Nimble traders will get ample opportunities

Volatility centred on energy prices is very likely due to crisis in several parts of the world

The ongoing civil war in Syria, which has already claimed close to 500,000 lives, has also triggered a potential crisis in Iraq. Hardline Islamists are now threatening the Iraqi regime. We might even see a strange alliance between the US and Iran, to shore up the Iraqi government. There is also an ongoing crisis in the Ukraine, where Russia could end up annexing chunks of the eastern region of that country.

Taken together, these events could have a huge impact on international prices of crude-oil and gas. Russia could raise gas prices if it is pressurised via sanctions. Instability in West Asia could translate into upward pressure on crude prices if there are fears of supply disruption. In fact, there have already been reactions across global financial markets due to Iraq.

Given India's position as a net energy importer, spikes in crude and gas prices have immediate adverse impacts on the economy. Higher crude prices inflate the trade deficit and have an inflationary impact on the domestic economy. Given a policy of subsidies in retail prices, and fertiliser subsidies as well, higher international prices also lead to a larger fiscal deficit.

If crude prices spike in a sustained fashion, it will be an acid test for the new government. There are strong expectations that the retail prices of petrol, diesel and kerosene will be rationalised and subsidies reduced, or gradually eliminated. Doing this will become a more urgent priority if international prices rise sharply. The method of gradually increasing retail prices in a staggered fashion might have to be abandoned for big hikes.

If gas prices rise (these tend to be somewhat correlated to crude prices, apart from possible Russian action) the new pricing formula will also push up costs of domestic gas. There are downstream effects to be taken into account as well. Huge gas-based power capacities are idle or under-utilised at this instant. Power rates would have to be raised to bring those capacities into play. In addition, the mechanism of fertiliser subsides would need to be reworked, gas is feedstock for fertilisers.

The immediate impact of crude and gas price volatility on the stock market will probably be sell-offs across the energy sector. This would be modified once the markets got a sense of likely policy action.

Broadly, higher crude prices means lower refining margins. In a free market, upstream producers make higher profits when crude prices rise, while there is a squeeze on the margins of downstream operations in refining and marketing. Ideally, of course, businesses are integrated across the value chain and, indeed, Reliance Industries Ltd (RIL) has attempted to become as integrated as possible. But the drop in production at Reliance's offshore field, KG-D6, means even RIL is not fully-integrated in effect.

If the subsidy mechanism is quickly rationalised, marketing public sector undertakings such as BPCL, IOC, HPCL, etc, would be hit less hard than if the present system continues. Upstream PSUs like ONGC and OIL would also get a better deal if they are not forced to share the subsidy burdens with their downstream PSU compatriots. However, the broad inflationary effect of high fuel prices might not be something the government is prepared to stomach. This is especially true given the predictions of a poor monsoon.

Traders have already started taking speculative long positions in crude contracts. The next week to 10 days could see a great deal of volatility in share prices of stocks across the energy sector. If the Iraq situation settles, crude prices will stabilise. If Iraq escalates, crude prices will rise.

It's impossible to make concrete predictions about a fluid situation like this. As news breaks and is absorbed and discounted, price trends could change rapidly. Volatility centred on energy prices is very likely and nimble traders should be prepared to exploit opportunities as those arise.