Crude Price Rise May Hurt Defensives

Print Edition: November 2012

Issues related to oil imports are part of India's huge energy needs and limited resources. India has been importing crude oil and coal and exporting petroleum products for decades. However, the export does not hedge India's exposure to energy imports given the volumes.

Crude prices have had a strong relationship with global economic activity since 2000. When activity improves, crude prices rise. However, it can be disrupted by event risks or economic distortions (eg: quantitative easing).

Bullish sentiments result in (initially) a positive feedback loop of higher investor returns, which reinforces risk appetite and funding liquidity. With increasing appetite, global investors increase exposure to risky emerging markets. This has historically benefited currencies like the rupee. It is reversed when liquidity tightens.

Crude prices tend to correct in expectation of reduced global economic activity. As observed in the recent downturn, a falling rupee prevents Indian consumers from benefiting from a reduction in global commodity prices, including crude oil. An inflexible domestic consumption further affects the fiscal condition.

As a net commodity importer, India is adversely affected by rupee depreciation. A falling rupee adds to inflation but aids exports growth despite it not being a sufficient condition. Stable global demand has a stronger impact on exports as seen during 2003-8, characterised by hardening of the currency and phenomenal exports growth. An appreciating rupee will favourably impact inflation.

Changing inflation transmission mechanism:
Controlled deregulation of fuel prices is only the first step in managing the energy problem and the more immediate problem of fiscal consolidation.

At the risk of giving an overly simple explanation, the fuel subsidy system works in the following manner. Rising oil prices hit the government directly or through oil marketing PSUs or oil companies (ONGC, GAIL). To meet this deficit, the government inevitably borrows from the domestic market, leading to higher funding costs and tightening liquidity and other Indian companies are invariably 'crowded out' of debt funding.

The rising cost of funding is transmitted to the system as higher inflation, but with a lag. However, controlled deregulation of fuel price will mean a hike in crude prices would directly impact household expenses. While it appears to be a zero sum game in the short term, there may be an upside in the long term.

Structural adjustments:
The current, almost static, consumption of subsidised fuel might change with the hike in prices. The higher price may reduce demand to a limited extent. More profound consumption behaviour may be exhibited in the medium term. It may vary from the mundane, such as increased use of public transport, to the aspirational, say installation of solar panels.

On the government front, it will provide the RBI room to change the monetary policy to support growth.

End of defensives:
Currently, capital intensive sectors bear the brunt of high cost of funding due to government borrowing. This is likely to change in a deregulated market as a fuel price hike would affect household finances instantly.

India Ratings estimates that the recent fuel price hike will reduce household spending on discretionary items by 3-8%. 'Defensive' sectors such as FMCG, retail and consumer durables may behave more cyclically and be among the first casualties of surging crude prices.

New winners:
In the medium to long term, industries related to renewable energy may see a demand surge, converting deserving SMEs in the segment into sectoral leaders.

Managing Director, India Ratings

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