Why are crude prices going up? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Why are crude prices going up? 

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In this issue:
» Can FDI in food solve India's hunger issues?
» SEBI's rules to increase expense ratio for MFs
» Forex reserves down to 7 months import cover: RBI
» Muted inflation may lead to QE III in US
» ...and more!

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Price of any commodity is a function of its demand and supply. If demand is high and supply remains restricted, then prices will rise. And vice versa. But what happens when demand falls? Ideally prices are supposed to follow suit. However, this does not seem to be happening in the case of one commodity - crude oil.

As discussed by Firstpost, the demand for crude oil has been waning off. The crisis in Europe, the slowdown in US and China, as well as in the rest of the world has hit the demand for crude. The IEA (International Energy Agency) has predicted that the demand for crude is expected to slow down in 2012 as well as in 2013. It expects an additional demand of only 0.9 m barrels per day (mpd) in 2012 and another 0.8 mpd n 2013. But if you look at the price side of the equation, things are different. Prices of crude have shot up by nearly 30% from its low earlier this year.

So what could be the reasons behind this rise? Certainly it does not appear to be demand. The other possibility is speculation. The cause for this speculation could be the growing geo-political tensions particularly those surrounding Iran. Iran produces nearly 3 mpd of crude and if this vanishes from the system then the supply of crude would be affected drastically. This could lead to a sharp rise in the price. But another side of the story is that these tensions are not exactly new. They have been around for a while. Therefore are they really the cause for the recent spike in crude prices.

Whatever the underlying reason, the point is that the rise in crude price has little to do with fundamentals at the moment. It seems to be driven by unnecessary speculation. Unfortunately when times are tough like they are at the moment, such speculation is doing more harm than good. Even worse there is little cure for it in the short term. Unless commodity traders become investors and stop this speculation and start investing based on fundamentals, prices are unlikely to ease off.

Do you think crude prices are high due to fundamental reasons or is it mere speculation? You can also share your comments with us or post your views on our Facebook page / Google+ page.

01:10  Chart of the day
One of the much hyped IPOs of recent times was that of the social media leader Facebook. In fact, it was the third biggest IPO (Initial Public Offering) in US. It was touted to be the company which could do nothing wrong. It had and still has a strong brand and fan following. And this prompted investment bankers to value it at astronomical valuations. But since its listing, things have changed. Investors have been hit by the hard realization that all the hype had little basis to support it. The underlying fundamentals of Facebook just did not match the valuations that its stock had been priced at. They have now come to wonder how the company would monetize itself and generate strong earnings. Unfortunately, this is something they should have done before they invested in it not after. The rude shock for these investors is visible in the drastic fall in Facebook's share prices which have been only heading south since listing as shown in today's chart. With nearly 2 bn shares becoming eligible for trading over the next 10 months, there would be plenty of investors looking to exit from this unprofitable investment. And this would hurt share prices even further.

Source: Yahoo Finance

The government has been facing stiff opposition for opening up FDI in multi-brand retail (foreign direct investments). As such, foreign companies are not allowed to set up supermarkets in India and sell multi- brands directly to consumers. However, in January 2012, it allowed 100% FDI (Foreign Direct Investment) in single-brand retail. In other words, foreign firms that sell items under a single brand can now fully own retail stores in India. But this space too has certain caveats. The government has now decided to exclude food items from the items enlisted under single-brand foreign investment policy. This was after foreign companies such as UK's Marks and Spencer and Sweden's IKEA showed interest in selling food items under their own brand in India.

Why is the government unwilling to open up the food sector to FDI? There are quite a few reasons. For one, food is a highly sensitive sector. Secondly, the foreign companies that expressed interest in selling food products in India want to import food items. This is so that they can maintain the same global standards. Such large-scale imports are unlikely to help the local food processing industry and the economy at large. On the other hand, retailers are allowed to source and manufacture domestically. Nestle and Pepsi are a couple of examples. We believe that there is certainly some merit in the government's arguments. But the problem is that there is not enough clarity in the existing policy. This, we think, the government should sort out immediately.

As we pointed out in one of our earlier 'Chart of the Day' Mumbai corners nearly 45% of mutual fund assets. Even other metros are grossly underrepresented; forget other smaller cities. How should penetration increase to other parts of the country? Well, the Securities and Exchange Board of India (Sebi) has an idea. The regulator has now permitted Indian fund houses to charge an additional 0.5% as total expense ratio (TER). The TER measures the total costs of a fund to an investor. The limit has been raised to 3% from 2.5% earlier, but there is a catch. Fund houses can charge an additional 0.2% across the board. However, for assets from cities other than the top 15, they are eligible to charge 0.3% more. This is provided that the inflow from these Tier 2 and 3 cities account for 30% of the overall assets. In case the inflow is less, a proportionate amount can be charged. This move may help improve the geographical reach of mutual funds and bring in long term money from smaller towns. These structural changes will be good for the industry over the long term.

Ever since India's import bills have been spiraling, the government has one worry on its mind. Whether it will have enough forex reserves to service several months of import bills. After all, the prices of neither oil nor gold, India's two biggest imports, seem to be holding up. Meanwhile the memories of 1991 balance of payment crisis keep haunting us. Not that we are yet anywhere close to such a dire state as was the case in 1991. However, any more callousness on the part of the government could land us in trouble!

For one, India's foreign currency reserves are already down to seven months of import cover. The same was about eight and half months cover at the end of September 2011. The sharp decline in forex reserves can be attributed to lower foreign fund inflows. This was mainly a result of Eurozone uncertainty and slowing domestic economic growth. Moreover, the Indian rupee has touched record lows since December. This has forced the central bank to sell dollars from its reserves to protect the local currency.

India's currency and balance of payment woes are not a thing of the past. Despite above average growth rates in the past few years, the economy continues to be threatened by grave risks. Comparing the current situation to 1991 and taking solace will not help. Instead the government should rather assess the situation with more realistic estimates.

This may be just the kind of ammunition that monetary hawks such as Bernanke could be looking for. As per reports, consumer prices in the US were flat in July for the second month in succession. What more, even the year on year increase was the smallest in 1-1 1/2 years. Looks like those who've been arguing that the non-stop money printing would lead to hyperinflation have been proven dead wrong. There are hardly any signs of the same what with inflation reading coming out pretty tame.

So, should Bernanke and Co indulge in another round of money printing? We believe they would be making a big mistake if they do so. It would be wrong to judge the potency of inflation by looking only at the CPI. It is quite possible that there is a lot of liquidity around but it has been tied up elsewhere. May be it has gone into buying up US Treasuries as evident from the record low interest rates. And also into the stock markets where valuations are rich despite the US economy showing no signs of improvement. Thus, there seems to be enough money supply and providing more of it may not solve the problem. What is needed is minimum Fed intervention so that the market forces could do their work.

In the meanwhile, after opening the day in the green, the Indian equity markets continued to trade above the dotted line. At the time of writing, Sensex was up by 109 points (0.6%). Among the stocks leading the gains were Tata Motors and ITC Ltd. Other major Asian stock markets have closed the day on a positive note as well with Japan and Hong Kong leading the gains in the region.

04:55  Today's investing mantra
"The investor of today does not profit from yesterday's growth." - Warren Buffett

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    Equitymaster requests your view! Post a comment on "Why are crude prices going up?". Click here!

    7 Responses to "Why are crude prices going up?"

    A V Rao

    Aug 30, 2012

    The Governments should implement ration system in supply and how long the meet the supplies


    Raj bhansali

    Aug 23, 2012

    The quality of equity master stuff has deteriorated significantly. From being a strong and unbiased research house, it has transformed itself into a irresponsible media house reporting junk and untrue news.
    Few things not looking into the article which has fuel oil prices are
    • US drought and US product inventories: While there is anticipated weakness in demand of oil products, the same has actually not step in till now as witnessed by inventory draws. Also drought has led to increased corn prices, which will lead to lower blending of ethanol, resulting into higher demand of gasoline produced from crude oil. Thus, better than anticipated demand led by better economic cues and drought led to inventory draw and higher gasoline prices and higher GRMS

    • Also in Singapore, here again same story demand better than antipcated, inventories at low levels of 5 year averages. Demand is also strong due to drought in India also led by power outages, Ramzan seasonally strong demand. Thus refineries making huge profits due to inventory position and coupled with heavenly assistance. Thus, refineries rushing to buy crude to make profits hope you know RIL rallied 15% in a month due to this). Thus the only thing which is right in article as pointed out that demand supply matters. Increased demand and lower supply propelled oil prices.

    • Thirdly, if you look at speculative positions on NYMEX that has not increased. Thus, article is baseless and trash material.

    • Finally, the backwardation in oil prices has increased, which means near term prices are at higher premium to long term prices. Which explains the rationale above and also that long term prices of oil is bound to moderate due to higher US production and higher LNG output globally.

    I guess either Mr. Dayal is not looking at Equitymaster operations or the management has recruited poor quality people who are damaging the good repute of the orgasnisation. I am totally disappointed. Hope I find a place on the comments.

    Like (1)

    SG Ramadurai

    Aug 20, 2012

    As crude price is closely linked to financial position of several countries ,its price to be capped and future trading to be banned

    Like (1)


    Aug 17, 2012

    it is a clar case of speculation by vested interests!
    another point to note is some years before, when the crude price went above 150 dollars, many predicted it will shoot up to 200$!!it never happened, recently it came down to 80$.
    all said and done crude price in the last 5 years have not escalated like other commodoties like gold, copper etc,..so my take is no future escalation for crude price given the resistance, recession in europe, shale gas prospects in u.s. ,although demand in china\india may go up!iran if allowed to pump to its full capacity, those additional requirements can be met with!enbargo in iran is one ploy to keep the price high to suit certain interests!!!?

    Like (1)

    Kersi Mahudawala

    Aug 17, 2012

    The main reason for increase in crude price is speculation and not due to tension of Iran which is there since long.Prices of crude have shot up by nearly 30% from its low earlier this year.However demand has only increased marginally.

    Like (1)

    Kranthi Mark

    Aug 17, 2012

    Dear All,
    I have good news for you ! which is very positive for Indian economy i.e Crude Oil prices will expected soften in the days to come . The key reason is in the last 5 years there were immense Gas & oil discoveries across the globe and USA energy consumption is shifting from OIL to shale gas . USA discovered immense shale gas discoveries in the last 5 years and because of slowdown the economy consumption has came down.Apart from USA , Mexico , Brazil and african nations like Kenya , Nigeria and Mozambique have made significant oil & gas discoveries. Russia is sitting on pile of oil reserves !. The global slow down of economies have taken a big hit on the energy consumption . If global curde oil prices stabilise at 70 $ per barrel, it will be a rejoicing point for India , since oil prices have ripple effect on all the commodities and inflation . once inflation come down to 4% from current 7.5 %. RBI Mr Subba rao will be active to cut the interest rates and the credit & growth cycle will start moving upwards.In India ,the stiff necked Ambani is not producing the required quantum of Gas from KG basin becuase of pricing issues , Oil ministry should bend his neck and make him to increase supply ! than waiting for his biscuts and kick backs ! . Once if we streamline all these things OIL prices in India will come down !!

    Like (3)

    Alberto Mascarenhas

    Aug 17, 2012

    In view of global variances in growth,on the whole there has been an overall fall in most short term quotients. While some asian countries are being fueled by demand, others in the pacific are being fueled by supply contingent, keeping in view that most parameters in global markets have yet to be asertained. It seems alternative energy levels have not picked up and so crude oil still holds the mantel for growth.

    Like (3)
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