Boiling Oil May Spoil Race

The movement in crude oil prices will play a crucial role in deciding the direction of the Indian stock market says Ramkrishna Kashelkar

INDIAN stocks were battered as the civil strife in the Middle East sent global crude oil prices soaring. A minor recovery was seen since then. However, the future of Indian equities will remain clouded unless oil prices ease significantly. The anti-government protests and the civil war that broke out in Libya, which happens to be an OPEC member country with 1.58 million barrels per day (mbpd) oil production in January 2011, has forced several oil producers in the country to close the taps. Official estimates put the loss of production at somewhere between 500,000 and 750,000 barrels per day, while the actual number could be as high as 1.2 mbpd. The success of uprisings in Tunisia and Egypt has brought about a general unrest in other countries in the Middle East and North Africa. This has created a general fear about a similar situation in other countries, choking off the world's oil supply in the near future.

WORLD IN SHORTAGE
At present the global petroleum industry is well geared to absorb this unexpected fall in oil production caused by problems in Libya. International Energy Agency (IEA), for example, mentioned, “collectively, the IEA members have 1.6 billion barrels of emergency oil stocks at their disposal, or in aggregate 145 days of import cover for IEA members.” Founded in response to the oil crisis of 1973, IEA has 28 industrially advanced countries as its members.Similarly, the 12-member countries of Organisation of Petroleum Exporting Countries (OPEC) together hold a spare capacity of 5.19 mbpd, which can come on stream on short notice. Overall, the markets remain well supplied and there are indications that the demand-supply mismatch of the last quarter of 2010 is not likely to continue. The US, for which the latest data is available, saw 11 million barrels addition to inventories during January 2011.

RISK TO GLOBAL ECONOMY
High crude oil prices, if the trend continues, pose a significant risk to global economic recovery. According to IMF’s estimates, the global economy grew by 4.8% in 2010 and is expected to grow at 4.3% in 2011. However, the fiscal health of the world’s leading economies, be it the US, the UK, European Union or Japan, remains fragile. High oil prices can increase overall production costs, leading to inflationary pressures, which can derail the recovery process. International Energy Agency has warned of this danger repeatedly in the past with the help of ‘oil burden’ concept. Oil burden is defined as nominal oil expenditure divided by nominal GDP. “A sensitivity analysis for 2011, holding GDP and oil demand constant, indicates that, at current prices of around $90 per barrel on WTI, global oil burden is rapidly approaching the 2008 ‘recession threshold’,” wrote IEA in its monthly update published on February 10. Since then, WTI prices have scaled up beyond $100.

INDIA’S WOES
Despite being a major energy importer, India lacks any structured policy towards ensuring energy security in the times of crisis. Unlike countries like the US, China or Japan, India has not built any significant capacity to store strategic reserves. The country’s three such projects are substantially way off the schedule. India’s net petroleum imports stood at 122.9 million tonne in FY10, which cost $58 billion. During the first 11 months of FY11, the country's net petroleum imports stood at 102.2 million tonne or around $70 billion. This doubled India’s current account deficit in the first half of FY11 to $27.9 billion and is likely to reach 3% of GDP for FY11 from 2.8% last year. This means the country is increasingly dependent on foreign capital inflows to maintain the strength of its currency. A reversal in capital flows, particularly in the portfolio investments, could end up weakening the rupee. On top of this, the problem of fiscal deficit is set to worsen as the government tries to act as a shock absorber between the market gyrations and the domestic consumers. For FY11 alone, the oil sector’s under-recoveries are expected to be around 1,00,000 crore, which
is likely to push government’s oil subsidy bill beyond 40,000 crore. If the current situation continues, each spurt in oil prices is bound to make global investors jittery on the rupee’s strength and future of India’s public finances. The future movement in crude oil prices, therefore, will play a crucial role in deciding the direction of Indian stock markets.

CONCLUSION
One cannot deny the fact that it is rising demand that is leading to higher crude oil prices over a period of time. However, at times the movement in oil prices turns out to be erratic. The spurt in oil prices of 2007-08 proved too sharp for many economies to absorb, which resulted in a global economic recession in 2009. A clear danger looms large that a similar scenario could play out in 2011 also. Whichever way you look at the developing scenario, the outlook for Indian equities doesn't appear encouraging.