How will this major commodity crash affect us?

Jul 3, 2013

In this issue:
» Facebook and Apple have lost more investor money than gold!
» What could ACC - Ambuja merger mean?
» No more speculative currency trading
» US manufacturing shows signs of recovery
» ...and more!

Correction in commodity prices is no longer a novelty. From prices of copper to bronze to other metals that signify the traits of global economy, most have been southbound for a couple of months. Thanks to the Fed's QE withdrawal scare, even gold seems to have lost it luster, albeit temporarily. But one commodity that has a disproportionately high impact on Indian economy is crude oil. And while global oil prices have hardly shown signs of correction, it may not be too early to take a contrarian view.

As per an article in Econmatters, global oil refineries are currently running at the highest utilization rate of nearly 90%. With oil inventories above 390 m barrels, we are well past the last peak of 375.3 m barrels reached in early May 2009. Only during a brief period in 1990 did supplies approach 390 m barrels. Thus it is believed that it may be only a matter of time before the supply overhang starts putting pressure on prices. Similarly, gasoline supplies are also much higher than last year.

Looking at the demand side, the biggest consumers of petroleum products, i.e. US, China and India are struggling with growth rates. The decline in demand from US and China is hardly being offset by other emerging markets. European automobile sales are also at record lows. In fact one can assess the possible impact of China slowdown on oil prices by looking at other commodity prices. The economies of Australia and Brazil have seen a massive dent in consumption of minerals, particularly iron-ore thanks to lower demand from China. The chance of this scenario playing out for oil remains very high.

Now the cartelization of oil prices by the OPEC is well known. But even the Middle East is looking less threatening in terms of potential supply disruptions. With Iran electing a moderate leader this time around, the possibility of Iran-US standoff looks less likely.

So while it may be difficult to time the correction in oil prices, the possibility of lower import bill on oil aiding India's deficit problem cannot be ruled out. This will automatically have a benign affect on inflation level as well. Thus instead of banning gold imports and forcing the RBI to cut interest rates, the government would do well to keep a hawk eye on oil imports. Moreover, making the country more self reliant in terms of energy security will automatically put pressure on oil cartels.

Thus India's economic scenario, although bleak at the current juncture, does have a lot of potential once the global economic imbalances correct. Investors therefore need to be more focused on how the long term story will play out.

Do you think correction in oil prices could be a major breather for Indian economy? Please share your comments or post them on our Facebook page / Google+ page

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 Chart of the day
Indian bond market is seeing renewed interest these days with both yields and tenures seeing a steep rise. The RBI, however, has cited warnings about the keenness of Indian companies to issue bonds overseas. Indian companies have been increasingly accessing international debt markets to raise cheap resources. The un-hedged forex exposures and an eventual increase in interest rates could put pressure on Indian corporates. The RBI has therefore also warned banks that lend to such corporates. After all, the forex risk of corporates has implications on the asset quality of banks and their profitability.

Source: RBI

We think it was the psychologist Dan Ariely who once said that humans rarely choose things in absolute terms. In other words, there's hardly any value meter inside us that tells us what is the worth of things. All that we seem to be capable of doing is finding the relative advantage of one thing over another. If you are in need of an example, go no further than the recent correction in gold prices. As one of the newsletters points out, the biggest gold ETF is US$ 28 bn under water over the past one year. And this is of course terrible news. Now consider the US$ 33 bn and US$ 122 bn in losses that shareholders of Facebook and Apple have incurred during the same period. Our comparison seeking brains immediately get the hint of things, don't they?

Notice how gold bashers conveniently leave out this fact. However, it is very important that one sees the facts for what they are. Simply put, gold does not seem to be doing as badly as it is being made out to be. Besides, it will be much easier for fickle minded users to give up on Facebook and Apple products. On the other hand, try asking millions of gold consumers in India and China to give up their affinity towards gold? Looks like an impossible task, isn't it? Thus, it always makes sense to keep a small percentage of one's portfolio in gold and gold related investments. As the allure for the yellow metal is unlikely to go away.

Manufacturing activity is a lead economic indicator. It gives a sense on where the economy is headed in future. Increase in manufacturing activity index is a sign of expansion and vice versa. The manufacturing activity data for the month of June in US got released recently. And the signs are quite encouraging. The manufacturing index came in at 50.9 in the month of June. This figure was at 49 in May. It may be noted that any number above 50 is a sign of expansion. Thus, it can be said that the US manufacturing sector is expanding. New orders in the manufacturing sector also improved in the month of June. But manufacturing employment declined. While the current expansion is seen with optimism it may have come on a lower base. Also, reduction in manufacturing employment in US signals that structured expansion in manufacturing sector is still away. Unless the demand scenario in US improves the manufacturing activity there is likely to stay muted.

Another wave of consolidation seems to be in the offing for the Indian cement industry. If an article in the Economic Times is to be believed, Holcim is planning to restructure its Indian operations. And this could entail the much-awaited merger of cement behemoths ACC Ltd and Ambuja Cements. However, it is important to note that the merger exercise is still at an exploratory process. The eventual outcome remains quite uncertain.

Nonetheless, it is worth considering what the merger of ACC and Ambuja Cements could mean? The merged entity would have a cement capacity of about 58 million tonnes per annum (mtpa). That would make it the largest cement player in India. In a commodity industry such as cement, big size means better bargaining power with suppliers and customers. In addition, there could be substantial synergies on the operational front, particular fixed costs and logistics.

However, the merger wouldn't be easy. There are several nitty-gritties to the process. Firstly, Holcim would have to convince minority shareholders of the two companies. Integrating the operations of the two companies would be a big challenge. The reason for this is that ACC's plants are much older than those of Ambuja's. Secondly, there are tax matters involved such as payment of stamp duty for the transfer of assets. A third concern could in be the form of regulatory hurdles by the competition watchdog. As such, it would be best to wait and see if the merger does materialise.

The RBI's stance over the past several years has been to not intervene in the forex market. It would only do so if there is too much volatility. So even when the rupee considerably depreciated to a level of 55 against a dollar, the central bank mostly chose to stay on the sidelines. But the Indian currency's recent freefall to a low of Rs 60 against the greenback has begun to give the RBI jitters. Certainly it appears so from its recent actions. As reported in an article on Financial Chronicle, the central bank seems to have discreetly asked trading desks with unusually explicit messages to cut their speculative positions in the currency. This is something that is unusual for the RBI even when it regularly monitors the positions and flows in the currency market. In the past whenever there was a considerable drop in the rupee, the RBI intervened and sold dollars in the forex market. This helped prop up the rupee during those times. But now the central bank is in a delicate position. It is reluctant to sell its dollar reserves. This is because they are enough to cover only seven months of imports. Whether these explicit measures yield the desires results remains to be seen. There is always the possibility of trading moving offshore. Infact, there has been a marked increase in offshore trading of rupee forwards especially in Singapore. All in all, these are indeed testing times for the RBI which already has the problem of inflation and slowing economic growth to deal with among other things.

Desperate times need desperate measures. As the country seems to be getting stuck with twin deficits, the Government finally seems to be giving way to reforms. The latest instance of this was seen in the telecom sector that has been mired in spectrum controversies in the last few years. In a recent move, the Telecom Commission has increased the FDI limit in the sector from 74% to 100%. Of this, 49% will be through the automatic route, while FIPB nod will be needed for further stake. The move is a shot in the arm of domestic telecom sector that seems to have entered a mature phase in the business cycle.

The new regulation is expected to attract foreign players in the sector. So far, the latter were forced to rely on domestic partners to operate in India. The move will also give the debt ridden domestic telecom sector access to foreign funds to retire their debt. With more players in the sector, we expect the competition and quality of services to improve as well. In short, it seems to be a win win policy for all stakeholders, consumers included.

However, the decision is yet to get the Cabinet approval. We expect it to face opposition due to national security concerns. Further, before such a move attracts foreign players, there are lots of issues that need to be addressed. These include clarity on policies related to taxation, mergers and acquisition and spectrum in the telecom sector. It should be noted that for similar reasons, the much hyped FDI in multi brand retail reform has not attracted foreign players. We hope that government will learn lessons from the past and the telecom sector will not witness a similar logjam.

Profit booking in power, banking, pharma and commodity heavyweights has kept the key indices in Indian equity markets well below the dotted line today. The BSE Sensex was trading lower by around 267 points at the time of writing. Indices across the board in Asia closed lower today while markets in Europe have also opened in the negative.

 Today's investing mantra
"Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar's destiny lies with Congress." - Warren Buffett

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    1 Responses to "How will this major commodity crash affect us?"

    Nadir Godrej

    Jul 3, 2013

    Oil will come down. This will help India. It is likely that we will have a current account surplus soon as all commodities are down and agricultural and mining production will rise.

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