With the sharp dip in crude oil prices, the chances are that sectors like auto, airlines and logistics could turn around faster than oil refiners.
Despite the war between Russia and Georgia, crude prices have eased, dropping to $113/ barrel from record highs of $147 on July 11. This downtrend is quite significant because the Caucasian region is very energy-sensitive.
British Petroleum closed down two pipelines running through Georgia and Europe’s access to the Caspian Seawas drastically reduced. One could have expected markets to react in panic since thisput over 3 million barrels a day (MBD) of oil and oil-equivalent (O&OE) potentially at risk.
One reason for the unexpected downtrend is that global demand is falling. The Paris-based International Energy Agency says demand from 30 developed nations located across Europe and North America has dropped by an aggregate 1.3 per cent per day to 48.6 MBD.
China’s July 2008 oil imports are down 7 per cent compared to July 2007 levels. This could be an aberration partly caused by shutdowns of smokestack industries in the Beijing region as China delivers cleaner Olympic air.
But high oil prices have had a textbook downwards impact on demand. So far in 2008, Americans have driven 50 billion kms less compared to the equivalent period of 2007. That translates to roughly two to three days less of US consumption (20MBD). Recession has also led to lower energy demand from industry.
Of course, $113 is an exceedingly high level in historical terms. But the downtrend has given some hope to oil-importers. If it does prove to be secular, nobody will be more relieved than the Indian government.
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In Indian politics, it is an imperative to subsidise retail prices of oil and gas. The NDA retained price-control of petrol, diesel, kerosene and gas, when it “abolished” the Administered Pricing Mechanism (APM) in 2002.
But the subsidy mechanism is randomised. Prices are reviewed every so often. PSU refiner-marketers are handed out IOUs in the form of long-tenure oil bonds. Almost Rs 100,000 crore worth of oil-bonds have been issued. That is around 2 per cent of GDP at face-value though the net present value is much less.
The ad hoc subsidisation has effectively bankrupted PSU refiners (which remain technically profitable). It has added a long-term burden to government finances. It has had two other negative long-term effects.
For one, it has created an insurmountable barrier for private refiners who wish to enter retail. Reliance and Essar have shut down retail networks. This means zero competition in the retail segment.
Second, subsidies don’t promote energy-efficiency – they have the opposite effect. India has low per capita energy consumption but it is wasteful.
China has an economy that is about 3 times as large (at nominal rates) and consumes 1.6 times as much natural gas and about 2.8 times as much oil. China is not notably energy-efficient so there’s a lot of room for India to improve its energy-efficiency.
There are plans being mooted to rationalise oil subsidies by monthly hikes in retail prices. This would give the economy a chance to adjust gradually while easing an intolerable fiscal burden.It may not happen until elections are over and it’s likely that election manifestoes would contain promises to continue subsidies.
In the long term, higher oil prices will drive growth in some industries. It has already meant a greater thrust on exploration and that has led to gas finds.
It could enable the rapid growth of bio-fuels and other renewables.
But the best chance for a quick comeback for the Indian economy lies in dropping oil prices. The biggest stock market returns would be generated in industries such as automobiles, civil aviation and transport logistics providers with some positive spin-offs into tourism and hospitality. If you believe that O&OE prices will continue to ease, those are probably the best targets for your portfolio.
Technically, PSU refiners and marketers are in the black. But in fact, they are hugely cash-flow negative and starved for working capital. Auto sales have been flat or negative for two years. Airlines have borne heavy losses and growth in aviation passenger and cargo traffichas slowed.
The chance of quick turnarounds in automobiles, airlines, logistics companies, etc., is higher than in PSU refiners, which remain subject to far more rigid controls. Above all, unlike PSU refiners, the auto-manufacturers, airlines and logistics outfits have competition to drive the quest for efficiency.