The ABC Of Crude Oil Pricing And Its Impact On Various Other Sectors

History:

It all started with political conflict building up among the major oil producing countries followed by Iraq’s invasion in the year 2003. Since then crude oil has seen tremendous volatility ranging from a price of USD 30 per barrel to the peak of nearly USD 145 per barrel. Crude oil witnessed its peak during mid 2008 with the prospect of attack on Iran by the Israelis (the then oil major) that led to a shortage in crude oil supply.

Subsequently, series of events in the US led to fall in crude price from its peak of USD 145 to USD 32; the then US President George Bush’s ban order on oil drilling followed by the US-Iraq war and the Lehman Brothers’ bankruptcy turmoil, the catastrophic event in the history of world markets. Another setback to the crude was a possible decline in demand from the European countries ahead of fear of economic slowdown.

In 2011, crude hit USD 100 again with political uncertainty in Libya that curbed oil production. Prices jumped further with the weakening of US dollar ahead of recessionary trends in the US economy. The competition turned fierce and some of bases increased production from Libya and North Sea.  Crude saw a lot of volatility between a price range of USD 50-60 amid fall in the US shale oil production and Yemen war. Oil hit USD 100 with Russia and Libya supply risks and split in Texas before the major fall.

The incentives to oil producers in the US led to the biggest fall in crude below USD 30 while all other OPEC countries were already facing supply glut.

Recent happenings:

World’s second largest economy and one of the largest oil consumers, China, curbed demand for most of the commodities, also fuel, due to its economic turmoil that led to a sudden drop in oil prices below USD 30.

The consistent appreciation in US dollar was another reason for the drop. The US stockpiles hit 120 million barrels during the season. The recent recovery was seen following the arrangement of potential production freeze by the key producers. Meanwhile, Russia and Saudi Arabia agreed on the terms if all others followed the crude oil production freeze suit.

The April Doha Meet

The overwhelming volatility in the crude oil prices since 2015 and its prices reaching a nadir in early 2016 was quite alarming. The reason being a supply glut as major OPEC and non-OPEC countries were desperate to maintain market share at the expense of others. OPEC countries denied freezing the output with a fear of losing their shares. Non-OPEC countries, specifically Russia and shale oil producers had already entered in leaps. Additionally, Iran was freed from its punitive sanctions over its disputed nuclear program and thereby Iran intended on pumping out as much crude oil as possible to compensate for the lost time to add more to the glut.

The urgency was felt when the restriction was put on the crude output to match January levels that declined their overall revenues to such an extent that GDP had suddenly shrunk. For instance, the Saudi economy endured a 9.4% increase in its annual debts as a percentage of GDP.
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The talks regarding over production had already started in February 2016 when the oil majors Russia and Saudi Arabia agreed to cut the production to January 2016 levels to bottom out the prices. Oil ministers from OPEC and non-OPEC countries decided and scheduled an urgent meeting in Doha, Qatar on April 17. The signatories viz; Venezuela, Saudi Arabia, Qatar and Russia put forth that the production levels be reduced to January 2016 levels for the next ten months to stabilise the prices and thereby ensure equilibrium in demand and supply.

The value of any such production freeze arrangement between OPEC’s Saudi Arabia and Non-OPEC’s Russia still is not clear. The major culprit was Iran, as some of the players point out.

Failure of the Meeting

Venezuela was hard-hit by the fall in overall oil market and thereby had summoned the Doha meet out of an emergency after facing political and economic uncertainties where its foreign currency earnings got totally exhausted.

The US was held the biggest offender in the Doha failure. In the meet, the US government was accused by Venezuela of refraining the efforts of major oil producers to curb their production levels. The political agenda was to bring downfall of Venezuela. Moreover, the rise in oil prices would mean depreciation of US dollar.

·        The US is said to have intentionally pressurised countries not to attend and to adopt hardline positions against the proposed measures.  

·        Saudi Arabia took a u-turn at the last minute and refused to make a deal without the participation of Iran and war-torn Libya.  

·        Tehran remained stubborn that would not freeze production at pre-February levels, during which time international sanctions severely reserved its output.   

The expectations from the meeting had brought a rebound in oil prices. However, the prices were heavily washed out in the next two days since its failure.

For a short term, the pouring crude oil market and failure of the meeting with no agreement about freezing of oil production weighed on crude oil prices. The crude oil prices fell for successive sessions below USD 41.5 ahead of the meeting but recovered again to trade just below USD 44.

Another reason for recovery was Kuwait’s strike. Kuwait went under a strike by oil workers that led to a massive decline in oil production. Kuwait’s crude oil production fell from 2.8 million barrels per day which is average per day production to 1.1 million barrels per day. However, the supply disruption could be short-lived. Local government officials were in negotiations with oil workers to compromise in order to increase oil exports.

The US dollar corrections also remained limited further downside for the crude oil prices wherein the fall in dollar made crude oil cheaper for the importers that increased demand and thereby the prices. Moreover, the rise in equities too boosted the oil prices.

Crude saw a breakout at USD 42 level. Hence if crude sustains above USD 42 and hits USD 46.50 on the upside it can hit USD 50. On the downside USD 37.5 followed by USD 35 will act as the support. The crude oil may witness levels of USD 47.50-67.50 in long term.

For long term, demand from India and China would prove to be the major triggers for crude oil prices. India produces nearly one million barrel per day as of 2014-15 according to Energy Information Administration (EIA). The consumption is said to increase marginally to 4.2 million barrels per day in 2016 and 2017 by surpassing other big consumers like Japan and China.

The global oil demand-supply gap is averaged at 1.8 million barrels per day (MMbpd) in the first half year of FY16 and is likely to reduce to 1 MMbpd. The narrowing gap would help prices to increase further.

According to EIA, oil inventories build up would be averaged at 1.4 MMbdp in 2016 which would maintain the oil prices at current levels. Further the inventories are likely to increase to 1.8 MMbpd in 2017. The rise being marginal may lead to price recovery to some extent.

However, widening of inventories may lead to price uncertainties as the additional storage capacity is unknown. Moreover, it may lead to higher storage costs and if the capacity utilization becomes full may lead to other expensive options like floating inventories on crude oil tankers.

The Indian context

There will be an impact on Indian equity markets as crude oil prices have major role. The country imports over 70 per cent of its crude requirement ultimately, falling crude oil prices would ease current account deficit and also significantly reduce the fuel subsidy burden. The expenditure on crude oil accounts for 30 per cent of India's import bill. There are various sectors which can be affected from the drastic movement of crude oil prices.

Oil exploration companies have been severely affected by the low oil prices. In January this year Cairn India, a Vedanta group subsidiary in Q3FY16 witnessed a drop in the net profit by steep 99 per cent. In the current scenario it does not look like the oil prices will settle immediately. Rather it could further add to the worries of Cairn India, and for this to happen OPEC should try and stabilise the prices ignoring all political gains and losses but that does not look happening any time soon.

OMCs aspects can be seen through the gross refining margin (GRM). GRM is measured as the margin they generate for refining one barrel of oil. Since crude oil prices and the product prices move in tandem, the GRM remains stable. There are three major oil marketing companies in India Indian Oil Corporation (IOCL), Hindustan Petroleum Corporation Limited (HPCL), and Bharat Petroleum Corporation Limited (BPCL).  These companies are likely to benefit from the soaring oil prices as they directly buy at the rate prevailing in the international market. Though the YoY revenue for the period (2014 -2015) has soared due to industry being interrelated and connected to the oil exploration companies, but the finance cost for the current year have come down. Reliance Industries Limited, another major oil marketing company in India has seen less pressure on its margins and also seen a reduction in their finance cost as the company has benefited from lower crude prices.

If the prices further prevailed to be lower, then USD 50 a barrel it will further benefit the aviation industry and it could further help to strategise the industry to increase the revenue. Low oil prices have made the balance sheet of various aviation players to be positive. The aviation sector accounts generally 70 to 80 per cent from total expenditure towards fuel prices. As, lower crude oil prices generated positive profits for the industry and bottom line of the companies from the sector witnessed increment during FY16.  Jet Airways from the 2014 to 2015 has increased the revenue margin by approximately 9 per cent this is possible only because of the low oil prices which has eased the pressure on profit margins.

Chemical industry is also going to be benefited from the low oil prices it has eased the pressure on the costs. Looking at the financial statements of TATA chemicals as YoY profits increased by 46 per cent for the period 2015-16. To a large extent the chemical industry has benefited, Pidilite Industries has also reported a good figure on YoY basis, they saw a revenue increase by 9.5 percent which was largely due to low oil prices as the cost of material wore cheaper.

Low prices also seem to be in the beneficial for the paint industry as for the paint companies, the fall in crude oil prices will be beneficial as they use crude oil derivatives as inputs. Paint companies use several crude oil products as raw material. Titanium dioxide and other crude oil derivatives such as Phthalic Anhydride and Penraerythritol account for 50% input costs. Also there has been a trend that falling oil prices have also boosted the share prices of the company. The oil prices also do not seem to be going at a high any time soon amid the pressure to gain a consensus in the future APEC meet does not seems to be happening at the earliest.

With the prices expected to be in a far normal range the above two industries are expected to gain as the both the industry are interconnected and inter-related. The automobile sector is expected to gain as low oil prices should increase the demand for automotive segment also Reserve Bank of India have also gone for rate cuts and is expected to go for the further in August which should also looks in favour for the automobile sector. Rise in auto sales means higher demand for tyres as well. Plus, one of the inputs for tyres, synthetic rubber, is a byproduct of crude oil. So, a fall in crude oil prices will be an additional advantage for tyre companies, which have already seen operating margins expand to double digits in the last couple of quarters due to steady fall in natural rubber prices. Apart from this for both the segments it has been observed that the pressure on expenses have been reduced to a larger extent which has seen EBITDA margin to go up significantly.

If the prices remain low to a larger extent, it is expected that FMCG which is believed to use crude oil for packaging, hair care and lab detergent will see an impact as low oil prices should decrease their cost of production thereby increasing their profits. FMCG companies also spend a huge amount of money on purchase of raw materials and use this material for packaging. With the oil prices to remain low FMCG companies have largely benefited and have passed on this benefit to the end consumer.