It's a 'crude' fact... - Views on News from Equitymaster

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It's a 'crude' fact...

May 7, 2004

Amidst the expectations game for the ongoing elections, stock markets seem to be overlooking one fact, which to us is of significance, i.e. rising crude prices. The significance not only emerges from the fact that we are highly dependent on crude but also it could impact return expectations of retail investors from equities. Before going any further, consider the fact from what the International Energy Agency has to say about the impact of crude prices on the global economy. This is an excerpt from the latest report released by this international agency.

"The chart shows oil intensity, defined as primary oil consumed per unit of GDP, in selected developing countries relative to that of the OECD. India, for example, uses more than two and half times as much oil as developed countries per unit of GDP, while the economies of China, Thailand and African countries are also very oil intensive. It is estimated that oil imports cost India US$ 15 bn or 3% of its GDP in 2003. The oil-import bill increased by 16% between 2001 and 2003. And oil intensity is still increasing in many developing countries as modern commercial fuels replace traditional fuels in the household sector and industrialisation and motorisation continue apace. Rising oil intensity is reflected in the share of oil imports in total imports, which is increasing in many developing countries - notably in China and India."

What this highlights is the relatively high dependence on crude oil to achieve a certain amount of output (read GDP) as compared to OECD countries. To simplify, if the OECD countries and India need to produce 100 units of output, we need 2.5 times more oil than OECD countries to produce that much of output. So, how will this impact the stock market?

  • For one, the need for oil would continue to grow as long as our economy is growing. What this will mean is that we would demand more crude oil in the future, which is primarily imported. Given the sharp spurt in crude prices in the recent past (currently at US$ 40 per barrel), the crude oil import bill is likely to be on the higher side.

  • If crude prices remain at a higher level, the product prices (i.e. petrol, diesel, kerosene and LPG) could increase, resulting in an inflationary pressure.

  • Since central bankers across the world are concerned with inflation, they may be forced to raise interest rates to soften growth.

What should a retail investor in equities do in these times? We had done a study of sectoral performance on the stock market since January 2004 and have compared this performance with the trend witnessed in Jan-Dec 2003 (Click here to read the article). It is apparent from this study that markets, overall, have gone nowhere in this calendar year. Even though some sectors have outperformed the Sensex, the gap has narrowed significantly as compared to the previous year. What it highlights is that the stock markets and majority of stocks have corrected fundamentally in terms of valuations. Further rise from here is likely to be accompanied by higher revenue growth.

We believe that if interest rates were to go up, sectors like banking, automobiles, consumer-demand dependent sectors are likely to find it difficult to grow in the future. Companies with large-scale capital expenditure plans have to be viewed with caution, as the cost of money could increase. While we are not trying to sound pessimistic, the concerns are for real. Sounds like cash is king!

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