Oil on the boil

The cushion between crude oil demand and supply has evaporated

With Nymex crude oil futures crossing the $50 a barrel mark, a 75 per cent rise in the last one year, the oil bulls are once again out in force.

To be sure, they say, the current spike is explained by lower US inventories due to the disruptions caused by hurricanes, and to a rebellion in Nigeria, but more fundamental factors are also at work.

On the demand side, growth in China and India and in the US has been blamed. But is that  enough for prices to move up by 50 per cent in one year?

Well, Chinese oil imports are up 40 per cent in 2004. On the supply side, the bulls point to the fact that while world discovery rates peaked in the 1960s, global oil reserves have not increased since 1990. And after reaching an optimum, the cost of production in oilfields rises rapidly.

The sceptics, on the other hand, point to the "political premium" in oil and to hedge fund activity.

The truth seems to be that the cushion between supply and demand is now so low that any negative event, such as a bomb in Iraq, or a hurricane, are enough to cause demand to overtake supply, raising prices. Analysts estimate this cushion at about 1 percent of total demand.

The International Energy Agency says that while world demand would rise by another 1.8 million barrels next year to 84 million barrels a day, Opec's production capacity would rise by a further 700,000 barrels a day in 2005. That would lead to an even tighter market next year.

Higher oil prices will increase inflationary expectations and that could lead to higher interest rates. However, much depends on the attitude central banks take, and whether they are more worried about higher crude prices affecting growth or fuelling inflation.

Back home, Aditya Birla group chief economist Ajit Ranade says that high oil prices are seeping into other commodities and that the inflation we see now is broad-based. That would call for more monetary tightening. That's what the market seems to believe, with the 10-year government bond yield hardening to 6.20 per cent.

Yield spreads

Why should higher oil prices lead to lower ten-year yields in the US, and higher ten-year yields in India? The gap between two-year and 10-year yields in the US bond market has shrunk  to 1.46 percentage points, almost a three-year low, and the explanation offered is that investors expect interest-rate increases by the Federal Reserve to curb inflation.

That would impact the short end, while the long-term yield is falling because rising oil prices would hurt growth.

In India, too, the spread between short and long-term securities has come down. For instance, the spread between 1-year and 10-year yields was 194 basis points on September 1, 170 basis points on September 14 and is now around 90 basis points. 

The reasons: dealers point to short-term yields moving up on the CRR hike and the sucking out of money through the market stabilisation bonds. Dealers also say that Indian bond markets are not so mature, and any impact at the short-end affects the long-end as well.

Markets and earnings

How far do markets reflect revisions in earnings expectations? To check that out, we've taken consensus earnings three months ago and today, and compared them with stock prices ruling three months back and those ruling today. In some cases like IT, the increase in the stock prices is somewhat in line with an expected increase in earnings.

For example, in the case of Infosys Technologies, the consensus EPS has improved 12.85 per cent but the stock has gained around 21.2 per cent. The balance is probably explained by IT being back in favour.

However, in some cases the movement in share price has no link with the changes in expected earnings. HLL's consensus EPS has dropped 17.41 per cent to Rs 6.07 but the stock has declined only around 7.69 per cent. Why? The market believes that the worst has already been priced into the stock.

For Reliance Industries the consensus EPS has improved just 0.49 per cent in the last three months, but the stock has gained around 17.3 per cent, thanks to the general uptrend in the market.

In some cases the longer term outlook is viewed as crucial in driving up the stock price "" take the case of Oriental Bank of Commerce which has taken over Global Trust.

OBC's consensus earnings have dropped 4.8 per cent over the last 3 months but the stock has moved up around 6.55 per cent during this period. Punters expect that an expansion in the south for OBC via GTB would help it to grow earnings in the future.

In summary, it's not only changes in earnings expectations that drive stock prices. Market sentiment and liquidity are crucial determinants.

With contribution by Amriteshwar Mathur