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Special Report : The Looming Crude Oil Crisis, simplified.

Background

From over $100 per barrel in January 2014 to a low of $50 per barrel in January 2015, the Brent Crude oil has perhaps seen the worst decline in prices over the recent 5 years. While this dramatic price decline has brought cheer to few corporate and perhaps few countries, it has disrupted oil producing economies. Literally nobody saw this coming; even if someone did, the magnitude of this fall (over 50%) was outside everybody’s imagination. Is this the bottom of the crash? Well, your guess is as good as mine, but the intensity of the crash in crude oil is so severe, it would be hard to believe the bottom is in sight.

So what really went wrong?

To understand what went wrong, we need to understand the dynamics of crude oil and how business was carried out before the recent crash. Oil rich countries produced several millions of crude oil barrels which were exported to US, China, India, and European countries on a daily basis. The oil producing countries are split into two baskets –

1) “Organization of the Petroleum Countries (OPEC)” nations which include countries like Saudi Arabia, Qatar, Kuwait, UAE etc and

2) Other oil producing countries such as – Brazil, Canada, Russia, Mexico, Norway etc choose not be part of the oil cartel i.e OPEC. Hence they are just referred to as ‘Non OPEC countries”.

Between the OPEC and Non OPEC countries close to 90 million barrels of oil were pumped on a daily basis. The graph below shows the daily oil production split between OPEC and Non OPEC countries –

The Trigger

Different countries produce oil at different rates; this mainly depends on the individual state’s finances and technology adaptation. However, these countries sell oil at a rate which is market driven. Clearly the breakeven point - expressed on a per barrel basis, is the rate at which countries need to sell per barrel of oil to cover the expense of producing the same, varies from country to country. Naturally selling oil below the breakeven point simply means that the country cannot balance their state budget.

In the backdrop of these trade dynamics, a triple digit oil price till early 2013 worked really well for the oil producing economies. However the recent developments changed the landscape of crude oil business dynamics. Specifically, the following three major events turned the tables around for crude oil prices -

1) American Shale Oil – The American shale oil, which comes from oil shale (sedimentary rocks containing bituminous material), which is an alternate to crude oil became technologically viable and the cost of producing the same became relatively cheaper. The output from the American Shale oil production increased, flooding the market with cheaper oil. With the current estimates, it is believed that US has enough shale oil reserves to last generations. Shale oil from Texas and North Dakota displaced exports from OPEC members to USA. This set the stage for a collapse in crude oil prices

2) Lack of co ordinate action - In the backdrop of increased shale oil production in USA and the ongoing slide in crude oil price, one of the methods for oil producing countries to control the situation was to lower the supplies and regulate the demand supply situation.  However, OPEC was not really successful in convincing OPEC and other non OPEC Oil major countries to cut the crude oil production to support the crude price. In fact cutting oil production is considered more expensive than pumping oil.

3) China Factor – China has been one of the largest consumers of major international commodities including iron ore, coal, and crude oil. In fact in 2013 China surpassed US in oil imports. However reports suggest that the Chinese economy is not growing at the same pace as it used to, resulting in lower demand for international commodities. Needless to say, this has a significant impact on the spiraling crude oil prices

4) Market Dynamics - The above three points triggered a steep sell off in crude oil, adding fire to this sell off was the heavy short position built up on Crude Oil contracts

Generally when the price of crude oil falls, the US dollar tends to get stronger especially over the currencies of the emerging economies. This is quite natural as an increase in oil price widens the US current account deficit, which obviously is not a great factor for the US Dollar, and the reverse helps the dollar strengthen. Hence the Dollar and oil share an inverse relation. Do recollect, in 2008 when Oil hit a peak of $148, US Dollar was trading at 1.6 to the EURO.

The Russian Episode

Russia is one of the largest (non OPEC) producer and exporters of oil. The Russian federation’s oil exports contribute nearly 40% of the total exports. With a slump in Oil prices, Russia is on a brink of a collapse. There are three factors working against Russia, two of which are directly attributable to the oil prices –

1) Oil Price - Russia needs oil price to be approximately in the region of $105 - $107 to balance its budget and fix its finances in order, clearly with oil at $50, Russia gets a severe blow on its budget

2) Ruble Trouble - Remember Russian is an emerging economy. With the slide in oil price, the Russian Ruble has massively weakened against the UD Dollar. So much so that the Russian Central Bank increased the interest rate overnight by 7.5% in order to defend the Ruble

3) Crimea Curse – Western countries continue to impose sanction cuts on Russia for its aggression on Ukraine. This means access to external capital is extremely difficult at this stage (when it’s most required) for Russia.
With all these factors playing out simultaneously on Russia, there is little hope that that Russia may not actually slip into a financial coma dragging the federation into a recession.

The India macro angle

On the face of it, the fall in crude oil seems to significantly benefit India as the pressure on petroleum subsidy eases. India being a net oil importer (nearly two-third of India’s oil requirement is imported) pays a heavy bill for its oil imports. Naturally the fall in crude oil means improvement in the fiscal deficit, easing of inflation, and a possibility of an interest rate cut.  All of which is desirable for India in the backdrop of current economic situation. 
But there is another angle to low oil prices, while it helps the domestic import bill, it will also impact our exports receipts. Most of the exports from India are to countries whose economy depends on oil – UAE, US, Saudi Arabia, Kuwait, Iran, China etc. Quite naturally, with low oil prices the spending by these countries also decreases, thereby impacting business with India.

In fact the October 2014 export & import data from RBI suggests the same – while the oil import bill reduced by 19% (y-o-y), the exports also declined by 5%. Clearly the advantage of low oil price should not over joy the stake holders. We got a glimpse into what can happen if the oil price continues its fall - on 6th January 2015, the NSE Nifty fell over 255 (~ 3.0% decline) points creating panic on Dalal Street. It was one of the biggest single day fall in the recent history.

Impact on the Indian Companies

State owned Oil marketing companies (OMC) such as HPCL, BPCL, and IOC are a direct beneficiary of low oil prices. Low oil price has a positive impact on oil marketing companies (OMC) in terms of reducing the stress on their working capital requirements. In fact, both BPCL and HPCL have retired over 25% of their short term borrowings in the recent 5 months. If the price of crude oil prices stabilizes around the current level of $50 per barrel, then naturally it will be great for these companies in term of cleaning up their balance sheets and improving their bottom line.

As we can see from the graph below, FII’s are placing their bets on Indian OMC’s. The FII holding in HPCL has increased over 5% in the recent quarter. Needless to say, HPCL has also outperformed its peers during the same period.

However, one should also note, in the short term these companies will suffer an inventory loss. The OMCs buy crude oil from the international markets well in advance and they use it at a much later stage. This means the current stock of crude oil in their inventory was purchased at a much higher price, translating to immediate losses.

Besides the OMC’s there are few specific Indian companies that deal with economies that are highly exposed oil prices. For example Dr.Reddy Laboratories Limited exports pharmaceuticals to Russia. The Russian crisis has significantly impacted Dr.Reddy’s stock price – it has declined nearly 15% from Rs.3130 per share to Rs.3650/-.

Is this the end?

Well, this just depends on the supply-demand situation. The thought or the possibility of production cut by OPEC or non OPEC countries still does not appear to be a possibility. Clearly as Saudi Prince Al-Waleed Bin Talal says, “If the supply stays where it is and the demand continues to be where it, then there is there is little hope for the oil prices to bottom out here”. Besides, US has withdrawn the 40 year export of commercial oil ban – which means more supply to the market, thereby putting more pressure on prices.

American, shale oil has no doubt has created a ripple in the market but there is another angle to this – how strong are the balance sheet of these companies fracking shale oil? Are they over leveraged? Are they overstating the reserves?  These are things the market will realize sooner or later, which will again impact crude oil prices.

However like I mentioned earlier, is this the bottom of the oil price crash? Well, your guess is as good as mine.

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