Economy

We don’t see crude oil in our daily lives. But numerous ways in which it touches our lives, will leave you stunned. Petrol, diesel and kerosene are the obvious derivative products of crude oil. But nylon, plastic containers, bags, tires, medical equipments, etc. are also made from by-products of crude oil.

So no matter who you are and what you do, the prices of oil have and will impact you on daily basis. Price of this commodity has the potential to bring down entire nations to their knees.

This is the reason why the world has a perennial affection for discussing crude oil prices.

And when we are regularly discussing investments and economic factors here, we should necessarily give some time to improve our understanding about oil prices.

World Oil Market

Till mid-2000s, production of oil was dominated by middle-eastern and OPEC countries. But after decades of decline, oil production in US started increasing rapidly. This was due to technological advancements which allowed extraction of oil from complex shale rock formations.

Russia too made tremendous headways in increasing its production, in order to increase its geo-political influence.

So now, even though OPEC countries are still the largest producer of crude oil (as a group), US has overtaken Saudi Arabia on a standalone basis. Third in list is Russia.

The table clearly shows that the clout which Saudi and OPEC had till few years back has now reduced. And this is the reason why OPEC is playing geo-political games to regain market share. We will come back to that in a bit.

Factors Affecting crude Oil Prices

Theoretically, prices should be determined by supply and demand factors.

Between 2000 and 2008, oil prices rose as global economic growth increased the demand for energy worldwide. But supply could not keep pace with demand and this resulted in oil reaching highs of $140 a barrel. The financial crisis of 2008 reduced worldwide oil consumption and this combined with increasing OPEC production, led to a collapse in prices.

Now crude oil has very dynamic and high-volume futures markets. So apart from actual demand and supply, prices also reflect traders’ own view of future demand and supply of crude oil. These views (aggregated) at times become so strong that they tend to severely impact actual oil prices.

But that’s not all.

There is another big factor that determines the direction of oil prices: Geo-Political Motives. And when that happens, forces of demand and supply take a back seat.

Why are Oil Prices Down Now?

Oil prices recently made multi year lows (<$35) and reasons for it are not hard to guess. The world economy is facing economic turmoil. China, the main engine of world’s growth has been plagued with internal problems and doesn’t seem capable of getting back to its high-growth days. So demand for oil is not increasing as earlier.

On the supply side, US has become the largest oil producer. Though it doesn’t export much, its imports have come down, thereby creating a lot of spare supply across the world.

The erstwhile oil kings, i.e. OPEC (mainly Saudi Arabia) have taken a unique step this time. Instead of cutting production to reduce supply and prop up prices, they have decided not to sacrifice market shares.

This move is expected to force high-cost shale oil producers to shut down. This will also bring serious financial difficulties for countries like Russia and Iran, which depend on oil revenues to pay for their social programs and investments.

So OPEC is actually trying to push the competition to the wall. And it can comfortably do it because low production costs allow it to make profits even at low crude oil prices. Add to this the fact that OPEC nations are sitting on reserves of almost a trillion dollars and it’s clear that they can withstand low prices for many years.

Their competition on other hand cannot. They will be forced to close down as their breakeven prices are much higher than the current prices.

So with closures, the production will fall and lead to recapturing of market share by OPEC. And once equilibrium is attained and production decreases, prices are expected to rise again.

Who Benefits & Who Doesn’t?

The current low price scenario has divided the world into three parts: ?

• First are non-OPEC (Russia, US, etc.) and weak-OPEC producers (Nigeria, etc.) which are losing money. Some of these countries lose a billion dollars worth of revenue with each dollar fall in oil prices.
• Second part is that of strong OPEC nations (Saudi, etc.) – which due to above discussed reasons, can still sustain for many years.
• Last are the lucky benefactors – countries like India that import oil for most of their energy requirements. These have benefited immensely from low prices as it has helped reduce the current account deficit. India is also getting a shot at increasing its energy security by purchasing resources abroad at distressed prices from producer countries.

Future of Oil Price

No one can perfectly predict the future of oil prices. But there are indicators that low oil prices are here to stay. OPEC will continue to flood the market as it has deep pockets. Non-OPEC supply will fall but not as drastically as everyone expects as these countries will not go down without a fight. Demand is also not expected to increase suddenly as main consumers like China are facing deep economic troubles.

So the gap between supply and demand will take some more time to narrow. Oil experts expect oil markets to move closer to some kind of a balance by 2017-18. But oil has a history of sudden spikes and crashes. Prices can flare up due to random geo-political conflicts or supply disruptions. They can also sink without warning if something like the fear of collapse of Chinese economy materializes.

As far as India is concerned, the overall impact on economy will be positive as inflation would remain under control and allow money saved on oil imports, to be used for more productive purposes. But till the time prices don’t recover, brunt would continue to be borne by upstream oil companies (producers).

Read more: About Research and Ranking.

What is Brexit?

Few days ago in a referendum in Great Britain (UK), almost 52% people voted in favor of detaching UK from the European Union (EU).

This is what is being referred to as the Brexit (Britain + Exit).

                                                                                      Source: Livemint.com

EU is an economic and political alliance of 28 European nations formed to enhance Europe’s clout in the global economy.

The idea behind formation of this alliance was pretty basic. Years ago, European leaders felt that Europe as one entity would be much stronger if it had a common market, shared institutions and a common regional currency (Euro), than what it would be if it operated as a collection of independent and competing units (nations).

But the results of the latest UK referendum show that people of Britain instead believe that they are better off without being a part of the EU.

Most in Brexit camp feel that the UK was unnecessarily forced to carry the deadweight of economically weak countries in the EU. And as an extension of this belief, it was increasingly being felt that going alone was the way forward to achieve better economic and geo-political strength.

What Happens Next?

There is still a long way to go before Brexit becomes a reality.

As of now, only the people of Britain have voted in favor of leaving the EU, i.e. this is the will of the people expressed in the referendum which is not legally binding.

So the Parliament still has to pass the laws that will actually initiate the process to pull Britain out of the EU. This requires activation of Article 50 of the EU Treaty. And once that happens, it is a 2-year long process for negotiations to take place between the EU and the UK.

But the current prime minister has resigned and made it clear that he is not the one to invoke Article 50 as he was not in support of Brexit. So it will take some more time before the new PM takes over and initiates the process of Brexit.

In near term, there are high chances that UK will face a recession due to uncertainty surrounding the impact of Brexit.

Though the Bank of England has said that it is prepared for any economic eventuality, the risks have nevertheless increased and Pound, UK’s currency is also expected to depreciate against other currencies.

Chances of corporate investments drying up are also real as businesses might consider postponing their investments if they eventually need to take a call of staying in Britain (which will limit businesses’ access to EU) or move out into EU (which is a bigger and more lucrative market).

But irrespective of what the consequences of Brexit are, one thing is pretty clear. This development is a big blow to globalization. Free trade agreements, opening of national trade borders, monetary union of countries – all these will be nullified to some extent when Britain exits EU. The development will also hurt the economic sentiments across the world and put further brakes on an already-slowing-world-economy. 

More ‘exits’ like Brexit in Future?

This is a real possibility. Many believe that Britain’s exit will start a new trend among other EU nations to leave the union. People of economically stronger EU members like France, Germany, etc. are showing signs of restlessness for having to pitch in for weaker EU members (like Greece).

So economically strong countries do indeed have reasons to move out of the EU.

But if more exits take place, future of EU and the Euro are in big jeopardy. The benefits of staying in EU should outweigh those of leaving it, if EU has to survive.

And if all strong members decide to leave the EU, then just having economically weak nations in the EU will defeat the very purpose of group’s formation.

But at the risk of sounding speculative, it does seem that remaining 27 countries in EU will have to work towards countering the negative impact of the Brexit for time being.

The US Fed might also avoid increasing the rates for some time as it might destabilize the precarious balance of the world economy. These factors will further influence currency movements and eventually, the prices of commodities.

As for gold, the outlook is bright as people will flock towards this safe haven in light of increasing political and economic uncertainty in the world economy.

Impact of Brexit on Indian Economy

There is no doubt that the Brexit is a big event as far as global economy is concerned.

So there is bound to be some impact on the Indian economy. Indians not only need to keep an eye on Britain but also on what the other countries of world plan to do in an era of Britain-less-EU.

As far as the direct linkages with Britain are concerned, the numbers are pretty small. Britain alone accounts for only 3.4% and 1.4% of India’s merchandise exports and imports respectively (FY16). The FDI flows too have been less than a billion dollars each in last two fiscals (Source: Finance Ministry and RBI).

But nevertheless, the increase in global risk aversion is expected to negatively impact the inflow of funds (both FDI and FPI) from Britain as well as other nations.

As of now, it is very hard to make a case of any meaningful impact of Brexit on the Indian economy and hence, markets too are expected to recover quickly if they fall in near term.

Interestingly, with Brexit getting all the attention, people are ignoring the continuous improvements that Indian economy has made in recent past. Have a look at some of the parameters below:

In spite of operating in a troubled global macro scenario, the fundamentals of the Indian economy are steadily improving and the long term outlook remains positive. Infact, a near term correction due to global events might be a good opportunity for discerning investors to buy shares of fundamentally sound companies at lower prices.

Impact of Brexit on Indian Companies

Impact of Brexit on Indian economy is one thing and that on individual companies is another.

Sooner or later, Indian companies doing significant amounts of business in EU or Britain will be affected. Though Brexit is about Britain exiting the EU, it will change the dynamics of how companies operate in both regions and will definitely affect the access and movement of goods and services across Europe.

Initial analysis shows that the Indian companies that have operations / subsidiaries in the UK will be impacted. Some companies have used UK as a base to export deeper into the EU. Such companies might even need to set up separate control centers for UK and EU and renegotiate their contracts. The volatility in currency (both Euro and Pound) will straightaway hurt the revenues and profits for most of these businesses. As of now, some of the automobile, IT and metal companies seem vulnerable.

But in past, the economic upheavals at global level have given Indian investors good investment opportunities.

Will it be the same this time around is difficult to say? But just have a look at the table below (& this article and you will understand the opportunity that Indian investors might get if markets do go down:

Barring Kargil War (in above table), rest of the events were global in nature and returns from there on range from good-enough (12%) to great (20%).

So, whether the Brexit will have an impact on Indian economy or not is the wrong question to ask. The world is so interconnected and complex that there is bound to be an impact. Only question is the severity of the impact.

But having said that, one should also not forget that India is a long-term growth story, which is already on a roll.

A lot of investments and economic decisions in last two years have set the stage for the next Bull Run. These steps are expected to benefit many companies in sectors like Railways, Power Transmission and Distribution, Mining, Roads and Urban Infrastructure. This view combined with the fact that Indian markets are currently available at attractive market cap / GDP levels; it becomes clear that for long term investors, there is nothing great to worry about.

Instead, regular investments and that too in the right stocks should be given more importance.

Read more:  How Long-term investing helps create life-changing wealth – TOI.