Fisdom Weekly Update (Issue #29): A sticky affair: What’s oil economics without crude politics?

“I’m a free trader, the problem with free trade is you need smart people representing you we have the greatest negotiators in the world, but we don’t
use them, we use political hacks and diplomats.”
-Donald Trump (much before the recent sanctions on Iran)

Leaders of major Asian countries woke up to find themselves in deep water as the alleged poster boy for free & fair trade – Donald Trump made a not-so-free-and-fair announcement to cancel all waivers awarded to the sanctions on Iranian oil. While the reason for such an announcement was mentioned as – an attempt to curb terrorism financing; however, the United States’ equivocal stance on Pakistan does not add much credibility to their apparent concerns around terrorism.

Asia contributes to ~35% of the total global demand for oil and is incidentally a key importer of Iranian oil. Within Asia, China and India are the top two importers of the Persian oil.

India imported Iranian oil worth $13 billion which translates to rough 12% of India’s total imports in 2018. India was among the few nations to receive an exemption on the U.S. sanctions on Iranian oil. Hence, with the announcement, India has caught itself right in the eye of the crude storm!

Presenting a brief insight into the economics & politics of the Persian Oil:

The Economics: Is this fuss worth fussing about? Seems so. 
As mentioned in the opening paragraphs, Iran has been a key source of oil to India. While India depends on imports to meet ~80% of its crude demand, we can expect this dependency to go up to 90% by the next fiscal year. In such a situation, cancellation of waivers on Iran oil is perhaps the perfect headwind to tip the Indian economy off-balance – at least in the short term.

Economic ramifications of the announcement:

Lost comfort: Iran offers India a comfortable 60-day credit period along with free insurance & shipping – almost similar to features offered by leading e-commerce retailers delivering the best customer experience through service. This is an important convenience lost.

Supply glut; steepened prices: Production of oil by sanction-hit countries like Iran and Venezuela has dropped by 500,000 barrels per day as on the quarter ending in Mar’19 while OPEC & friends have affirmed their intention to cut production by 1.2 million barrels per day. While we can expect OPEC participants to overshoot their target production, the likelihood of overshooting by over 2 million barrels per day is a tad bit wishful. We can expect crude prices to steepen further.

INR Depreciation: An increase in the price of crude oil is synonymous with an appreciation in USD and implicit depreciation of the INR. Post-announcement, USD/INR has breached a critical threshold of INR 70 per USD.

Dampened foreign investment in Indian equities: An extension to the forex impact, a weaker rupee for dollar exchange rate essentially translates into lower dollar returns for foreign investors. As a teaser, Indian capital markets witnessed a trajectory-breaking net outflow of foreign money to the tune of ~ 210 mn in the two days following Monday’s announcement.

Widening deficit & swelling inflation: As a plain rule of thumb, it is safe to assume that with every $10 increment in the price of crude per barrel, the Current Account Deficit is widened by ~0.4% of the GDP. At the same time, a fuel that forms a major component of the Consumer Price Index basket may also fuel a spurt in the inflation situation in India.

Now, this could translate into quite a fiscal mess as RBI is on a liquidity-injection spree and a fraction of the market seems to be pricing in another round of rate-cut while a widened deficit & increased inflation may nudge for a relatively hawkish stance.

Indian Exports: India majorly exports rice (~30%), Tea (~4%), Flat-rolled products of steel (~10%), etc. We see this ban will have a short-term adverse impact on the exports. As quoted of ICRA (A well know rating agency), Iran has remained a major export destination for Indian Basmati rice and the industry’s concentration on Iran has only magnified in FY2019. Discontinuation of crude oil imports from Iran can lead to issues on the recovery of outstanding dues for the Basmati rice shipments already made, hampering the financial position of such exporters.

The Politics: Slippery tactics & crude intentions

Geopolitical importance: Iran offers India geographical leverage to access key regions of  Afghanistan and Central Asia. Choosing to stop buying from Iran could possibly incite sourness in the otherwise healthy relationship India shares with Iran and open up possibilities of restrictions in geographical access as well.

Domestic feud: Back home, India is going through the largest democratic election process and the ruling government is fighting oily battles on multiple fronts. While the Congress & Left Front have allegedly asked the government to not accept the U.S. sanctions and continue buying from Iran “so that the people can benefit from cheaper oil”, this seems no less than propaganda capitalizing on events & sentiments during the election season. The current ruling party will have to do the tight-rope if it wants to balance its fiduciary duties with political ambitions.

India at crossroads- the way ahead?

We expect India to explore alternate import sources from the Middle East (specifically, Saudi Arabia & UAE). Also, at the same time, India can be expected to maintain smaller token trades with Iran through the rupee payment mechanisms to establish good intent.

Meanwhile, globally, crude oil prices can be expected to hit the $80-mark by as early as June this year – given that the Iranian sanctions are followed by all importers to the letter. Any bold move by importers may change the expectation scenario completely and warrant another round of analysis.

Sticky-notes for the Indian investor:

• Now is a good opportunity to invest in a systematic fashion – try to average costs through the next two months at least by utilizing SIPs and STPs.
• For debt funds, stick to funds with a high proportion of AAA-rated papers and a duration towards the lower end of the curve.

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