Both WTI crude and Brent crude are trading at 10 month highs with the spread between these two benchmarks having widened to $7 per barrel. India is the world's fourth largest importer of oil and imports nearly 75 percent of its demand.
Looking at the daily candlestick charts of the Western Texas Intermediate (WTI) June futures contract, we can already see that the market price is factoring in a risk premium for the Iraq geopolitical risks.
The Relative Strength Index (RSI), which shows how strongly a future price is moving in its current direction, is currently 70, a level associated with an overbought territory. We also notice that oil prices have broken above the upper Bollinger Band, a chart overlay that shows the upper and lower limit of 'normal' price movements based on the historical standard deviation of prices. This is also considered a momentum contrarian selling opportunity.
However, it should be noted that the width of the Bollinger Bands increases once oil prices start trading above $108 per barrel. Thus, if oil prices trade above this level on the back of further negative news flow out of Iraq, we can expect to see a volatile breakout to around $116 per barrel. This would be a high probability event as prior to the militant insurgency, the 20-day volatility contract in the Brent benchmark was at an all time low of 7.2 percent on June 3 according to Bloomberg data.
Historically, there has not been a strong correlation between rising oil prices and Indian equity performance. In fact, out of all oil shocks of the past 25 years, it was only the 1990 oil shock (Iraq war) that left Indian equities in the red for the next 6 months according to Morgan Stanley research. It may be the case that the 1990 shock pushed India into a balance of payments crisis making it an isolated incident. If we exclude the 1990 oil event, the Sensex has risen 24 percent on average in the six months after an oil shock.
During the Libyan crisis in 2011, when Brent crude prices rose from around $100 per barrel to $120 per barrel between February and April, Indian equities managed to rally 10 percent and also outperform the MSCI emerging market index.
To analyze the impact of oil, it is important to assess capital flows into the country. Morgan Stanley had estimated back in 2011 that if rising oil prices are accompanied by capital flows, Indian equities correlate positively with oil and vice versa. Every US $10 average rise in oil needed US $8 billion in flows to be offset.
Within the current environment of the FIIs being massively overweight India, an outflow of funds certainly seems improbable. Oil price changes may have very little explanatory power on forward Indian equity returns.
The fact that the theme for the rupee still remains gradual depreciation against the dollar will also prove problematic if oil prices remain sticky or move higher from current levels. We may have seen the Rupee bottoming out near the 58 mark against the greenback.
The Reserve Bank of India has seen strong inflows to build up its FX reserves. According to the weekly data released by the RBI, headline FX reserves have risen by $17 billion since the end of last year, with a rise of $5.7 billion between April 25 and May 16 alone.
The RBI's attempt to build up FX reserves is of course a long term positive for the rupee, but in the short run, this is likely to limit its upside against the greenback. Further, the narrowing of the current account deficit to 0.2 percent of the GDP in the first quarter of 2014 from as large as 6.5 percent in the fourth quarter of 2012 is unsustainable. HSBC estimates that nearly half of that decline stemmed from a sharp drop in gold imports. The other half was due to a temporary boost to exports from a cheapened currency last year and compressed imports owing to weak domestic demand.
As restrictions on gold imports are gradually lifted (which is inevitable), the current account deficit will widen again. A doubling of gold imports from the current depressed levels of 25 tonnes per month would widen the gold deficit by about $1 billion per month (0.2 percent of GDP, assuming stable gold prices) according to HSBC. This would still be well below the pre-restriction trend of gold imports of about 80 tonnes per month.
US yields rising towards 3 percent as we move forward on the back of the QE taper is also universally bullish for the dollar. Thus, India faces the risk of importing inflation and an increased import bill due to the double whammy of higher crude prices coupled with a weakening rupee.
However, at this point, it would not be prudent to expect any change in stance of monetary policy from the RBI.
Indian equity markets hit an intra-day high of 7,563 on the Nifty on the back of the historic Narendra Modi led BJP win. Since then, the benchmark Nifty has remained range bound between 7,250 and 7,650, with gains mostly coming from the small-cap and mid-cap index.
The prospects of a pre budget rally have been dampened by the upside risk to global oil prices in coming weeks. Risk aversion has led to IT and pharmaceutical stocks witnessing buying interest while high beta cyclical names have corrected from their 52 week highs. Oil prices are not the only tail risk - the market reaction to the budget and the monsoon will also be key drivers.
However, assuming the geopolitical tensions abate over the short term, the recent correction should be used as a buying opportunity for investors who have remained on the sidelines. Medium term market participants with an investment horizon of 12-18 months should remain bullish on Indian equities.