Thursday, June 16, 2005

Oil - What is happening?

BSE closed at 6906 today. As Edwin Lefevre wrote “More money has been lost during the last 10% and first 10% of a bull market than has been made in the middle”. And maybe that is the case now in the Indian markets.

Oil closed up again today at $55.60. The reason is that Department Of Energy (DOE) report in the morning showed a worse than consensus drawdown in inventories. OPEC raised its production ceiling by 500K, but they were already producing at this increased level of 28 million barrels/day, so effectively that means no new production is coming on-stream.

Why are oil prices going up? My guess is because of demand from US, China and India. US consumer demand remains strong amongst a sharp increase in wealth due to high real-estate prices and good returns from the stock market in the last two years. Americans continue to buy cars and gas-guzzling SUVs, and continue to drive across the nation on weekends. Why is that? Because of low-interest rates. If interest rates went up slightly to calm down the real estate market and also make car financing less attractive, consumers would start taking notice of the high gasoline prices and maybe cut down on oil consumption.

But why are interest rates in the US so low? Bulls say that even though they are low if seen historically, they are higher than the rest of the world currently, and so investors outside are investing in US to take advantage of the relatively high yields. Add to that the current uncertainity in the Euro area (France and Netherlands rejected EU constitution), where there might be interest rate cuts to stimulate economy, and that makes US Treasuries attractive.

However, we shouldn’t forget the huge US trade deficit, at around $55billion/month. Economic theory indicates that $ should weaken as a result. It hasn’t. And that is because foreigners (China) are lending back to the US (by buying treasuries) the surplus they get through trade. Why? Because, as I pointed out in the last paragraph, there is no other place to invest. If EU had been growing faster, then some investments might have gone in Euro. Unfortunately, that is not the case. It is sort of vendor financing that is going on here. Which brings us to China.

China has the biggest trade surplus with US. Till yuan is pegged to dollar, logic would dictate this trade surplus would exist and keep on growing. US wants the yuan to appreciate and dollar to depreciate. This would lower the overall economic growth in China (due to lower exports due to stronger Yuan), which would arguably curtail consumption of oil in China. At the same time, China would reduce its problem of investing all its trade surplus, which it currently does in US treasuries. This would inch US bond yields up. And as we discussed above, this would be a double whammy for oil.

Where does India fit in here? By keeping the lid on retail prices, Indian government has its own hand in keeping demand for oil artificially high in India (i.e. artificial to current oil prices). By bringing oil prices in line with global prices, Indian government would temper the demand of oil a little bit, and prevent unsubstainable economic forces from building up in the economy

Who benefits if oil prices increase? HPCL, BPCL. Who loses - maybe everything else. High energy prices are not good. Is it time to short Pantaloon?

A way to play coal shortage (see yesterday's post) might be to buy Cement companies -some people are arguing that coal shortage would imply that only small incremental capacity comes online, and with utilization rates tight and demand booming, this could lead to a jump up in cement prices. However, I haven't seen any numbers associated with the analysis, so I would just hold off.

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