Nov 13, 2017
“It is dangerous to make forecasts, especially about the future.” – Yogi Berra
The Dark Knight for the markets – crude oil – has risen, after a roughly 3 year hiatus. Crude has been, directly or indirectly, a contributor to every major recession going back to 1973-74. The situation today is evolving into a geo-political chess game that bears close watching.
It Started with a Meeting in the Desert
A Who’s Who from industry and politics were invited by Mohammed bin Salman to Riyadh in Oct-17. Stephen A. Schwarzman (Blackstone Group), Masayoshi Son, (SoftBank), Steven Mnuchin (Treasury), Peter Thiel, Laurence D. Fink were amongst 3,500 invitees collectively in control of roughly $22 trillion in assets.
The Trumps and Saudis Have Met Thrice This Year
Separately, President Trump’s son-in-law and senior adviser Jared Kushner returned recently from his third trip to Saudi Arabia this year, where he’s purported to have met Mohammed bin Salman as well.
An Aramco IPO or a 5% Stake Sale?
On the table is Saudi Arabia’s Aramco listing, which started out with an initial valuation of roughly $10 trillion. Since then, the value has settled at roughly $1 trillion, with some estimates as low as $400 billion. The U.S. is exerting pressure that Riyadh move forward with an IPO listed in the U.S exchanges. China has purportedly come forward with a $100 billion bid for 5% of Aramco, to ensure continuity of oil supplies. Saudi Arabia’s choice is sure to have repercussions in the geo-political arena.
Saudi Arabia’s Precarious Budgetary Situation
The Saudis, along with some other OPEC producers, are in the midst of a budgetary crisis, as a result of a failed strategy to bankrupt shale producers. The Saudi Prince also met with the world’s leading Hedge funds and oil traders a few months ago to understand what would cause them to go bullish on crude oil.
Crude Oil Has Been a Contributor to Every GDP Slowdown Since 1974
The Russians Appear Content to Extend Production Cuts
The Saudis recently met the Russians. The Russians would appear perfectly willing to let Crude rise. The Saudis need Crude to remain robust for the next year at minimum as the Aramco IPO comes forward, or a potential off market sale occurs with the Chinese.
Brazil Has Rejected OPEC Overtures
Meanwhile, Brazil has rejected an informal effort by Saudi Arabia to coax Latin America’s top oil producer into joining OPEC-led production cuts aimed at boosting prices that have been hit by oversupply.
The U.S. Would Be Wary of an Oil Spike
One would suppose the U.S. is keenly aware of a crude spike exposing the economy to a painful tailspin. Their concern is obviously mitigated by the rising shale output coming out of the U.S. We would further presume that the U.S. would be content with a controlled rise in Brent, and a widening Brent/WTI spread.
Rising crude prices will help shale producers. Already the rig count has risen in the U.S. and with the dramatically declining cost of shale production, we would expect U.S. supplies to come forward. U.S. crude oil production was up for the week ending 03-Nov-17 at 9.620 million barrels per day, a new high for 2017 after reaching a high the week prior. Incidentally, India received its first shipment of U.S. shale last month, as part of a roughly 8 million barrel consignment.
However, shale production may not be enough to offset the rise in demand and the lack of investments the past couple of years in exploration and production. So supply is an issue of concern.
A Consensus in the Middle East Remains Unclear
Saudi Arabia is also in the midst of tense relations with Iran, a country that benefitted from the prior agreement on production cuts. Whether the OPEC can manage to keep the cartel together remains to be seen.
Meanwhile China and India Both Remain Vulnerable
The Chinese are painfully exposed, as is India, and most of Europe. China, India and Europe are clearly in favor of oil at current or lower levels. The U.S. would appear to favor oil at current levels as breakeven prices for key shale projects are now below $40 per barrel.
Breakeven Prices for Key Shale Projects Are Below $40
Crude Is An Expensive Problem With Repercussions Across Macro Factors
Rising crude prices would be visible in rising inflation, rising interest rates, lower investment, higher fiscal deficit, higher current account deficit and a weaker exchange rate.
The Union government reduced excise duty by Rs. 2 per litre on petrol and diesel last month; this was followed by a reduction in value-added tax by states such as Gujarat and Maharashtra. More such moves in the run-up to crucial state assembly elections in 2018 and the general election in 2019 could strain government finances at the aggregate level. Reduced revenues would then impact public investments and growth. GST brings further uncertainty related to revenue and economic activity.
With worldwide consumption of 96 million bbl per day crude oil, India is the world’s third-largest consumer, importing 4.4 million barrels per day. The import bill for crude rises by $1.33 billion for every $1 rise in crude oil prices. A $10 rise in prices means a $13 billion rise in import cost of crude, or roughly 80k crores. While it’s early days to start re-thinking the fiscal math, it’s certainly on the radar as a cause for concern.
A Further Rise in Crude Can Send Yields Above 7%
Earnings Muted at Index Level But Much Better Than Would Appear
While earnings at a consolidated level look mediocre, it’s instructive to note that Consumer Staples and Discretionary earnings are up 7.0% and 11.2% YoY respectively. The consumer is doing fine. Energy is up 10.7%, also doing fine. Financials – excluding PSU banks, Axis Bank – particularly NBFC and Private Banks are over-valued but doing fine. Incidentally, PSUs are reporting better results so it would appear the sector is basing. Industrials and Materials are doing well. The real estate sector is showing signs of a recovery in corporate earnings. Information Technology remains impaired and low single digits is what we expect. Pharma is possibly bottoming. Utilities are doing well. The picture from a sectoral perspective is better than expected.
CNX 500 Earnings Are a Mixed Bag, but the Consumer Looks Healthy
So the story at the index level remains that PSU banks, Pharma and Telecomm are dragging down earnings. Interestingly, each of these sectors are recovering. Much of the market is delivering good earnings growth.
Policy Choice – Fiscal Prudence, Borrowing, Spending, Inflation
The government faces a policy choice. Excise duty per litre of petrol and diesel are Rs. 19.48 and Rs. 15.33, respectively. Should the government choose to subsidize any rise in crude, fiscal borrowings or government spending are likely to be impacted.
Should the government choose fiscal prudence, inflation looks set to rise, the exchange rate weaken, rates rise, consumer disposable income decline. The tax on the rural poor will be especially steep, something the government can ill afford with a busy election cycle upcoming.
The Mexican government has since 2005 been consistently hedging against declines in the cost of crude by buying puts. India would be well advised to put in place a call hedging strategy on crude every year to mitigate price risk.
All Eyes on Nov 30th OPEC Meeting…
Attention shifts to the OPEC and non-OPEC countries meet in Vienna on 30-Nov-17. The organization is seeking to achieve a consensus agreement before then on how long to extend a global pact to curb oil production.
Shale Vs OPEC
For a couple of years, shale has acted as a cap on crude. That thesis will be tested in coming months. We expect the U.S. will actively increase production. It remains to be seen if the Saudis are effective in cutting production and holding the cartel together.
Fixed Income – Rate Outlook Dependent on Geo Political Strategy and India’s Response
Our view a fortnight ago was that rate direction would be set by government borrowing plans. We recommended conservative corporate bond funds, and away from duration.
Fiscal borrowing and the deficit was already a concern before the rise in crude oil. Yields have risen to 6.94% on the 10 year bond and the outlook on rates will now be determined by geo political strategy, and India’s response. We’ve stayed away from duration and would continue to stay away, but at some point in coming months, duration and the long end will start to look attractive.
Should crude continue to rise, it will get incrementally tougher to remain optimistic about equities amidst high valuations. Earnings growth over the past 3 years has been dismal at the index level. For the past year, it appeared evident that earnings were likely to come through, but painful reforms delayed the recovery each time.
We expect the government to take a measured approach. The Rs. 2 cut in excise was indicative that the government is prepared to absorb some pain without sacrificing fiscal discipline. The Union budget for 2017-18 has assumed an average crude price of $50-$55 per barrel and so the government’s fiscal math will need to be re-assessed.
On the domestic front, earnings to date have been reasonably good. As usual, a third of the market continues to deliver stellar earnings growth. The current regime understands the importance of reviving economic growth. Signs of a recovery are visible in consumer, and real estate sector earnings, and the government will be keen to keep the momentum flowing. Domestic flows will continue to provide support to the market.
The global macro picture becomes more complicated with crude back in the mix of risks to consider. There’s a geo political chess game unfolding. The outcome globally on crude, and India’s policy response and fiscal plan will provide further clarity on the prospects for equity markets.
Quarterly Earnings 2Q FY18
67% of Companies Have Met or Exceeded Expectations in the Nifty 50 To Date…
60% of Companies in the CNX 500 Have Met or Exceeded Expectations To Date…
Upgrades / Downgrades Are Healthy at 2:1 for the CNX 500 But Only 1.2:1 for the Nifty 50…
Upward Earnings Revisions Have Been Strong In Energy & Materials… …And Weakest In Information Technology, Financials and Industrials
One Third of Companies Are Delivering Strong Sales Growth… …And 62% of Companies Are Delivering Strong PAT Growth Above 10%
…And a Majority 54% of the Market Remains Expensive With a P/E Above 30
After couple of weeks of rally, market witnessed profit booking as the Nifty lost 1.25% for the week to close at 10322 levels. From the below weekly chart it can be seen that index has touched rising resistance trend line and witnessed some retracement. Thus, market may see further profit booking if it fails to hold Friday’s low. Immediate support zone for the market is seen in the region of 10200-10125 levels. Here cluster of previous swing highs and lows is seen which will act as support for the market. In the Nifty option too, 10200 strike price has the highest open interest suggesting a strong support for the market. Below 10125 levels next support level for Nifty is seen at 9950 levels. On the daily chart index has formed bullish hammer candlestick pattern suggesting market can see bounce back if it holds the low of 10254 levels. On the upside immediate level for Nifty is seen at 10525 and above that 10650 levels. FIIs have been net buyers in equity segment this month to the tune of Rs. 9237crores (provisional). But in index futures they have been net sellers to with Rs. 6863 crores suggesting hedging of long positions. INDIA VIX measure of volatility has seen a jump in last one week of 13.18% to 13.48 levels. Thus, further spike in VIX will be cause of concern for the market and lead to pressure in the market.
Nifty Weekly chart