Energy market fluctuations are likely to trump the Budget, in terms of impact on portfolios
Crude oil and natural gas, occupy a special place among financial assets. Energy is the cornerstone of modern civilisation and oil & gas (O&G) provides the lion's share. The US Energy Information Administration (EIA) estimates 60 per cent of global energy is from oil (37 per cent) and gas (23 per cent), while 25-26 per cent is coal-based. Hydro (6 per cent) and nuclear (6) contribute much of the rest. Renewables like solar, wind and geothermal collectively contribute 2 per cent.
O&G are much more versatile than coal, apart from being cleaner. It is difficult to design coal-based jet engines or internal combustion motors. The Germans did synthesise petrol from coal during World War II but it's not cheap or easy. Global energy demand will grow steadily as India, China and Brazil bootstrap out of poverty. There has been only one year (2009) since 1982 when energy consumption fell due to the global recession. There are question marks as to the post -“peak oil” future. Peak oil is the point, probably coming sometime in the next decade, when global production of crude peaks, (while energy demand grows). There are also environmental issues centred on carbon emissions and climate change.
One certainty is that throttling back energy consumption is politically impossible. Another is that the environmental lobby will promote energy efficiency, and cleaner, greener technologies. A third certainty is that, while more alt-energy technologies will come to market as fossils become expensive and scarce, the world will remain dependent on O&G and coal. It will take 15-20 years, maybe longer before renewables make meaningful contributions.
According to British Petroleum, global proven reserve to production (RP) ratios at current consumption are 119 years for coal, 60 years for gas and 44 years for oil. Reserves may grow in absolute terms, as more assets are struck and better extraction technology exploits coal-bed-methane (CBM) and shale. But consumption will also grow so the RP could actually drop. Further, all energy assets are price-correlated, taking the lead from crude. Energy demand is not very price-sensitive. Tiny supply shortfalls cause huge price swings. Upticks in energy prices cause inflation.
Even the fear of small future supply shortfalls cause massive price gains. So do projections of heightened economic activity, which translate into higher future demand. Energy prices tend to soften temporarily during periods of lower economic activity. Globally, the energy futures markets offer great price-discovery and hedging/ speculation mechanisms. O&G contracts can be taken month-on-month for many years ahead. When fossil prices harden, there's always bursts of investment into alternate energy.
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The threat of supply disruption is high because most O&G exporting nations have unstable, undemocratic regimes. The revolutions in Tunisia, Egypt and now civil war in Libya, has already triggered what could be a secular rising trend in crude prices. That in turn, has led to hardening gas and coal prices. Arabia produces a large chunk of O&G exports and turmoil there makes supply disruption quite probable. It's anyone's guess how far this could go but the price-direction is up. If the disruption lasts for a while, it could choke global economic recovery and add to inflationary pressures on Indian finances.
As a rupee-investor, there are several ways to hedge this situation. One is to directly buy crude futures contracts n the MCX/ NCDEX. The problem is that the contracts aren't very liquid or high-volume though they are correlated to international prices. A corollary is to buy USDINR futures, anticipating rupee falls as crude prices rises, inflating the import bill. Another possibility: buy energy commodity producers like ONGC, Reliance, Cairn, OIL, and Coal India (CIL). The problem is the high probability of policy interference. The Indian government often does strange things to “combat” rising energy prices. A corollary is shorting standalone PSU marketer-refiners. A third possibility is to find energy traders such as JSW Steel, which has a big share of coal imports. Here again, you'd need to look carefully to see if it can pass on cost increases, or if it's locked into price-invariant contracts.
You can also try alternative energy investment. Companies involved in wind and solar energy production were flush with funds during 2004-2007. The US invasion of Iraq and the subsequent mess were responsible for that. Investing in alternate energy means a lot of independent analysis but the prospects look good. It seems strange to completely ignore the Budget and focus on energy at this instant. My hunch is that energy market fluctuations will trump the Budget in terms of impact on portfolios. However, I expect the Budget to be mildly negative in fundamental impact and received very pessimistically by the markets.