Higher oil prices – the macro impact
For India, the immediate impact of higher oil prices is on the trade deficit as India still relies on crude imports for ~75% of its daily oil needs. But a higher trade deficit is only the macro impact. It impacts individual portfolios in two very distinct ways. Firstly, higher oil prices mean higher inflation. It is not just about the 2.4% weightage that crude has in the CPI inflation basket. It is all about the strong externalities of oil as it has a downstream impact on every conceivable commodity. Higher inflation means pressure on bond yields and that is not positive for stock markets. Secondly, there is a bigger problem of the rupee weakening. When the trade deficit and the CAD move up, the first casualty is the INR. Weak INR impacts sentiments and leads to FPI selling as we saw so eloquently displayed last year. The impact of higher crude prices and weaker rupee is most visible on the mid cap and small cap companies that are most vulnerable.
What higher oil prices mean for banks and financials
You may wonder why banks and financials should be impacted by oil prices but there is an important linkage. Banks and financials account for nearly 38% of the total Nifty weightage, and hence is almost a proxy for the Nifty. Higher crude prices means higher inflation and that has a direct impact on the bond yields. Higher bond yields hit financials in two ways. Firstly, there is the impact on bond portfolios (the ones that have to be marked to market). Secondly, higher bond yields lead to higher cost of borrowing and that means greater solvency risk for companies.
Crude prices and the user segments
There are a lot of sectors that are directly impacted by crude prices being user industries. Auto is a classic example. We have seen auto demand falling sharply on higher fuel prices in the previous year. Auto demand is best managed when the price of fuel is under control. Then there are other industries like chemicals, pharmaceuticals and paint which are user industries and are likely to be negatively impacted by higher oil prices.
Finally, what happens to oil companies themselves?
With a weightage of nearly 15% in the Nifty, any impact on the oil companies is very likely to have an impact on portfolios overall. Let us look at the oil extractors and the refiners. Technically, both these sectors should benefit from higher oil prices as it leads to better realizations for extractors and better inventory valuations for refiners. However, in India pricing is rarely free and the impact can get quite distorted. Then we come to the downstream companies. Typically, the OMCs should not worry about higher oil prices if they can pass on the costs in a free pricing regime. But that is easier said than done, especially in election times. As we saw late last year, the chances of pushing the subsidy burden on OMCs are quite high.
Overall, very high prices of oil are never good for your portfolio just as very low prices are also not conducive. There is merit in moderation!