Day Of The Drone At The Desert

Last month featured a drone attack on facilities owned by Saudi Arabia’s petro-giant, Aramco. This led to a spike in global crude oil prices and petrol and diesel prices shot up sharply. The RBI Governor pointed out that if crude prices stayed high, India’s trade balance (the difference between exports and imports) could be badly affected.

This is a good moment to think about India’s exposure to crude and gas prices. India imports over 80 per cent of its crude, and 30 per cent of its gas. In per capita terms, India has low consumption of energy. As the economy grows,  energy usage and imports will rise.

Oil and gas are necessary goods. The demand for necessary goods doesn’t change much with price fluctuations. Think of it this way. If the price of petrol halves, you won’t buy twice as much petrol. You will  use the money for something else. On the other hand, if the price  doubles, you will find some way to buy whatever petrol you need and curtail other expenses.  This holds true for the entire economy.

Since demand stays reasonably stable, the price of crude varies a lot with small changes in supply. Given a small surplus of supply over demand, price drops sharply. Given a small supply deficit, price rises sharply.  In the global market, traders and businesses book futures contracts years ahead, to meet  future requirements.

The Aramco attack knocked out about five per cent of global crude production capacity -  the biggest disruption since the Second World War. Hence, the price spike was  expected. Gas prices also move in tandem with crude prices so there’s upward pressure on gas prices as well.

Not only did this attack knock out production, traders are afraid that it could trigger an escalation of hostilities between Saudi Arabia, Iran and the USA. That may lead to future supply disruptions. It’s impossible to predict the likelihood of the many frightening scenarios that may arise.

About 20 million barrels of crude and gas from several nations passes daily through the Straits of Hormuz.  Iran could control the access to that narrow channel and blocked it, at least temporarily. Or, the US might bomb Iranian facilities, or impose even tighter sanctions to financially starve Iran. Or, there could be another attack on Saudi facilities, or even a terrorist attack on US oil facilities.

Investors have to be prepared for such unusual scenarios and recognise that India has no control whatsoever over crude prices. Whatever the price, India will have to pay. At best, India holds around 10 days of reserve supplies in a strategic reserve it could tap in emergency.  If oil prices rise, the trade balance will become very unfavourable (it’s already poor). If imports exceed exports by large amounts, the rupee would slide.

Investors also need to understand that, if crude prices rise, producers of oil and gas can charge higher tariff. But refiners and marketers who buy and refine crude to produce petrol, diesel or kerosene, pay more. So do fertiliser companies. Those downstream industries cannot pass on the higher raw material cost. Their margins get squeezed and they may suffer losses.

India has very few domestic producers of crude and gas. Two major oil and gas producers, ONGC and OIL, are government-owned. They are often asked to sell at a discount to other PSUs such as BPCL and Indian Oil. Refiner-marketers like BPCL and IOC are also often forced to keep retail prices low, for political reasons.

Without that x-factor of tensions between Saudi Arabia-Iran and Iran-US, we could expect crude prices to stay down since global growth is slow. But investors must be prepared to handle a scenario where crude prices suddenly spike and the rupee falls. They will need to go overweight in export-oriented industries such as infotech and pharmaceuticals if this does happen. Any business with an export orientation may be worth looking at, if the rupee falls some more.

The author tracks economic, behavioural and corporate trends, hoping to gauge good avenues of returns