Why Oil at 30$ is toxic for the Stock Markets?

Much has been written in the mainstream media about the oil-price carnage (or ‘Oilmaggedon’ as Citi puts it) over the last few months and in general there is a post-facto consensus that such low prices are not benefiting anyone. Yes, there is a respite for net oil-importing economies (like India & China) in terms of managing their current account deficit and cheer for car/SUV manufacturers, but that is where the good news ends. In every other sector and in overall macro-economic terms on a national/global scale, ultra-low oil prices are proving to be a disaster at least in the short term. On a wholesome level, this article would attempt to identify trends (normal as well as abnormal) in oil prices, key reasons for the global turbulence in stock markets and some crystal ball-gazing into the future as to what the future holds.

Oil Price versus the Equity Market:

The heading may have evoked questions as to which stock markets are being referred to in here. Is it the S&P or FTSE or DAX or NIKKEI or Shanghai Stock Exchange? Maybe a decade back this would have been a different analysis for each of the individual markets but unfortunately with increasing connectedness & inter-linkage between global markets driven primarily by ease of capital flows, the effects are quite homogeneous across all of them. Hence for simplicity sake we can assume that effects of a global commodity like oil would reverberate in a similar fashion across global markets. Traditionally, oil prices till a few years back did not show any direct correlation with stocks and usually based itself on demand-supply fundamentals controlled by OPEC. In statistical terms, the correlation used to be in the range of 0.25-0.3 for the period analysed - starting from late 90’s to the midst of the financial crisis in 2008-09. The below chart shows the S&P 500 and Brent crude prices from the period (1997-2011).

However the trend between oil prices and equity markets have been surprisingly on the positively upward side in the recent past, perplexing economists who have begun to question the traditional consumption models. If the new found love affair between oil price & equity markets is indeed true, then one should kiss good-bye for hopes of any market revival in the near future and brace for more pain in the coming months [The equity prices have still not corrected much in comparison to the oil prices which have nearly come down by 75%]

It also raises pertinent questions as to what is the differentiating factor over the past few years that has caused this relationship to strengthen. In my view, the overall global market-connectedness is again playing a part in this story wherein more and more there is a tendency to align structurally different asset classes not via the traditional forces of demand and supply but more with the availability of capital chasing high-returns and cheap money fuelled by the central banks insanely since the global financial crisis.  The easy money has flooded itself in almost all of the major asset classes across economies so much so that if any one of them catches a cold, the preventive reaction has a contagion effect across all of them.

On this point, the major factor which is impacting the global equity market (in the Oil led rout) has been the Sovereign Wealth Funds (SWFs) primarily driven by petrodollars.  In a study conducted by FiRN (Financial Research Network), it was found that in normal circumstances, though SWFs contribute to liquidity in general yet have destabilizing effects on the equity markets on an overall basis. One of the biggest SWFs – Abu Dhabi Investment Authority has supposedly more than $770 billion in assets primarily consisting of the excess oil reserves in the UAE. Imagine the impact which has been faced by these SWFs in the oil price erosion which would undoubtedly cause them to withdraw capital out of their investments in equity markets (and though these are across developed and emerging markets agnostic of asset class, yet emerging markets being on a higher risk platform would face the bigger brunt).

The list below includes SWFs having assets more than $100 Billion and no prizes for guessing that more than 50% of these SWFs are oil-denominated.

Effect of low oil prices on global economies

As highlighted earlier, the benefits of lower oil prices are there but for the far and few especially in this connected world. Over the course of last two decades, many of the economies have come to be heavily dependent on oil for their prosperity and ultra-low prices to the tune of 30$/barrel do not merely pinch them but can have profound effects ranging from social unrest and unemployment spikes to government upheavals e.g. Venezuela has around 95% of export earnings coming from oil revenues and as of 2015 end, the inflation rate exceeded 100% in the country battered by low oil prices. Saudi Arabia saw its budget surplus from $53 Billion in 2013 to a record deficit of $98 Billion in 2015 causing it to embark on a spending cuts program planned over the next few years. These are just few examples from the large number of countries dependent on oil on their fortunes with other big names being Russia, Nigeria, Norway and other oil producing ex-Soviet era countries.

Even in case of oil-importing economies like India, there are indirect effects which play out in form of reduced remittances from Gulf countries. Let's keep in mind that remittances in developing economies like India & Philippines are a major contributor to the national GDP contributing more than 4% in absolute terms.

For oil-surplus and developed countries like US & European countries, the negative effect is more on the big oil corporations like Exxon, Shell or service providers like HLS, Schlumberger who are suddenly facing the scenario of big losses and massive job cuts after years of super-normal profits. As is often said, a job-addition in the mainstream economy adds around 3 more jobs in the subsidiary economy. Hence, I would expect the reverse to play out as well with mainstream job-cuts leading to increased unemployment. It would be interesting to follow the US non-farm payroll numbers over the next few months and see where they are headed.

High oil prices may never return

What is perhaps needed and would happen gradually is a structural adjustment in the world order with the realization that high prices for oil (i.e. $100+ per barrel of oil may be years ahead). These are some factors which explain why:

Whatever be the intention of OPEC, it will never be able to kill off the shale oilboom happening in US (which can gradually spread to other countries). Low oil prices may have the temporary effect of halting any new investments in Shale oil production, but it would not deter them to extract oil from set-ups already established. Moreover, as the oil price picks up to a reasonable level $60-$75 per barrel, it would automatically put the Shale production engines in action whose sustained output will ensure that oil price never really goes northward by a great margin.

Also, with new technological advancements in the oil industry, the ‘time to market’ has come down significantly i.e. Time between investments in a new oil well to its reaching the end consumers. Hence, any spike in oil prices may start the now-halted spree of exploration activities adding to the supply. With Iran coming into the picture after years of sanctions, it would try to establish itself in the global oil market and further add to the oversupply. Other long term factors that deter the growth of oil demand and accordingly prices would be the greater focus on clean energy based automobiles, impact of Chinese demand slowdown and increased efficiencies in shale/crude oil extraction. Of course, a lot of these may be offset if OPEC steps up and really starts to control supply of oil in the global market. But given recent unfolding of the events that have played out recently, that appears to be a tall order.

Into the future

In all, one can conclude to an extent that in the current global structure there is a high dependency on oil prices to remain high from a stock market perspective. With the markets virtually running on ‘Nitro’ boosts from cheap money flows from Central banks and SWFs/investment funds till now, it is very easy for markets to lose control in absence of either of these. And do remember that neither the Fed is going for any additional quantitative easing anymore in the foreseeable future nor are the SWFs going to be extravagant in their investments. I foresee prolonged pains in the equity markets and when the dust subsides, it may be time to go back to the basics of stock market investing focusing on old school of profitability and growth. Till then, let’s all wake up to the new reality.

Uber - Tougher days ahead

Having been a fan of the ride-hailing aggregator Uber, I write this post with some cynicism keeping in mind that they are valued around $70Bn after their last round of fund raising. Yes, they have done a great job so far and created a disruptive influence (so much that ‘uberization’ may well enter into the official Oxford dictionary) but the question remains as to whether it can sustain the momentum in the long run.

Let’s address some basic facts first and I must acknowledge that they have done a lot to fundamentally change the cab-hailing industry. It has become massively simple to book a cab with the likes of Uber and Ola (Imagine the days before wherein one had to walk around the street looking for a cab with no certainty of getting one in time or haggle with the driver over the fare or being concerned with the safety of the passengers or using the expensive operators who burn a hole in your pocket), yet the long term feasibility of the service sometimes brings in mind a question or two.

I generally engage into conversations with the Uber drivers whenever I get to ride one. And have seen the optimism and excitement of the drivers gradually fading over the course of last 5-6 months.  And the feedback has been across two biggest cities in India for Uber at the moment – Delhi & Kolkata. I remember the excitement few months back wherein the drivers were ‘uber-happy’ with the loads of freebies and commissions which they received. Although the ride commissions were very dynamic with changes coming almost every other week, yet the initial marketing blitz which Uber played out to acquire the riders and drivers was phenomenal. Without a single TV advertisement or hoarding, they managed to convey the message across plain and simple. Though, have a feeling that the euphoria may come to curse them if they do not play their cards well going ahead.

 The early days of Uber started with great excitement with news splashes of drivers earning more than INR 125k/month in some cities. An average number which most of them admitted to was in the range of 50k-80k. That mind you, was a huge ‘surge’ over their status quo wherein most of them made around 20k-25k on a monthly basis before driving for Uber. The commissions used to be boggling with sometimes even ranging from Rs. 300-400 per trip irrespective of trip duration or amount. An average driver making 8 trips a days (with an average of Rs.150 per trip) made a cool Rs.3000-4000 per day. Adjusting for the monthly expenses in form of fuel, maintenance and EMI, most of them still managed to score a 50% premium over their past earnings. This combined with other qualitative benefits like ease of use, weekly payment being directly credited to bank accounts, no looking-out for potential customers in all made a grand proposition to the drivers. Again, with a business giving super-normal profits, it also attracted a fair number of people who wanted to cash-in on the boom and became car-owners who in turn employed easy-to-get drivers and managed to earn a decent profit right from the start.

From the customer perspective, things were rosy as well. With massive discounting (promotional offers getting as low as Rs.5/km for a sedan), big referral credits and host of other qualitative benefits one got hooked onto the service pretty soon. All you needed was a smartphone and a decent data plan! No doubt, the strategy proved to be a massive success both with the demand and supply side of the equilibrium with each rising exponentially every passing week.

The burning question which investors in Uber (as also with scores of other ‘unicorns’) is how to turn into the corner of profitability. This has to be done keeping in mind the mega expectations which have been created on both sides of its equilibrium and this is where I foresee challenges going ahead. Recent conversations with Uber cab drivers have elicited despondency with some proclaiming that things are not going well (a driver claimed that ‘acche din chale gaye’ ! J). Rapid scale-backs in commissions, imposition of specific number of rides to be mandatorily completed have lowered the enthusiasm. My last conversation with a cabbie (who was driving for an owner) revealed that the cab made around Rs. 42k last month as revenues (with expenses of around 35k including the driver charges and fuel maintenance) leaving a pittance for the owner. Also, going ahead I see the per-ride commissions completely going away with Uber standing as a provider who simply act as a demand fulfillment center via use of a technology platform. The question that would arise here is:

1. In the future days, whether it would act as an incentive enough for the cab drivers (or owners) to part with 20% of their income to Uber without any commissions whatsoever (assuming a commission oriented model which they follow globally)? Or,
2. Continue doing their business as usual without tagging with Uber and having the freedom to set higher fares (a la Meru or other private operators)

Coming from the demand perspective, all of us virtually know that the low pricing schemes for Uber not going to last for long. An off-hand calculation reveals that to sustain the journey over the longer term, the pricing would need to rise more than 40% over current rates. I see per/km rates to be in the range of Rs.15-25 in the longer run which would again dampen the rider enthusiasm. Specially, India being a price sensitive play, an increase in fares would definitely introduce more churn in the Uber rider demography. The question here is how Uber would handle such a scenario given that it also plans for an IPO in a couple of years’ time raising concerns around profitability and long term sustainability.

I foresee it as a gentle balancing act as they cannot afford to let any side of their driver-rider equilibrium to go out of sync. Yet, it doesn’t seem to an easy task especially with competitors virtually offering similar (or in some cases better in few cities) service than Uber.

Apart from the demand-supply balance, other relevant questions do arise as well which I am sure Uber has got their strategy teams working on:

1. The metro city-play is fine and may well turn to be profitable in the longer run. How do they plan to remain profitable in the smaller Tier II and Tier III cities where affordability drops further, price sensitivity increases and cheaper options may be available?
2. How do they plan to combat the ride sharing platforms that are emerging with the likes of Shuttl which offer much cheaper options to the consumer? Agreed, that they themselves have created an Uber ride sharing service but is it competitive enough? Can it cannibalize their existing business model?
3. How to they plan to tackle the regulatory hurdles that they face specially with almost every state in India dictating their own? Even globally, it faces a massive backlash from scores of cities and countries each of which fight would slice away a pie from its road to profitability.

Believe there are lot of other concerns which no doubt the Uber team is working on as they go ahead in their global conquest.

P.S. Most of the above questions would be applicable to competitors like Ola or Lyft as well.