Betting on crude oil drop

Investors could look at financials of non-PSU refiners, rather than relying on state-run actors

The international prices of crude oil have dropped to five-year lows at $65-70 a barrel. Most energy industry entities are expecting further falls through the next year. The demand-supply equation looks straightforward. On the demand side, global gross domestic product (GDP) growth is expected to be low in 2015 and maybe in 2016. Europe, Japan and China are all struggling with slowdowns and recessions. On the supply side, the US shale and tight oil revolution has increased supply and reduced US dependence on imports and the Organization of Petroleum Exporting Countries (Opec) intends to maintain the production levels. There is also a chance of Iran coming off the sanctions list, while production could also ramp up in Iraq and Libya. One school of thought is that the Opec decision may lead to retarded shale development. Many shale fields are reportedly unprofitable at under $80/barrel and lower prices will make shale/tight oil financially unviable. However, a recent estimate also claimed that most of US shale will hit breakeven at $42/barrel and since prices are well above that, shale might not be so badly affected.

Low crude oil prices are a windfall for India. Crude, coal and gas prices are falling in tandem. Given that 80 per cent of crude oil is imported, along with one-third of gas and significant amounts of coal, the balance of payments will be under less pressure. Energy subsidies will also reduce and this makes it easier to manage the fiscal deficit. Ideally, there may be a decontrol of kerosene and cooking gas.

Two things could derail the current downtrend. One is some geopolitical explosion that crimps supply. ISIS could complicate things, for example. The Russia situation is also volatile. If the rouble collapses, or inflation spirals to unacceptable levels, Putin will find it hard to maintain stability.

The second situation that could lead to a trend reversal would be an unexpectedly quick recovery in global economic activity. The global demand-supply balance is delicate. A two-three per cent dip in anticipated demand has led to a 35 per cent drop in price. If growth picks up, crude oil prices could move back till the $120 level as easily.

Analysts will be running models and assigning different probabilities to such events. They will also be looking at potential changes in world supplies, given price trends. Oilfields and gas fields are developed on the basis of anticipated prices. Crude oil prices also affect the development of renewable capacities. While this trend of lower prices may last for a fair length of time, it will not last forever. The government can use it as a breathing space to improve the fiscal balance. It would be sensible to use this to cut the fiscal deficit.

Low prices also make it possible to decontrol fuels at a point of time when it doesn't hurt. Then, by the time the cycle changes and prices start rising, consumers would be more inured to coping with the concept of paying market price.

But for example, building generation capacity on the assumption that prices will perpetually remain at low levels would be stupid. Yet, this is exactly what happened when gas was struck offshore at KGD6. Entrepreneurs assumed that domestic gas supply would be ample and prices held down. Those gas-based generation units are now utterly unviable. Another example of poor policy is the current decision to raise excise duties, without passing on the hikes to retail customers. It is sensible to raise excise duties. As crude oil price drops, the retail price could be kept more or less stable with the government skimming off a larger chunk of excise and customs duties. This would help reduce the fiscal deficit.

But the oil marketing PSUs should be allowed to reap profits, instead of the insistence that they absorb the excise duty hikes. In a related development, the Centre should not have reduced LPG rates for "unsubsidised" gas cylinders. Instead, it should have gradually hiked the rates for subsidised cylinders. There have been multiple occasions when analysts have looked at the energy sector and suggested investing in oil and gas businesses on the basis of changes in the global crude/gas cycle. But most of these businesses are PSUs. In theory, the PSUs in O&G retail/marketing will gain from decontrol, given lower input prices. Upstream PSUs will also gain because they won't have to subsidise the downstream players. But the barrier to such investments remains arbitrary policy. The government cannot be relied to take sensible commercial decisions. Those comfortable with commodity futures could go short on crude oil. Or investors may look at the financials of the few non-PSUs in the refining space since these businesses should also gain from lower crude oil prices.