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The oil wildcard - Views on News from Equitymaster
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  • Mar 17, 2006

    The oil wildcard

    Riding on the 'India Story', the stock markets have moved into an unchartered territory. With investor appetite for stocks increasing by the day, even concerns about hardening crude prices and burgeoning current account deficit have taken a backseat. Here we contemplate on the prudence behind doing so.

    Guzzling oil...
    Developing countries in Asia are not only the fastest growing regions in the global economy, but are also the most inefficient consumers of oil in the world. China for example, currently requires about 2.3 times as much oil per unit of GDP as compared to a developed country. For India, the ratio stands at 2.9 times the OECD norm. To some extent, this is understandable, as Asia is currently in the midst of what could be termed as the most 'energy and materials intensive phase' of its development. That is, capital investments at the current levels are significant for cementing the future growth path. Given this, countries like India are extremely vulnerable to a sharp run up in oil prices. It must also be noted that oil prices have a larger impact on price levels in emerging economies. As a thumb rule, advanced economies witness a 0.25% decline in their GDP growth due to a rise in crude prices by US$ 10 per barrel. The same for emerging economies like India stands at nearly 1%!

    India's net oil import bill was about US$ 8.9 bn during 2QFY06 (crude oil at US$ 63 per barrel). As per budgeted estimates, should crude prices touch US$70 per barrel, India's annual net oil import bill could increase by over 35% YoY, pushing the current account deficit to 5.9% of GDP (5.4% of GDP in FY05, Source: Fitch). It would also challenge the government's capability to protect the domestic economy from further rise in oil prices. The challenge is likely to be more daunting if oil prices rise further.

    Lessons to learn from the US?
    The historically high US current account deficit (6.4% of GDP in 1HFY06) warrants a re-look here. As per the IMF, if oil prices were to average at US$ 70 per barrel by the end of 2006, the current account deficit would expand to US$ 943 bn (7.2% of GDP), even if the non-oil deficit remained at the 1HFY06 level of 4.8% of GDP. This would require roughly US$ 2.5 bn per day of capital inflows from the rest of the world or US$ 2 bn per day of non-FDI and equity inflows to the US (equivalent to 3% of non-US global GDP).

    Subsidies - a potential threat...
    In developing nations like ours, the government 'manages' prices artificially. However, it will not be long before the government takes a balanced stand as far as oil prices are concerned. Certainly, this is not good news for both the consumers as well as the corporates. The Reserve Bank of India (RBI) notes that, though increases in crude oil prices have so far been managed via fiscal and monetary measures, any further escalations in crude oil prices could 'endanger the fragile balance' that has been maintained between the government, oil companies and consumers.

    Given the aforementioned facts, investors need to factor in the possible downsides to the corporate earnings growth going forward. By not doing so, they will be ignoring a crucial threat that has the potential of endangering investor expectations, which are currently supporting the market advances.



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