lead to a recovery in the crude oil prices. Inversely, if crude oil remains under pressure, then equities may also have to give away expectations of high growth”, he opines. 

On the impact of lower crude oil prices, Sinha maintains that, “One has to see how the invisibles and exports fare during the year. The fall in crude will definitely lead to a reduction in the trade deficit; the CAD, however, is highly vulnerable to invisibles and capital flows”. He expects the CAD to remain on the higher side till the end of the year. He said that the sustainable level of CAD for India is 2.5 per cent, anything above which is unfavourable.

Madan Sabnavis, Chief Economist, CARE Ratings notes, “Lower crude prices will benefit us in terms of lowering the oil import bill, given that it accounts for a little over 30 per cent of our imports. This will moderate our CAD. Lower prices will positively impact our subsidy bill and inflation – we will have to provide relatively lower subsidy amounts for diesel in particular. Also to the extent that prices remain low, the fuel inflation component will show stable tendencies”.

Stock brokerage firm Religare has estimated that, “A 15 per cent fall in crude to USD 95 barrel in FY14 from the FY13’s average of about USD 112/barrel with flat volumes, would lower FY14 trade deficit by a sharp USD 21 billion and CAD by 90 basis points to 2.9 per cent of GDP, ceteris paribus”.

In an interaction with DSIJ, Vaibhav Agrawal, VP Research, Angel Broking expressed the opinion that, “CAD is expected to show a moderation in the range of 3.7-4.0 per cent in FY2014. The decline in crude prices is expected to reduce under-recoveries on fuel, and thus help in narrowing the fiscal deficit to an extent”. 

Overall, lower crude prices will reduce the pressure on the government to lower the CAD. The fall in gold and crude oil prices have done what the government couldn’t have done this year. The rupee may also see some appreciation owing to the improving financials of the country. According to Sinha, though, a sharp correction in the rupee is not expected and the national currency will remain between `53-55 against the dollar. 
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Equity Markets

Equity markets tend to have a positive relation to the crude oil prices. The 10-year data that we have com- piled shows that the returns from the Sensex and those from the Oil & Gas index have followed the trend in crude oil prices. The only exceptions are the three years 2003, 2006 and 2011, when the Sensex and Oil & Gas returns showed a negative co-relation with the crude price movement.

The markets, however, seem to be ignoring this trend this year as the Indian markets are already up four per cent YTD, whereas crude oil has fallen more than seven per cent. The global markets are also soaring, with the Japanese indices at a five-year high and the US markets showing strength.

Foreign institutions have already started earnings upgrades of the oil & gas companies. Morgan Stanley, in its report dated March 12, 2013, has gone overweight on RIL, ONGC, Cairn India, BPCL and HPCL. Of these, we had recommended Cairn India in DSIJ Vol. 28, Issue # 6 (dated March 10, 2013). In the same issue, we had also recommended Essar Oil to our readers. We would advise our readers to stay invested in these stocks as they would get a profit-making opportunity going ahead.

The Crude Outlook

Overall, the outlook on crude oil remains bearish at least in the short term. The key indicators to watch are liquidity as well as the strength in the global economy. With the monetary policies of the major central banks still remaining growth-oriented, liquidity is not an issue. The crack in the recovery, though, remains a concern for the crude oil market. For India, the fall in oil prices seems to give no reason to worry. We expect an 80 basis points fall in the CAD as well as a significant fall in the fiscal deficit. The improving financials of the country bode well for the equity markets.

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