How to side-step oil price risks

Aarati Krishnan | Updated on March 12, 2018

Ever played whac-a-mole in an amusement park? It's a popular game where you score points by taking a whack at annoying mole-like creatures that keep popping up from holes in a wooden cabinet. Investing in the Indian stock market has begun to resemble this game quite closely today. Just when you thought one particular problem has been knocked out of the way, there's another cropping up! Look at the totally unexpected action in crude oil prices this week. Just a few months ago, no one would have dreamt that oil would cross the $100 a barrel mark, with global growth looking quite sluggish, Europe mired in debt worries and no political upheavals in sight. But in a matter of weeks, the picture has changed. We now have a surprisingly strong recovery in the US, resurgent global demand for commodities and political uprisings in the Arabian countries which threaten to upset the finely balanced global oil market.

Potent risk

Whether the recent spike in oil is a mere flash in the pan or a structural change still remains to be seen. However, investors should note that, of all the new risks that have surfaced for the Indian market in recent weeks, the spike in oil prices is the most potent. The reasons for this are manifold. With its significant external dependence for crude oil (60 per cent of it sourced from Middle East and North Africa), a rising non-oil import bill and adverse trade and current account balances, the Indian economy is today far more vulnerable to a slowdown triggered by soaring oil, than most other developed or even Asian economies.

That the prospect of a rising import bill comes amid pullouts by FIIs (foreign institutional investors) makes the problem worse. An improving US economy and cheaper valuations in developed markets have prompted FIIs to reduce their emerging market exposures this year. If crude oil imports bloat India's deficit and the Rupee weakens, they may turn even more wary of Indian stocks.

There is also the fact that the Indian stock market offers very few opportunities for investors looking to make money from soaring oil prices. Oil exploration, marketing and refining companies make up about a 13 per cent weight on the Nifty, but they are only partial beneficiaries of rising oil prices.

Artificially low retail prices for most oil products, the absence of a market-linked pricing mechanism for oil marketing companies, the resulting subsidy burden and the ‘sharing' of subsidies by upstream oil companies make sure that none of the large Indian oil companies can benefit from soaring crude oil prices. Even Cairn India, which does stand to gain, has uncertainties hovering over it in the form of its pending takeover by the Vedanta group. In contrast, the US or European markets feature a raft of companies that could gain from a sustained rise in crude oil prices, whether it is oil producers such as Exxon Mobil or allied players such as Halliburton. For institutions such as Exchange Traded Funds, which are looking to invest in India mainly through the index route, the low ‘oil' weight in the index will be a key deterrent.

What to avoid

So how should domestic stock market investors respond to this new risk? Given that the market has already corrected substantially, liquidating a big portion of your portfolio at these beaten down prices, is not a good move. However, as these developments do point to muted FII flows, it would be best to take new investments in cautious doses. You can certainly change your sector choices too, to sidestep ‘oil price' risks. Oil marketing companies are obviously a strict no-no until the government clears the air on how it plans to apportion the additional subsidy burden. You should also limit exposures to companies from the consumer space that peg their input costs to oil or petroleum-related products.

Airlines, whose margins are strongly linked to aviation turbine fuel prices may face a setback, especially as they face resistance to tariff hikes. Fertiliser makers too would be exposed to escalating prices of inputs such as naphtha, gas and ammonia.

Makers of detergents (who use linear alkyl benzene and plastic packaging) and paints (about a third of materials are oil-linked) are two sectors to avoid until they pass on cost increases to consumers. In fact, with most commodity prices on the ascendant, pricing power may be the one key ingredient that investors should look for while they select stocks in the days ahead.

Published on February 26, 2011

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