Invest only that part of the portfolio in equities that you will not require in the short term.
The Budget involves three sets of numbers. The initial Budgetary Estimate (BE) is released in February when the Budget is announced. The Revised Estimates (RE) are released next February, based on three quarters of data. The Final Estimate comes a year or so later.
The BE assumptions always have large error factors – they're done by extrapolation based on between 6-9 months of data, with most of the drafting done in Q3. The 2011-12 BE assumed crude prices would stay below $100/ barrel, which was reasonable in Q3, 2010-11.
It was doubtful by February 2011 when the Budget was announced. It looks very unlikely now. Crude futures price chains on the Nymex are all trading well above the century mark for the next year and indeed, longer.
If crude stays above $100, it will hit growth, it will cause inflation and it will bloat the fiscal deficit. One can make different estimates about the degree of impact but it cannot be good for India. That means scaled down growth projections. Again, it's a question of degree, rather than direction.
Unfortunately the trouble has gone on long enough to guarantee disruption in global crude supplies.
Oil is a physical commodity. It takes infrastructure to extract, refine and transport. By all accounts, Libyan infrastructure has been damaged. Even if the civil war ends within the week (very, very unlikely) and efforts are made to put production online immediately, it will take several months before there's stable supply out of Libya.
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Given what has already happened in Tunisia, if we assume Libya is out of the oil export equation for the better part of calendar 2011, the global oil (and natural gas) supply-demand situation will be very tight. The OPEC -13 nations together export around 40 percent of the world's oil. No non-OPEC nation has much production capacity to spare.
At the moment, only the Saudis have significant spare capacity. Net-net, spare oil production capacity exceeds global demand by about 3 per cent. The best guesstimates about inventories held by OECD nations suggest that, at current consumption, there's around 50 days of inventory. If trouble escalates in Libya, Yemen, Syria and other Arab nations, OPEC capacity will inevitably see cutbacks.
This situation – less than 60 days of OECD inventory and less than 5 per cent of excess production capacity due to political turmoil – has occurred before, in 1973, 1979, 1980, 1981, 1991 and 2008. In each case, crude prices spiked sharply and drove up gas, coal and other fossil fuels as well. The global economy took time to adjust to the shock and GDP growth flattened or went into recession. In each case, India went through pain.
It's quite possible that oil price spike will hit global recovery and cause drawdowns in energy demands. That would be the natural route to global economic adjustment. However, global oil demand wasn't slated to grow much – the five year CAGR is around 1.5 per cent. Core demand for energy is likely to remain within 1-2 per cent of current levels.
What should the investor do? The imponderables are due to energy policy uncertainty. What is the Indian government (GoI) going to do about subsidies? Returns from investments in the energy sector depend on that. My sense is that dabbling in energy sector stocks could fetch great returns if the GoI is eventually forced to act sanely.
But there would be risks, particularly in downstre-am exposure. Rising crude prices put a cap on broader equity valuations. That is an opportunity for those who have the patience to wait for returns. Assume equity prices will travel down or at any rate, won't move up for an extended period.
Such an extended period of lower prices gives the investor a chance to put together a war chest and buy stocks at acceptable valuations. Of course, this has to be done with money that is not required for other short-term purposes.
The investor must also factor in the possibility of capital losses even as he invests, and therefore, focus on averaging down without being too concerned about losses. In those circumstances, the broader the exposure, the better. Also bigger the business, the more likely it is to emerge unscathed. Hence, this is a good scenario for systematic investments across exchange-traded funds / index funds tracking large cap indices.