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Is This The Beginning of an Era of Low Oil Prices?

Dec 9, 2015

In this issue:
» Sin tax in India not the highest
» Will Chennai reconstruction bolster cement demand?
» ...and more!
0:00
Radhika Pandit, Managing Editor of ValuePro

What a difference sixteen months can make. In June 2014, global oil prices were trading at nearly US$108 a barrel. This week, oil prices crashed to below US$37 a barrel - the lowest price since the height of the global financial crisis in February 2009.

How does one make any sense of it? Oil prices ultimately are influenced by demand-supply dynamics. Let us look at the supply side first. Prices started falling post June 2014 when the US shale oil production boomed. This led to a huge oversupply in the global oil market.

One hoped that the OPEC cartel would respond with a cut in oil production. But that did not happen. Saudi Arabia is the biggest player in OPEC and has taken the view that maintaining its market share is more important than bolstering oil prices. Thus, the latest OPEC meet saw the cartel choosing not to cut production.

On the demand side, European economies continue to remain weak. Asian economies, most notably China, are slowing. So the demand has waned. The US has also not seen its economy spectacularly pick up. Demand is subdued, and so the market is not able to absorb excess crude supplies.

Thus, too much supply and not much demand has led to the plunge in oil prices. But the real question is whether such low oil prices are here to stay.

First, US shale production has begun to slow down, though not enough to prevent the oil price slide. Big energy companies and US shale gas producers have reduced capital spending to protect their balance sheets and preserve their cash reserves. While US shale producers can stay above water if oil prices are more than US$55 a barrel, anything below that causes real pain.

Second, can OPEC really live with low oil prices? CNN Money has highlighted how OPEC members are divided. One side is led by Saudi Arabia, which remains the top oil production nation. The country, along with its rich allies, can digest very low prices. But the same cannot be said of countries such as Nigeria, Venezuela, and the others for whom high oil prices are necessary to keep their economies going.

So while near-term pressures could remain for oil prices, in the longer run, such low prices may not be sustainable. According to a CNBC article, Dan Yergin, IHS Vice Chairman, expects oil markets to begin balancing in 2016 or 2017. He says that the global oil market cannot remain low like this because it will not encourage the kind of investments required. By 2020, the world oil market is going to need another seven million barrels a day of production. So oil prices eventually will start firming.

What does all of this mean for India? It is not necessarily all good. As oil makes up a large share of the import pie, low prices mean a lower oil import bill and less pressure on the country's current account balances.

As far as India Inc, lower crude prices will translate into lower input costs thereby boosting profits. This especially could not have happened at a better time as India Inc continues to grapple with weak demand and sluggish revenue growth. However, oil companies, especially those into exploration and production, are likely to face a tough time in the near to medium term as low prices exert considerable pressure on their overall financials and impact viability of fresh investments.

Having said that, Richa Agarwal, our in-house energy analyst, opines that this is more of a short term phenomenon. In the longer run, factors such as high demand for oil, finite supply and rising cost of exploration suggest that oil will be expensive in future.

Ultimately, it is tough to predict where oil prices will head next, though the long term trend suggests that oil prices cannot remain low for very long and will average at somewhere around US$60-65 a barrel. This is more of an average and one could see spikes and plunges along the way. Thus, it would not be prudent to assume that oil prices will stay low for a long time to come.

Do you think that oil prices will continue to slide and firm crude prices are a thing of the past? Let us know your comments or share your views in the Equitymaster Club.


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3:03 Chart of the day

As developed countries across the world are moving towards a strict regulatory stance against smoking, developing economies like India are also facing the heat. Measures such as ban on smoking in public places and pictorial graphic warnings on cigarette packs have already been implemented in India. Apart from that, the government has been raising excise duty on cigarettes. While cigarette companies had been passing on the incremental duties by raising prices, successive hikes in the past four years is adversely impacting their sales.

Cigarette companies are of the opinion that punitive taxation does little to curb tobacco consumption that find its way through counterfeit cigarettes or other forms such as bidis and smokeless tobacco. However, relief for domestic cigarette companies is not likely. As per a report by World Health Organization (WHO), the tax incidence as a proportion of retail price of cigarettes in India is still lower than countries such as Bangladesh, Sri Lanka and Thailand. Therefore, it is no surprise that the government committee has recommended a higher GST rate of 40% on tobacco and related products. The standard GST rate is in the range of 17-18%.

Implementation of GST will remove multiple taxes at state and centre levels and usher in a uniform tax rate. This will benefit cigarette companies that have been subject to a plethora of tax rates. Presently, cigarette companies pay excise duties in the range of 30%-52%. It is to be noted that ITC has a lower excise incidence due to presence in consumer goods and paper that are not so heavily taxed. But with no clarity on the quantum of benefits to accrue from GST implementation, the likely impact of a higher GST rate for cigarette companies continues to remain in the realm of conjecture.

Sin tax in India not the highest
4:01

The devastating floods from the heavy rainfall in Chennai may be a blessing in disguise for the cement companies in the region. Nearly half of the installed cement capacity of 350 million tonnes in the country lies in South India. However, poor demand and excess capacity has led to the capacity utilization falling below 60% in South much lower than 70% utilisation level across India.

If reports are to be believed then the heavy downpour has led to extensive damage to houses, bridges and roads in Chennai. Reconstruction activities estimated at Rs 80 billion along with investments of over Rs 2.42 trillion to build green houses announced by the government are expected to boost demand in the region. Even Andhra Pradesh is building its capital city in Amaravati. The government has also announced housing scheme for the poor in the state. The development of infrastructure is likely to propel cement consumption. This in turn may benefit earnings of southern based cement companies, particularly those that have rationalized their operating expenditure and have invested in moving up the value chain.

4:45

Indian equity markets had a volatile trading session today and languished in the red for the larger part of the day. At the time of writing, BSE Sensex was trading lower by 102 points and NSE-Nifty was trading down by 37 points. Both mid cap and small cap stocks were not spared either and were trading lower by 1% each. Losses were largely seen in oil & gas and metal stocks.

4:55 Today's investment mantra

"Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Madhu Gupta (Research Analyst).

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7 Responses to "Is This The Beginning of an Era of Low Oil Prices?"

Rajendran. T

Dec 11, 2015

No. Oil price will definitely go up in the future.

Like 

Shamal Parab

Dec 9, 2015

As the economy develops, especially in EMs, the level of energy consumption will spur in the near future. Which means there will be more environmental pollution and sustainability concerns among G20. The world is trying to move to Green / Alternate Energy (i.e. Solar or Wind). This all will have impact on oil consumption and exploration. OPEC members already have huge pile of cash reserves (just like Builders) and they can sustain the low oil price pain for some more period. They know that the price can be controlled by reducing the production at any time. However, they do not want any new competitors. As I envisage, the oil prices may spike in near future for some time and then again stabilise between USD 50 to 70. Most of the financial models for oil production assume USD 40 as a worst case scenario.

Like 

Moiz A Tankiwala

Dec 9, 2015

Really intresting to observe not the oil prices and world economy only; but the behaviour pattern of Saudi's and Americans. It is a cold war.
In your analysis pl mention about Iran and Russian crudes also. They will play a very important role. If we take into considerations both these countries production together with India demands nowonwards and China getting back by late 2016. There will be upward trend then onwards. Pl let me know your views.
Regards

Like 

O.P.GOYAL

Dec 9, 2015

I could not understand why falling oil prices has become a cause of concern. In fact it was a curse when oil prices were made to shoot up through cartelisation. If oil prices remain at present level or slide further, it is going to help every one except the brokers who are making money.

Like 

SAIBAL GANGULY

Dec 9, 2015

This is nothing but like a game rich children play.They may need 20 shuttles a day, wasting most of them because they have not been taught.
But can the same logic apply to the richest countries? NO. It is a game of ego and supremacy that is playing now and the Creator knows how long it will take them to know the WIN-WIN formula, and adjust their producing plans so that it is a perfect WIN-WIN from the LOOSE-LOOSE GAME their ego is forcing them to play mow. Without long term planning, what may seem to be a honourable plan now may suddenly bounce back and destroy then, remember,Napoleum & Hitler. lets see how oil prices would adjust

Like (1)

OM PRAKASH GUPTA

Dec 9, 2015

Yes, I agree that such low prices of crude oil can not sustain for long, as producers will be forced to reduce the production or keep themselves away due to lower margins or no margins at this price level.
Therefore, it is essential to get a fair price to remain in the market for producers.
More over, no further investment will come in the sector if viability does not fits.

Like (1)

N.T.Fapale

Dec 9, 2015

STOP SENDING SUCH MESSAGES.

Like (1)
  
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