The benefits of falling oil prices for India

September 25, 2014

(Any opinions expressed here are those of the author and not necessarily those of Thomson Reuters)

The fall in global oil prices couldn’t have come at a more opportune time for India. In August, oil imports dropped 15 percent year-on-year, driven primarily by a fall of $10 per barrel in prices. Brent has fallen below $100 over the past month, and could slip further. Increasing supplies from the United States and slowing demand are contributing to the weakness in prices.

This offers India several benefits. First, the scope for elimination of diesel subsidy. While the government has been steadily increasing the retail price of diesel in the domestic market, the fall in oil prices has nearly wiped off the need for subsidised support. Assuming the rupee stays stable, the government has a golden opportunity to market-link diesel prices.

Secondly, this would help tame inflation. Falling fuel prices have a direct effect on inflation, whereas indirectly they lower production costs for firms with petroleum-based primary input. Many industries such as paints and packaging are beneficiaries. While we can expect companies from these sectors to retain part of the gains, the rest will get passed on downstream and help lower inflation.

Thirdly, lower oil prices help in the management of India’s current account deficit (CAD). At 36 percent, oil constituted a lion’s share of our imports in fiscal 2014. Lower oil prices typically help reduce CAD, although this is not a linear relationship. Slipping oil prices result in a disinflationary environment that, if sustained, supports growth in real GDP.

Finally, falling oil should provide a more conducive environment and more elbow room for the Narendra Modi government to initiate bolder reforms. The government has taken a number of small steps towards de-bottlenecking of clogged sectors such as infrastructure and has shown its intention to work towards kick-starting growth in labour-intensive sectors such as textiles and food processing. Against this backdrop, falling oil prices are a welcome externality.

As if on cue, real GDP growth inched up to 5.7 percent in the first quarter of this fiscal. Even corporate earnings showed improvement, with revenues of an aggregate of 1,001 top listed manufacturing and services firms growing 11.7 percent year-on-year and their operating margin rising 102 basis points (100 basis points make a percentage point) to 17.5 percent in Q1 FY2015. The improvement was broad-based with even small-cap companies reporting a 71 basis points rise in EBITDA margins. If oil prices sustain at these levels, these indicators should improve further.

CRISIL expects oil to remain between $90 and $100 by 2018, though intermittent volatility – such as those caused by the geopolitical unrest in the Middle East – can’t be ruled out. Does this mean benchmark equity indices have more steam left in them? Maybe yes, but in the longer run. Over an extended period, sustainability of earnings becomes important and equity markets usually mirror the growth in corporate earnings. However, the short-term behaviour of markets is usually driven by valuation considerations. At the current level of around 8,000 for CNX Nifty, the one-year forward price-to-earnings ratio stands at over 16.50. These valuations aren’t cheap by any standard and indicate expectations of significant improvement in corporate earnings.

The valuations are also supported by favourable global liquidity. In the United States, the Federal Reserve has shown its willingness to hold on to an accommodative monetary stance for considerable time. The Bank of Japan and the European Central Bank both continue with their expansionary monetary policies. In such a situation, it was only natural that the improving Indian economy attracted liquidity and valuations shot up.

Foreign institutional investors have pumped in more than 260 billion rupees into the Indian equity markets over the past three months. At current valuations, investment in fundamentally stronger companies remains a preferred option. Strong management and corporate governance practices – necessary ingredients of fundamental strength – play an important role in providing sustainability to earnings and in supporting growth. In the longer run, markets usually reward fundamentals more than anything else.

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Let all the benefits of the drop in oil prices be passed on to the people, let the price of gas also be revised according to the drop in price of oil and let the need for bank accounts and aadhar card be removed as the prices have fallen below subsidy levels in India. Let this be done immediately else let the government be removed.

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