Why India doesn’t need to worry about oil prices in near future

Nitin Singh & Aditya Sharma

Singh is MD & head, Standard Chartered Wealth Management, India, and Sharma is director, investment strategy, Standard Chartered Wealth Management Views are personal
Oil has fallen out of favour in recent years, with prices dropping by more than half since mid-2014. From about $115 per barrel in mid-2014, Brent crude oil prices fell to a 12-year low of close to $28 by January 2016, before settling around $50 per barrel. While there is room for further upside, India as a major oil importer need not be too worried as prices are unlikely to rise too sharply, given the substantial global oversupply. To understand the dynamics of oil prices, one needs to examine the causes of the price rout of the past few years. The biggest driver has been the surge in the US oil production as a result of the so-called ‘shale revolution’, whereby improved productivity and increased efficiency in extracting oil from shale rock formations boosted US’ recoverable oil reserves. As a result, the US crude oil output almost doubled from around 5 million barrels per day (mbpd) in 2008 to a record 9.6 mbpd in 2015, turning the country into one of the world’s top-three oil producers alongside Russia and Saudi Arabia, and reducing its reliance on oil imports. Although global demand has been rising steadily, mainly from major Asian consumers such as China and India, this was not sufficient to absorb the rising US output, leading to a worldwide glut. By the time the other major oil producers, particularly members of the oil cartel OPEC came together to agree on curtailing output in 2016 to offset the rising US production, world oil inventories climbed to record highs. Alongside the US shale revolution, there are other structural factors that are likely to limit significant price gains. For one, there are increasing efforts by major economies to reduce their reliance on oil.
Developed economies are gradually moving to ‘alternative’, renewable energy sources such as solar, wind and hydro power, besides using more natural gas for power generation. Germany, for instance, generated about 85% of its electricity in April this year from such renewable sources. The UK, France and India have announced plans to end the sale of oil-powered motor vehicles by 2040. Given this backdrop, there is much uncertainty surrounding the outlook for oil prices. The key to assessing the investment implications of oil prices is to separate the near-term outlook from longer-term structural trends. Oil prices have likely bottomed out in the near-term and there is a 75% probability to oil prices being above $45 per barrel in a year’s time.
The decisive factor in the near-to-medium term uptrend will be OPEC’s ability to curtail output among its members. OPEC and major non-OPEC oil producers such as Russia have so far managed to reduce production after reaching an agreement last November. These cuts are likely to be sustained into 2018 (although increased output from some OPEC members which have been left out of the production-cut agreement such as Nigeria and Libya remains a risk). Meanwhile, US shale production—currently on a renewed uptrend—is likely to peak close to its 2014 record highs as most shale production efficiencies—reflected in lower breakeven costs—are mostly behind us.
Indeed, there is some evidence of cost inflation and stress in the US shale oil sector. Also, global oil demand is likely to continue to rise in the near-term as the global economic recovery extends well into 2018 and possibly beyond. Recent geopolitical tensions over the economic blockade of Qatar by several Middle Eastern countries may increase demand for oil as Qatari gas usage in the region is halted. Against this backdrop, inventories are likely to continue to fall and, at some point, result in a tightening supply situation that should support oil prices. So what does this mean for energy-related investments?
Depressed valuations in the global energy equities sector as a result of the decline in oil prices in recent years offer an opportunity for near-to-medium-term investors. Historical data points to a close relationship between crude oil prices and outperformance of the global energy sector equity vs. equity benchmarks. An expected recovery in oil prices is, thus, a clear tailwind for the sector. The improvement in the fundamentals of the industry—through lower operating costs and breakevens—is another positive for the sector. Leading producers have seen rising profit margins as a result of their cost-control measures.
Emerging Market currencies are also likely beneficiaries of rising oil prices in the near-term as they have a close correlation. This is possibly because both oil and EM currencies rise at times of accelerating global growth. The Indian Rupee, however, can be considered an exception and could underperform in periods of rising oil prices given India is the world’s third-largest importer of oil and rising import costs is a negative for its current account balance. S&P Global Platts, an oil industry data provider, forecasts India’s oil demand to grow by 7% in 2017, faster than China’s 3%—this would be the third year in a row that India outpaces China.
Evidently then, the slump in oil prices in recent years has been favourable for India. Equally, a recovery in prices would be a headwind for the economy. Nevertheless, prime minister Narendra Modi’s government has targeted 10% reduction on oil and gas imports by 2022. Success on this front should reduce the impact on India from the expected recovery in oil prices. Moreover, increased foreign capital inflows in recent years have helped India amass a large FX reserve position. Indeed, Reserve Bank of India has had to intervene in the currency markets to prevent a sharp appreciation in the value of the rupee. Thus, oil prices will need to rise substantially to turn the tables on India’s comfortable balance of payments position—an outlook which we do not foresee.

Source: financialexpress