The Trickle Down Effect

The spurt in crude oil prices may lead to a rise in costs for India Inc. But it is not always such a bad thing, says ETIG’s Ramkrishna Kashelkar

THE latest inflation numbers might have fallen below the ground zero, but that does not change reality. The prices of commodities, food articles and energy are on a steady rise. Obviously, you couldn’t expect to see a different picture after experiencing the roller coaster ride in crude oil prices. Within just four months, the crude oil prices have more than doubled from their lows of February 2009 – faster than even last year when the crude prices touched historic highs. While the crash in crude oil prices marked a plunge in consumer confidence and contraction of economic activity the world over, the reversal does indeed signal a change in mood. However, when a commodity like crude oil changes gears so fast, the impact goes far beyond just changing moods. Crude oil is the world’s largest traded commodity and almost everything used in modern day life from pin to piano can be traced back to it, some way or the other. In 2008, the crude oil averaged $100 per barrel, while the world consumed 85.8 million barrels every day. At this rate, the world’s total expenditure on crude oil was more than thrice India’s GDP in 2008. It is no wonder that the industry using crude oil as a direct input is always the one to take the first hit when the oil prices fluctuate so fast. The petroleum refining industry, which was making merry in the June 2008 quarter when oil prices were on a rise, incurred heavy losses in the September and December 2008 quarters as the prices crashed. The impact, however, goes even deeper to the further downstream industries such as petrochemicals and polymers.

THE CRUDE IMPACT

The rising crude oil prices affect companies in two ways. It increases thee fuel cost for some, while for others it simply raises the feedstock costs. Although the availability of natural gas is fast increasing in India, a number of companies use liquid fuels derived from crude oil for their energy needs, either due to lack of availability of natural gas or lack of connectivity. RCF’s liquid fuel consumption in FY2008 was Rs 1712 crore or nearly 4.3 times its operating profit for the year. The company has long been suffering from insufficient natural gas to run its plants at optimum level. It had consumed over half-a-million tonne of naphtha in FY08 alone. Although the company’s fuel consumption figures for FY09 are not available yet, it will save a chunk of that cost in FY2010 thanks to 3 MMSCMD of gas it is now getting from RIL. Several companies – particularly in southern India – are yet to find pipeline connectivity to avail natural gas in the near future. The spurt in crude oil prices will continue to haunt companies such as Tamilnadu Petroproducts, SPIC, Mangalore Chemicals and FACT.

LOGISTICS

For the logistics industry, the liquid fuels derived from petroleum crude oil form the basic raw material and they have very little scope of replacing it with natural gas. The players in this industry will be at the receiving end of a rise in petroleum prices. The fuel cost of Jet Airways jumped over two-and-a-half times in the first half of FY2009 to nearly Rs 3200 crore or half of its revenues for the period. With the crude oil prices falling subsequently, the company cut its fuel costs by around 25% in the second half. Still, for the whole year, the company’s fuel bill was a staggering Rs 5850 crore or 44% higher against last year. The shipping and courier industries also witnessed a similar trend in FY09. Other expenditure, where their fuel costs are accounted for, bulged in the first half and eased in the second. The slowdown in traffic, due to the global economic slowdown, added to the woes of this industry.

PETROLEUM AS A FEEDSTOCK

Apart from being a major source of fuel, crude oil also accounts for chemicals used in various colours, fragrances, plastics and yarns, and as additives to boost the characteristics of other materials. Since crude oil is the common factor, a rise in crude prices lends a natural push to the prices of the dependent industries. However, it would be wrong to assume that a fall in crude oil prices would help these industries — petrochemicals, manmade fibres, rubber and tyre, plastic products etc — by reducing their raw material costs. In fact, historical analysis shows that their operating margins improve when the crude oil prices move up. (See the adjoining Chart). When the crude oil prices were hitting their bottom in the December 2008 quarter, these players reported their worst ever performance for over 20 preceding quarters. Most of them wrote off hefty inventory losses. Turnover suffered as customers postponed purchases in view of falling prices. The movement in the prices of these downstream petrochemicals and polymers also depend on the demandsupply dynamics. For example, basic petrochemicals such as ethylene and propylene gained around 25% since February this year despite the crude oil price doubling. The polymers derived out of these chemicals such as polyethylene and polypropylene have gained around 40% during the same period.

PLASTIC PROCESSORS

The plastic processing industry is at a peculiar juncture. As a number of new polymer production facilities are added in West Asia and China, the availability of polymers is set to go beyond its demand. Most upcoming projects in the West Asia are based on natural gas as feedstock, which is available abundantly and cheap there.

HIGHER COST OR BETTER MARGINS

This could put the polymer prices under pressure in the years to come. At the same time, these low prices could induce replacement of metal products by plastic products. Thus, the plastic processing industry is likely to benefit both ways, by a reduction in raw material costs and a steady growth in demand over the next couple of years.

MARCH 2009 PERFORMANCE

The stability in crude oil prices helped Indian industries to recover in the March 2009 quarter from the debacle of December 2008 quarter. Our sample of 79 companies, representing petrochemicals, plastic products, rubber and tyre and synthetic fibres industries, showed a substantial improvement and this pushed the operating margins back to levels seen in good times. The petrochemical companies have displayed the best turnaround, while synthetic textiles industry experienced only a marginal improvement.

OUTLOOK

The reversal in crude oil prices has renewed the confidence among investors and is also likely to contribute to an improvement in the quarterly performance of India Inc. For one, the industry will not suffer any losses on inventories and the appreciation in rupee will prevent foreign exchange losses. The logistics industry should continue seeing pressure on margins before the traffic picks up. However, manufacturing companies from petrochemicals to plastics are likely to witness an improvement in performance when they announce their June 2009 quarter numbers.