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India Equity Strategy
Oil on the boil: implications for India
Is US$100 oil already priced in?
India’s equity risk premium tends to rise sharply during periods of elevated oil
prices. In 2008 the BSE Sensex multiple contracted by about 400bps over a period
of six months after oil pierced the psychological threshold of USD100. India’s
valuation has already compressed by 200bps+ since the start of 2011. MSCI
India’s valuation premium to MSCI Asia has also compressed to 220bps (the
lowest in past eighteen months) from 384bps in December 2010. Consequently
we believe that the market may have largely priced in oil at 100. However, given
the high sensitivity of oil to India – in an environment of already elevated inflation -
should the tensions in the middle east escalate further - driving oil prices higher -
we would not rule out a further compression in India’s valuation multiples and a
narrowing of its premium to MSCI Asia. We believe that the market is likely to stay
nervous until the headwind on inflation and policy inertia has abated.
Oil- India’s bete-noire
With India’s high dependence on oil imports (India imports ~75% of its oil needs
and oil accounts for. ~33% of India’s total merchandise imports) and more
importantly, the government tempering the automatic transmission of global oil
prices into the domestic economy, rising oil prices have tended to be a major
source of worry for Indian policymakers and for the Indian equity market. Our
economists highlight that if oil price were to average USD120/bbl, the annual
current account deficit could expand to 3.2%, fiscal deficit could rise to 6% and
inflation could remain elevated around 8.5%.
Cairn India the biggest beneficiary, OMCs adversely impacted
Amongst the companies under our coverage, we note Cairn India benefits the
most from rising crude oil prices and is our preferred pick. For every 1$/bbl
increase in oil price, Cairn’s valuation rises by ~INR4/sh. Oil marketing companies,
led by HPCL, are adversely impacted in an elevated oil price environment as gross
under recoveries mount. ONGC and Oil India will likely be affected only marginally,
as the positive impact of higher oil prices is neutralized by the higher outgo for
subsidy contribution. Reliance Industries (RIL) also has insignificant impact from oil
price movements as the revenue and EBITDA contribution from its oil assets is
marginal.
Continue to favor global cyclicals and companies with pricing power
We continue to prefer global cyclicals and consumer companies which have a
demonstrated track record of pricing power. In an environment of rising global
commodity price and an improving US macro we are overweight on IT Services
(Infosys, TCS), Metals (SAIL) and Oil & Gas (Cairn India). We also prefer
Automotives (M&M, Tata Motors), Telecom (Bharti) and select consumer names
with strong pricing power (ITC, Asian Paints). We remain underweight on cement,
healthcare, real estate and utilities. We are neutral on banks and industrials.
Oil on the boil
Crude prices likely to remain elevated and pose headwinds for
Indian economy
The recent insurrection in Egypt and fears of the contagion spreading to other regions in the
middle east have resulted in a further increase in oil prices- which were already at elevated
levels. While Egypt is not a major oil producer, a significant amount of oil flows through both
the Suez Canal (2 million barrels per day) and the SUMED pipeline (3 million barrels per day,
about 6% of daily oil production) – both controlled by Egypt. Hence the continuation of crisis
in Egypt and its potential spillover will likely heighten concerns over oil supply and therefore,
keep crude prices elevated in the near term.
Our global oil team believes that oil supply, demand and inventory fundamentals are pointing
towards a gradual tightening in the oil markets. It is possible that (i) strengthening in the US
dollar against the euro, or (ii) weakness in the US equity markets could remove some of the
support for oil prices, but the traditional supply/demand fundamental are likely to play an
increasingly powerful role in price formation over the next few years.
Oil – India’s Bete Noire
With India’s high dependence on oil imports (India imports ~75% of its oil demand, and oil
imports account for. ~33% of India’s total merchandise imports) and more importantly, the
government tempering the automatic transmission of global oil prices into the domestic
economy, rising oil prices have tended to be a major source of worry for Indian policymakers
and for the Indian equity market. We believe that benign oil prices (averaging littleUS$79/bbl)
during 2010 gave Indian policymakers considerable breathing space to not only take the bold
decision on petrol deregulation (however complete deregulation is yet to take place) but also
manage the fiscal situation and were seen as a strong tailwind for the Indian market.
Rising oil prices aggravate concerns on inflation and rise in twin
deficits
We worry that the recent rise in oil prices and particularly, Brent crossing the psychological
threshold level of USD100 will bring back the memories - and likely revive the fears - of 2008,
when oil prices had peaked at USD147/bbl. We are particularly concerned about rising oil
prices which in our view are likely to exert additional pressure on the government of India,
which is already grappling with elevated and persistent food inflation.
Our Economists (Taimur Baig and Kaushik Das) highlight the following sensitivities of oil on
key economic variables.
On Inflation: Fuel products make up about 15% of the WPI; within this segment, petrol and
diesel prices have already seen substantial increases (+24.5%yoy and +15%yoy respectively)
in the past year. Still, both products would likely see further upward adjustment in prices as
the global crude oil price heads toward USD100. Another 10% or so rise in petrol price and 4-
5% increase in diesel price is likely, in our view. First and second round effect of the fuel
price increase could add another 80bps to WPI inflation, as per our calculations.
Consequently the 2011 average WPI inflation could well exceed 8.0%.
On current account deficit: We estimate the elasticity of the current account with respect
to oil price to be about 0.15, .i.e. a 10% rise oil prices worsens current account by about
0.15% of GDP. Hence the current account deficit could exceed 3% of GDP in 2011, but not
much more than that if oil prices stay around USD100 through the course of the year.
However, if the oil prices were to rise to an average of US$110 -120/bbl then the CA deficit
for the 2011 could rise to 3.1%/3.2%.
On fiscal deficit: We estimate that higher oil price in 2011 could pose a ½% of GDP worth
of risk to the FY11/12 budget. However the authorities are unlikely to absorb the entire
additional cost, preferring to push some of the spending to the next fiscal year and some offbudget.
The government could also force substantial losses on state-owned oil companies as
yet another way to defray the explicit cost of living with US$100+ oil price.
But has the market already priced in a USD100 oil price?
India’s equity risk premium has risen sharply during periods of elevated oil prices. In early
2008 – when oil prices pierced the USD100/bbl mark, the BSE Sensex multiple contracted by
about 400bps over a period of six months. However the multiple contraction at that time was
also exacerbated by the onset of the global economic crisis.
The valuation multiple for India has compressed by 200bps+ since the beginning of the year
on account of the strong gale of headwinds (elevated inflation, policy inertia and worries of an
inflation wary government adopting unorthodox tools to curb inflation). Consequently we
believe that if oil prices remain range-bound around the current levels, the market is unlikely
to move down further. However should the insurrection in the middle-east worsen, it may
compress multiples further as it will elevate pressure on the monetary environment, external
accounts and fiscal policy.
India’s premium to Asia ex-Japan should has also contracted sharply in Jan 2011
While sharp escalations in oil prices are normally negative for both India as well as Asia ex
Japan’s valuation multiples, the impact on MSCI India is far more pronounced given India’s
dependence on imported oil is much higher vs. its Asian peers, while India simultaneously
runs current account deficit vs. CA surplus in most of the Asian peers.
Inflation worries coupled with expected policy inertia have already resulted in India’s PE
premium to MSCI Asia compressing sharply since the beginning of the calendar year;
premium has now compressed to 220bps versus 380bps in December 2010. The premium is
now the lowest in past eighteen months. Consequently we believe that unless oil prices rise
further or the policy environment worsens, the premiums are unlikely to compress
meaningfully from current levels.
Impact on Indian oil & gas companies- Cairn India the biggest
beneficiary, OMCs adversely impacted
Deutsche Bank’s Brent crude forecast stands at US$95-98 per barrel for CY11-14 with longterm
oil price assumption at US$100/bbl. This is higher than the average crude price recorded
for any financial year till date bringing back fears of FY09 for Indian oil marketing companies
(OMCs – IOC, BPCL and HPCL) when gross under-recoveries (losses on sales of subsidized
petroleum products) were reported at INR1043bn. Unrest in Egypt has already driven up
Brent Crude oil prices to over $100/bbl.
Our oil and gas analyst Harshad Katkar, has analysed the sensitivity of oil price movement on
the gross under-recoveries as well as on the Indian oil & gas companies under our coverage.
We find that gross under-recoveries rise exponentially with increase in crude oil prices. Every
1% increase in crude oil price raises gross under-recovery of oil marketing companies by
3.2% or every US$1/bbl increase in oil price increases gross under-recovery by INR32.6bn.
Amongst the companies under our coverage, Cairn India benefits the most from rise in crude
oil prices and is our preferred play on high oil prices. For every 1$/bbl increase in oil price,
Cairn’s valuation rises by ~INR4/sh. On the other hand, oil marketing companies, led by
HPCL, are the losers when oil prices go up as losses on sales of subsidized petroleum
products keep mounting. ONGC and Oil India will be impacted by the crude oil price only
marginally as the positive impact of higher oil prices is neutralized by the higher outgo for
subsidy contribution. Reliance Industries (RIL) also has insignificant impact from oil price
movements as the revenue and EBITDA contribution from its oil assets in MA-1 and Panna-
Mukta-Tapti is marginal. RIL’s E&P assets are mostly gas rich while its downstream refining
and petrochemical businesses are more dependent on product margins than the absolute
levels of crude oil.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India Equity Strategy
Oil on the boil: implications for India
Is US$100 oil already priced in?
India’s equity risk premium tends to rise sharply during periods of elevated oil
prices. In 2008 the BSE Sensex multiple contracted by about 400bps over a period
of six months after oil pierced the psychological threshold of USD100. India’s
valuation has already compressed by 200bps+ since the start of 2011. MSCI
India’s valuation premium to MSCI Asia has also compressed to 220bps (the
lowest in past eighteen months) from 384bps in December 2010. Consequently
we believe that the market may have largely priced in oil at 100. However, given
the high sensitivity of oil to India – in an environment of already elevated inflation -
should the tensions in the middle east escalate further - driving oil prices higher -
we would not rule out a further compression in India’s valuation multiples and a
narrowing of its premium to MSCI Asia. We believe that the market is likely to stay
nervous until the headwind on inflation and policy inertia has abated.
Oil- India’s bete-noire
With India’s high dependence on oil imports (India imports ~75% of its oil needs
and oil accounts for. ~33% of India’s total merchandise imports) and more
importantly, the government tempering the automatic transmission of global oil
prices into the domestic economy, rising oil prices have tended to be a major
source of worry for Indian policymakers and for the Indian equity market. Our
economists highlight that if oil price were to average USD120/bbl, the annual
current account deficit could expand to 3.2%, fiscal deficit could rise to 6% and
inflation could remain elevated around 8.5%.
Cairn India the biggest beneficiary, OMCs adversely impacted
Amongst the companies under our coverage, we note Cairn India benefits the
most from rising crude oil prices and is our preferred pick. For every 1$/bbl
increase in oil price, Cairn’s valuation rises by ~INR4/sh. Oil marketing companies,
led by HPCL, are adversely impacted in an elevated oil price environment as gross
under recoveries mount. ONGC and Oil India will likely be affected only marginally,
as the positive impact of higher oil prices is neutralized by the higher outgo for
subsidy contribution. Reliance Industries (RIL) also has insignificant impact from oil
price movements as the revenue and EBITDA contribution from its oil assets is
marginal.
Continue to favor global cyclicals and companies with pricing power
We continue to prefer global cyclicals and consumer companies which have a
demonstrated track record of pricing power. In an environment of rising global
commodity price and an improving US macro we are overweight on IT Services
(Infosys, TCS), Metals (SAIL) and Oil & Gas (Cairn India). We also prefer
Automotives (M&M, Tata Motors), Telecom (Bharti) and select consumer names
with strong pricing power (ITC, Asian Paints). We remain underweight on cement,
healthcare, real estate and utilities. We are neutral on banks and industrials.
Oil on the boil
Crude prices likely to remain elevated and pose headwinds for
Indian economy
The recent insurrection in Egypt and fears of the contagion spreading to other regions in the
middle east have resulted in a further increase in oil prices- which were already at elevated
levels. While Egypt is not a major oil producer, a significant amount of oil flows through both
the Suez Canal (2 million barrels per day) and the SUMED pipeline (3 million barrels per day,
about 6% of daily oil production) – both controlled by Egypt. Hence the continuation of crisis
in Egypt and its potential spillover will likely heighten concerns over oil supply and therefore,
keep crude prices elevated in the near term.
Our global oil team believes that oil supply, demand and inventory fundamentals are pointing
towards a gradual tightening in the oil markets. It is possible that (i) strengthening in the US
dollar against the euro, or (ii) weakness in the US equity markets could remove some of the
support for oil prices, but the traditional supply/demand fundamental are likely to play an
increasingly powerful role in price formation over the next few years.
Oil – India’s Bete Noire
With India’s high dependence on oil imports (India imports ~75% of its oil demand, and oil
imports account for. ~33% of India’s total merchandise imports) and more importantly, the
government tempering the automatic transmission of global oil prices into the domestic
economy, rising oil prices have tended to be a major source of worry for Indian policymakers
and for the Indian equity market. We believe that benign oil prices (averaging littleUS$79/bbl)
during 2010 gave Indian policymakers considerable breathing space to not only take the bold
decision on petrol deregulation (however complete deregulation is yet to take place) but also
manage the fiscal situation and were seen as a strong tailwind for the Indian market.
Rising oil prices aggravate concerns on inflation and rise in twin
deficits
We worry that the recent rise in oil prices and particularly, Brent crossing the psychological
threshold level of USD100 will bring back the memories - and likely revive the fears - of 2008,
when oil prices had peaked at USD147/bbl. We are particularly concerned about rising oil
prices which in our view are likely to exert additional pressure on the government of India,
which is already grappling with elevated and persistent food inflation.
Our Economists (Taimur Baig and Kaushik Das) highlight the following sensitivities of oil on
key economic variables.
On Inflation: Fuel products make up about 15% of the WPI; within this segment, petrol and
diesel prices have already seen substantial increases (+24.5%yoy and +15%yoy respectively)
in the past year. Still, both products would likely see further upward adjustment in prices as
the global crude oil price heads toward USD100. Another 10% or so rise in petrol price and 4-
5% increase in diesel price is likely, in our view. First and second round effect of the fuel
price increase could add another 80bps to WPI inflation, as per our calculations.
Consequently the 2011 average WPI inflation could well exceed 8.0%.
On current account deficit: We estimate the elasticity of the current account with respect
to oil price to be about 0.15, .i.e. a 10% rise oil prices worsens current account by about
0.15% of GDP. Hence the current account deficit could exceed 3% of GDP in 2011, but not
much more than that if oil prices stay around USD100 through the course of the year.
However, if the oil prices were to rise to an average of US$110 -120/bbl then the CA deficit
for the 2011 could rise to 3.1%/3.2%.
On fiscal deficit: We estimate that higher oil price in 2011 could pose a ½% of GDP worth
of risk to the FY11/12 budget. However the authorities are unlikely to absorb the entire
additional cost, preferring to push some of the spending to the next fiscal year and some offbudget.
The government could also force substantial losses on state-owned oil companies as
yet another way to defray the explicit cost of living with US$100+ oil price.
But has the market already priced in a USD100 oil price?
India’s equity risk premium has risen sharply during periods of elevated oil prices. In early
2008 – when oil prices pierced the USD100/bbl mark, the BSE Sensex multiple contracted by
about 400bps over a period of six months. However the multiple contraction at that time was
also exacerbated by the onset of the global economic crisis.
The valuation multiple for India has compressed by 200bps+ since the beginning of the year
on account of the strong gale of headwinds (elevated inflation, policy inertia and worries of an
inflation wary government adopting unorthodox tools to curb inflation). Consequently we
believe that if oil prices remain range-bound around the current levels, the market is unlikely
to move down further. However should the insurrection in the middle-east worsen, it may
compress multiples further as it will elevate pressure on the monetary environment, external
accounts and fiscal policy.
India’s premium to Asia ex-Japan should has also contracted sharply in Jan 2011
While sharp escalations in oil prices are normally negative for both India as well as Asia ex
Japan’s valuation multiples, the impact on MSCI India is far more pronounced given India’s
dependence on imported oil is much higher vs. its Asian peers, while India simultaneously
runs current account deficit vs. CA surplus in most of the Asian peers.
Inflation worries coupled with expected policy inertia have already resulted in India’s PE
premium to MSCI Asia compressing sharply since the beginning of the calendar year;
premium has now compressed to 220bps versus 380bps in December 2010. The premium is
now the lowest in past eighteen months. Consequently we believe that unless oil prices rise
further or the policy environment worsens, the premiums are unlikely to compress
meaningfully from current levels.
Impact on Indian oil & gas companies- Cairn India the biggest
beneficiary, OMCs adversely impacted
Deutsche Bank’s Brent crude forecast stands at US$95-98 per barrel for CY11-14 with longterm
oil price assumption at US$100/bbl. This is higher than the average crude price recorded
for any financial year till date bringing back fears of FY09 for Indian oil marketing companies
(OMCs – IOC, BPCL and HPCL) when gross under-recoveries (losses on sales of subsidized
petroleum products) were reported at INR1043bn. Unrest in Egypt has already driven up
Brent Crude oil prices to over $100/bbl.
Our oil and gas analyst Harshad Katkar, has analysed the sensitivity of oil price movement on
the gross under-recoveries as well as on the Indian oil & gas companies under our coverage.
We find that gross under-recoveries rise exponentially with increase in crude oil prices. Every
1% increase in crude oil price raises gross under-recovery of oil marketing companies by
3.2% or every US$1/bbl increase in oil price increases gross under-recovery by INR32.6bn.
Amongst the companies under our coverage, Cairn India benefits the most from rise in crude
oil prices and is our preferred play on high oil prices. For every 1$/bbl increase in oil price,
Cairn’s valuation rises by ~INR4/sh. On the other hand, oil marketing companies, led by
HPCL, are the losers when oil prices go up as losses on sales of subsidized petroleum
products keep mounting. ONGC and Oil India will be impacted by the crude oil price only
marginally as the positive impact of higher oil prices is neutralized by the higher outgo for
subsidy contribution. Reliance Industries (RIL) also has insignificant impact from oil price
movements as the revenue and EBITDA contribution from its oil assets in MA-1 and Panna-
Mukta-Tapti is marginal. RIL’s E&P assets are mostly gas rich while its downstream refining
and petrochemical businesses are more dependent on product margins than the absolute
levels of crude oil.
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