Why are oil prices and the Nifty moving higher?

This is the surprising part because the macros appear to be telling a different story.

Aug 07, 2018 06:08 IST India Infoline News Service

In the last few days, we have seen a strange phenomenon in the markets. Firstly, the price of Brent oil, after coming down sharply from $80/bbl levels down to $72, has again moved closer to the $75/bbl-mark. That, in a way, is understandable considering the Iran sanctions. But the Nifty appears to be making new highs on a daily basis. This is the surprising part because the macros appear to be telling a different story.

The RBI has hiked repo rates for the second time in less than two months and higher oil prices hint at higher inflation and a widening trade deficit. Then why is the Nifty rallying so sharply under these circumstances?

What exactly is the story with oil?

Chart Source: Bloomberg

Oil price movements are largely predicated on the twin factors of demand and supply. But oil is never about a single script and there are a number of sub-texts to any oil prices story. What explains the sudden spurt in oil prices?
The 40% rise in oil prices since August last year can be largely explained by the production cut brought about by the Organization of Petroleum Exporting Countries (OPEC) and Russia. That has only been partially withdrawn.
Here is the sub-text:
  1. Supply-side uncertainties: On the supply side, the US has emerged as the largest producer of crude followed by Russia and Saudi Arabia. The fall in Saudi Arabia’s output is one of the supply-side uncertainties putting pressure on oil prices. The bigger issue on the supply side are the proposed US sanctions on Iran. Currently, Iran produces nearly 4.50mn bpd and makes up for a substantial margin of supply in the oil market. With Saudi Arabia banning movement of oil through the Bab-al-Mandeb strait in the Red Sea, the supply pressures are likely to continue.
  2. Demand-side has stabilized: Investor fear in the immediate aftermath of the trade war between the US and China was that a slowdown in trade could result in a fall in Chinese GDP growth and have spill over effects across the world. For now, the impact on demand is not discernible and better sense appears to be prevailing on the trade war front. But demand could play a key role.
  3. Hedge funds jittery due to two-way oil uncertainty: This sounds slightly humorous but the fact is that hedge funds are finding it hard to predict the direction of oil. There are supply-negative factors and there are also demand-negative factors as explained above. As a result, the net long positions in Brent and WTI are at the lowest level since mid-2016. With low speculative F&O positions, any supply shock has the potential to sharply push up oil prices, just as a sharp fall in demand could mean a crack in the prices.
But why is the Nifty at an all-time high?

The massive Nifty rally since 2013 was predicated on weak oil prices. The question is why is the Nifty trending up in the last six months when oil prices have been on a roll?

Considering that India depends on imports for 75% of her daily crude oil requirement, this argument is certainly justified. There could be two reasons to explain this rally in the Nifty:

More beneficiaries of higher oil prices: This is an interesting aspect for the Indian market despite India being a net importer of crude oil. When oil prices were falling, the biggest beneficiaries in terms of profit performance were the mid-cap and the small-cap companies. Among the large-caps, India has a predominance of companies that benefit from higher oil prices. You have upstream companies like ONGC and OIL that benefit from higher realizations. Refiners like Reliance, IOCL, BPCL, and HPCL benefit from a higher valuation that they can get for their inventories with GRMs largely being protected. Downstream companies are largely protected since the government intends to keep petrol and diesel prices as free as possible. Then there are other large companies that benefit from higher oil prices via higher inflation and higher commodity prices, including metals, FMCG, banking etc. Higher oil prices are actually beneficial for a chunk of the market cap of the Nifty companies.
RBI’s masterstroke of front-ending rate hikes: If you noticed the positive reaction of the market to the second rate hike in August, then it was certainly a monetary masterstroke. By combining the rate hike with a neutral stance, the RBI virtually signaled that there would be no more rate hikes in 2018. That element of certainty and predictability has surely helped markets. But above all, two of the most volatile indicators pertaining to the Indian markets -- 10-year bond yields and the value of the Rupee have stabilized. The 8%-mark has emerged as the ceiling for bond yields, while the 69/$-mark has emerged as a ceiling for the rupee. That stability and predictability is worth its weight in gold for the markets. That, probably, explains why the Nifty continues to hit new highs on a daily basis.

In a nutshell, oil prices may be volatile in the range of $70-$80/bbl. In the absence of any extreme price movements, the Nifty is unlikely to be overly worried.

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