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Grim Times Ahead

Continue passive broad investments & go overweight on crude, gas and coal producers…

Two separate crises have brewed up in Japan and West Asia-North Africa (WANA) in the last month. Earlier, the impact would have been isolated. Today, given that every major economy intersects, the two separate crises will have a combined impact on the global economy.

The destruction and loss of life caused by a massive earthquake, followed by tsunami and then a nuclear disaster in the world’s third-largest economy has to hurt. It’s impossible to quantify. But the effect cannot be positive, and it may be very negative.

Instead of growth that might have helped revive global GDP, Japan will see GDP contraction. For comparison, the Kobe earthquake of 1995 led to a 2 per cent contraction in Japan’s GDP and it was followed by several years of negative growth in Japan.

In addition, the nuclear power industry will suffer from such a public disaster. Plans to build new nuclear capacities, in India as well as elsewhere, will be put on hold or reviewed. This means the global energy mix could change from current projections, as the share of nuclear power is cut back.

That’s where WANA enters the picture. Turmoil across Arab nations in the past four months could have a huge impact on energy markets as well as on Islamic radicalism. Tunisia and Egypt have seen regime changes with dictators thrown out by civil unrest. It’s unclear what the successor states will be like.

Libya is in a civil war and UN-backed international forces have intervened. Bahrain has been invaded by Saudi and UAE forces supporting the current regime. There are a dozen other Arab states where shaky dictatorships may be in trouble.

WANA produces most of the world’s oil and gas exports. Dependency on crude will grow with nuclear energy out of the equation, until the very long-term, when alternative energy sources may be developed. Libyan supply disruption is guaranteed for a while.

If WANA sees massive political change, successor regimes would be run by people who want a large slice of the pie. It doesn’t matter whether successor regimes are democratic, run by military strongmen, Islamic militants or some mix of the above — any ruler would want to control oil.

Oil price spike inevitable
Realignments of contracts, etc., will likely result in supply disruptions and price spikes. In fact, price spikes have started in anticipation. In addition, if radical Islamic regimes take control, they may use oil as a weapon just like OPEC did in 1973, after the Yom Kippur War, to punish governments they don’t like.

Bearish for India
All this sounds bearish. Especially for India with its inefficient energy sector and massive dependency on imports. It isn’t only crude and gas. Coal imports are increasing as well and coal prices always rise in tandem with crude. In fact, Coal India (CIL) hiked prices by an average of 20 per cent in the past three months.
Given rapid GDP growth, Indian energy demand is bound to increase and so will imports. As a rough rule of thumb, energy demand will grow at least as fast as GDP grows, probably faster, for the next several years.
The Government of India (GoI) has no control over international prices and imports must be paid for in hard currency, at going rates. If those prices are directly reflected in domestic energy costs, it means inflation. If those prices are not reflected directly due to subsidies, it means large burdens for government finances and financial ruin for PSUs forced to sell at loss. Subsidies also mean inefficient use of fuel by consumers.
It’s a tough problem for policy-makers. All the Budgetary estimates could go haywire. Most assumptions saw crude prices ranging between $85-100 per barrel through 2011-12. Beyond that range, inflation estimates go up and growth estimates, down. It is now very likely that fuel prices will be considerably higher than the assumed band.

Surplus refining capacity a positive
One point in India’s favour is that domestic refining capacity is already surplus to current needs and most players have expansion plans on the table. High crude prices hit gross refining margins (GRM). This could actually be a positive. Indian refiners have very competitive GRMs. The re-export of value-added petro-products allowed private refiners like Reliance to reap a bonanza in 2007 and 2008.
If that scenario repeats, earnings from petro-product exports would keep the trade deficit in check by offsetting the burden of higher crude prices. The trade balance therefore, is probably not a cause for major concern, though a slow global economy will mean lower export earnings on other fronts.

Review policies
The external crisis will certainly force the Indian government to review its current energy policies, just as the 1991 oil-crisis forced overall liberalisation and reform. This is another positive. Indian governments avoid reforms except when they gain the courage born of desperation.
Many bits and pieces need review. The diesel subsidy needs to go if the GoI is to maintain its fiscal health and if marketing-refining PSUs are to survive. The kerosene subsidy needs to go. The LPG subsidy needs to go. The gas allocation policy and discriminatory gas-pricing need to go.
The gas pipeline authorisation policy needs review. Exploration & production (E&P) needs to be given a boost by rationalising and extending tax holidays. City gas distribution needs speeding up. E&P of coal needs a boost and the allocation of captive coal for power plants needs rationalisation. So does the allocation of coal-bed methane blocks.
These involve politically sensitive decisions that any given government would prefer to avoid. Most of these reforms have been talked about since 1999 and no government since has actually taken hard decisions.
The Nilekani Committee is supposed to find ways to directly subsidise lower-income consumers of LPG and kerosene. This would imply lower-income consumers being handed money directly, while kerosene and LPG prices are linked to market rates. That reduces some of the burden on consolidated government finances and prevents wholesale adulteration of diesel with kerosene. Freeing diesel pricing would help even more and may actually make PSUs financially viable.
Even so, it’s not a pretty picture. Producers of crude and gas such as RIL and Cairn should be worth buying — especially so, if the GoI doesn’t insist that ONGC, OIL, etc. share the subsidy burden. If there is substantial reform, it may even be worth looking at PSU refiners like HPCL, IOC and BPCL. There are possible investments in pipelines and CGD on the horizon.
The rest of the Indian economy will, frankly, struggle if there is a growth slowdown, coupled with higher inflation. That scenario looks increasingly likely. This should bring share prices down across the board as indeed, one has suspected would occur even before the crisis broke.
The formula for an equity investor would be to continue passive broad investments on a systematic basis. You get low average prices with this strategy and it would pay off in the long run, once things get better. At the same time, you should be looking to go overweight on crude, gas and coal producers. The third category is most confusing. Apart from Coal India, investors need to focus on corporates like JSW Steel, which have tied up coal imports.
Finally, it is quite likely that the alternative energy plays in solar and wind will receive a boost. There aren’t too many listed companies in this space but anything that’s available will probably be worth looking at. So would IPOs.