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Amity Business School

AU, Noida
Research Paper
On

Impact of crude oil and inflation on

markets

Submitted to: Submitted by:

Dr. G N Bhardwaj Sachin Saini
A0101907408
MBA (Gen), Sec B

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Impact of crude oil and inflation on markets.

Sachin Saini

A010190408

MBA (Gen)

Amity Business School, AU, Noida

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ABSTRACT

This paper explains the effect of crude oil price rise and inflation on the Indian and
global markets. These two factors are of major importance in the study of markets
across the world.

Today when India is facing rising inflation and crude oil prices, these two things have
become major concerns foe the government. The Indian government is making huge
efforts to cope up with this scenario. Recent hikes in repo rate, CRR, and petrol and
diesel prices are some of the majors taken by the government but still there seems no
respite from them. Here we will study various factors leading to inflation and oil price
rise and their effects on markets, global economies and people.

Here we will consider factors like weakening dollar, rise in oil consumption, speculation
of people, supply & demand etc. various charts and graphs will give a clear
understanding of the situation. This paper has been prepared after a vast study of
various news articles, magazines, internet blogs and few research papers.

KEYWORDS:

Inflation, crude oil price, supply demand, weak dollar, speculations.

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Introduction

Before studing the impact of crude oil and inflation on stock market we must understand
what stocks and stock market is.

What are stocks?

Plain and simple, a “stock” is a share in the ownership of a company.

A stock represents a claim on the company's assets and earnings. As you acquire more
stocks, your ownership stake in the company becomes greater.

Some times different words like shares, equity, stocks etc. are used. All these words
mean the same thing.

So what does ownership of a company give you?

Holding a company's stock means that you are one of the many owners (shareholders)
of a company and, as such, you have a claim to everything the company owns.

This means that technically you own a tiny little piece of all the furniture, every
trademark, and every contract of the company. As an owner, you are entitled to your
share of the company's earnings as well.

These earnings will be given to you. These earnings are called “dividends” and are
given to the shareholders from time to time.

A stock is represented by a "stock certificate". This is a piece of paper that is proof of

your ownership. However, now-a-days you could also have a “demat” account. This
means that there will be no “stock certificates”. Everything will be done though the
computer electronically. Selling and buying stocks can be done just by a few clicks.

Being a shareholder of a public company does not mean you have a say in the day-to-
day running of the business. Instead, “one vote per share” to elect the board of directors
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of the company at annual meetings is all you can do. For instance, being a Microsoft
shareholder doesn't mean you can call up Bill Gates and tell him how you think the
company should be run. The management of the company is supposed to increase the
value of the firm for shareholders. If this doesn't happen, the shareholders can vote to
have the management removed. In reality, individual investors like you and I don't own
enough shares to have a material influence on the company. It's really the big boys like
large institutional investors and billionaire entrepreneurs who make the decisions.

For ordinary shareholders, not being able to manage the company isn't such a big deal.
After all, the idea is that you don't want to have to work to make money, right? The
importance of being a shareholder is that you are entitled to a portion of the company‟s
profits and have a claim on assets.

Profits are sometimes paid out in the form of dividends as mentioned earlier. The more
shares you own, the larger the portion of the profits you get. Your claim on assets is
only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left
after all the creditors have been paid.

Another extremely important feature of stock is "limited liability", which means that, as
an owner of a stock, you are "not personally liable" if the company is not able to pay its
debts. In other legal structures such as partnerships, if the partnership firm goes
bankrupt the creditors can come after the partners “personally” and sell off their house,
car, furniture, etc.

Owning stock means that, no matter what happens to the company, the maximum value
you can lose is the value of your stocks. Even if a company of which you are a
shareholder goes bankrupt, you can never lose your personal assets.

Why does a company issue stocks?

Why would the founders share the profits with thousands of people when they could
keep profits to themselves? The reason is that at some point every company needs to

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"raise money". To do this, companies can either borrow it from somebody or raise it by
selling part of the company, which is known as issuing stock.

A company can borrow by taking a loan from a bank or by issuing bonds. Both methods
come under "debt financing". On the other hand, issuing stock is called “equity
financing”. Issuing stock is advantageous for the company because it does not require
the company to pay back the money or make interest payments along the way.

All that the shareholders get in return for their money is the hope that the shares will
someday be worth more than what they paid for them. The first sale of a stock, which is
issued by the private company itself, is called the initial public offering (IPO).

It is important that you understand the distinction between a company financing through
debt and financing through equity. When you buy a debt investment such as a bond,
you are guaranteed the return of your money (the principal) along with promised interest
payments.

This isn't the case with an equity investment. By becoming an owner, you assume the
risk of the company not being successful - just as a small business owner isn't
guaranteed a return, neither is a shareholder. Shareholders earn a lot if a company is
successful, but they also stand to lose their entire investment if the company isn't
successful.

There are no guarantees when it comes to individual stocks. Some companies pay out
dividends, but many others do not. And there is no obligation to pay out dividends.
Without dividends, an investor can make money on a stock only through its appreciation
of the stock price in the open market. On the downside, any stock may go bankrupt, in
which case your investment is worth nothing.

What makes stock prices go "up" and "down"?

Stock prices change every day because of market forces. By this we mean that stock
prices change because of “supply and demand”. If more people want to buy a stock

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(demand) than sell it (supply), then the price moves up! Conversely, if more people
wanted to sell a stock than buy it, there would be greater supply than demand, and the
price would fall. Now I will proceed with study of following two factors :

1. Inflation
2. Crude oil price

Methodology

I have adopted a very simple approach to study these two factors. I will discussing
various factors that lead to rise in inflation and crude oil price and then the effects these
factors are having on global economies and market.

Various graphs and charts are included in the study for a better understanding of the
paper.

INFLATION

I. Inflation, a global phenomenon

After Subprime, inflation has become the second most dangerous word today. Globally,
economies are struggling to fight this rising menace, which has started making the
situation more complex for the world, already ailing with credit squeeze, bankruptcies,
declining consumer and business confidence, etc. Inflation figures have shot up in
different geographies, which were earlier thought to be not-so-related. In the US,
inflation on the Consumer Price Index (CPI) rose to 4.0 per cent for the twelve months
ended Feb. 2008. In Japan, other East Asian countries and EU, the situation is almost
the same. For the month of February, the CPI figures jumped up, on a Y-O-Y basis, in
the case of Japan (by 1 percent in core index excluding fruit, fish and vegetables),
France (by 3.2 per cent, highest since 12 years), Germany (by 3.2 per cent), the whole
European Union (by 3.5 per cent), Argentina (8.2 per cent in January) and Brazil (4.61
per cent, 8 years‟ high). Closer home, China got severely battered by the rising prices.
Its CPI for the month of February rose to 8.7 per cent on Y-O-Y basis (fastest pace in 11

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years), and within that, the index for rural China shot up to 9.2 per cent, widening the
gap further. While, consumer prices in Sri Lanka and Vietnam have neared or exceeded
20 percent. Singapore's consumer price gains have reached levels not seen since 1982.
And yes, we are not mentioning here the case of Zimbabwe, where the annual inflation
figures in January shot up to an unprecedented and unbelievable level of over 1,00,000
per cent! In fact, Zimbabwe's month-on-month growth rate has topped 130 per cent
every month since October 2007.

II. Inflation raises its head again in India too

India, too, is suffering from this same global phenomenon coupled with her own
economic realities. The inflation figures here, measured on the Wholesale Price Index
(WPI), reached a 13 and a half months high of 6.68 per cent on week ending March
15th. It was 5.11 per cent on 1st March and 5.92 per cent on 8th March. In the
corresponding period last year, the inflation rate was relatively stable at 6.51 per cent on
3rd March and 10th March and 6.56 per cent on 17th March.

The current spike is mainly due to supply side constraints being faced by almost all
economies. The paltered global supply of food articles (especially, wheat and edible
oils) and metals (primarily, steel) has contributed the most in the whole inflation story.

III. Inflationary Trends in past one year

When we look at the past one year WPI data (in the chart below), there was a dip in the
composite commodities index in June 2007 due to a huge decline in the primary goods
prices and also a negative growth rate in the case of Fuel, Power, Light and Lubricants
(FPL). The earliest indication that the inflation could soar, started coming in late Nov.
‟07, when the FPL segment started growing rapidly. This later got reflected in the
increase in primary goods and also in the increase in input costs for the manufacturing
segment too.

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Now, when we take the inflationary trend in food prices (see the chart below), the
months of Dec. ‟07 and Jan. ‟08 was the time when food prices started soaring,
especially due to increased imported edible oil and fruits prices.

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In the chart below, we can see price of imported edible oil soaring in Dec. ‟07 itself,

which started getting reflected in the broad edible oil segment by Feb. ‟08 only. A cut in
the import or custom duties much earlier would have nipped the inflation in the bud
itself.

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But the most fluctuating commodity prices were of the fruits and vegetables and within
that of the vegetables. We can see in the chart below, the huge spikes and dips in the
vegetable prices throughout the year.

Apart from the huge jump in the imported edible oil and fruits and vegetables during Feb
and March. Of the current year, the biggest whammy came from the sudden spurt in the
steel prices. The prices went up by as much as 27 per cent in the last reporting week.
The Y-O-Y rise in the steel prices was as high as 48 per cent during the same week on
Y-O-Y basis. Wheat prices also climbed by around 4 per cent during the same time (see
the chart below).

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And all this was happening when the RBI was constantly maintaining that it would
exercise all the monetary tools available to keep the average annual inflation figure
within 5 per cent limit. But the whole exercise went awry when the supply side
constraints started putting pressures on the monetary policy. The RBI responded to that
with hiking policy rates on several occasions but the moderation in inflation seems still a
distant reality.

IV. What caused this rise in inflation?

As we have seen earlier, the major cause of this jacked up inflation levels has been
abrupt rise in global as well as domestic commodity prices. Coupled with that was the
pent up demand in the domestic economy due to very high money supply in the past

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couple of years. Let us look at all these factors in detail to analyze their comparative
impacts on the rising prices.

A). Demand-side Factors:

There has been a very high rate of growth of the money supply (M3) in the system
during the last couple of years. The RBI was always worried with this and tried at
several occasions to contain that with hardening the monetary policy. The target set by
the RBI in its Monetary Policy for 2007-08 was a growth limit of 17.0 to 17.5 per cent
only for the M3 growth. But the average M3 growth for the whole year till date has been
around 20-21 per cent, much high than the target set down by the RBI (see the chart
below). There was a large increase in the total overhang of liquidity over the year,
reflecting them sizeable expansion in primary liquidity generated by the large accretions
to the RBI‟s net foreign assets. In the foreign exchange market, large inflows have
imposed persistent upward pressures on the exchange rate of the rupee which have
become accentuated in the wake of cuts in the US Federal Funds target rate. The third
quarter review of the current monetary policy observed that the overhang of liquidity as
reflected in the sum of LAF, MSS and the Central Government‟s cash balances
increased from Rs.85,770 crore at end-March 2007 to Rs.2,58,187 crore on January 17,
2008 before declining to Rs.2,32,809 crore on January 24, 2008.

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(B) Supply-side Factors:

Apart from the heightened liquidity in the system, there were a host of supply side
shortages, which resulted in spiraling commodity prices. As has been explained earlier,
much of these price rises were due to hike in the imported commodity prices. We can
see this in the charts above with acute rise in imported edible oil, wheat and steel prices
in the past couple of months. However, rising food and other commodity prices is at
present a global phenomenon. The situation is so grim that the World Bank has
estimated that 33 countries around the world face potential social unrest because of the
acute hike in food and energy prices. The unfavorable climate change across the globe
has resulted in unprecedented poor harvest in most of the countries. Australia, the
second-largest wheat exporter in the world, experienced the worst drought in recorded
history starting from 2002. The impact has been severe on crops, particularly wheat,
with its global production at its lowest in the last 12 years. Similar climate conditions hit
parts of Europe, such as Spain, Portugal and Ukraine and certain North African
countries. Similarly, the international rice market is already under tremendous strain as

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Vietnam, India, Egypt and Cambodia have restricted exports, affecting one-third of total
supplies in the global market, while countries such as the Philippines, the largest
importer of the grain, and Sri Lanka are still looking to buy more rice. Edible oils, pulses,
sugar, etc. too are under very short supply globally, pushing the prices further.
Metals too are contributing a lot in this inflation and in that group the price of finished
steel, pig iron, sponge iron, chrome, manganese, etc. have become excessively in short
supply. And most importantly, the huge upside seen in crude oil prices crossing USD
130 per barrel is complicating the problems more.

V. What are the impacts on public policies?

The RBI has always been maintaining throughout the year that it would always give
more priority to price stability than high growth. It was right, keeping in mind that the
major contributing factor for the rising inflation levels was zooming food prices. And
keeping in mind the fact that for Indian masses, the major expenditure in its entire
monthly outlay is food (as much as 55 per cent in rural areas and approximately 45 per
cent in urban areas), reigning in the rising food prices due to supply bottlenecks is
extremely necessary. Just recently, the Central government too took some actions
required to ease out supply side concerns. The impact of the custom and import duties
cuts on the imports; and removal of concessions and ban on certain exports can only be
visible in the next three to four weeks.
While keeping the inflation target between 4.5 and 5.0 per cent, the RBI was constantly
Monitoring the money supply, credit growth and price levels. But the global and
domestic environments are in such a state of flux that the latest inflation figure has
forced the governor to comment that this „alarming‟ situation may warrant another set of
hiked policy rates. The table below contains prime lending rates, deposit rates and the
call money market rates over the past one year. We can see a hike in both lending and
deposit rates in early part of the last year due to hike in regulatory policy rates.

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prime lending deposit rate call money rates

rate borrowing lending
14-Mar-08 12.25-12.75 8.25-9 2.5/9.5 2.5/9.7
29-Feb-08 12.25-13 8.25-9 3.5/9 3.5/9
25-Jan-08 12.75-13.25 8.25-9 4.5/8.4 4.5/8.4
28-Dec-07 12.75-13.25 8.25-9 6/8.55 6.0/8.55
30-Nov-07 12.75-13.25 8.25-9 4/8.1 4.0/8.1
26-Oct-07 12.75-13.25 8.0-9.0 3.75/6.2 3.75/6.2
28-Sep-07 12.75-13.25 8.0-9.5 2.75/9.5 2.75/9.5
31-Aug-07 12.75-13.25 8.0-9.5 2.5/8.4 2.5/8.4
27-Jul-07 12.75-13.25 7.5-9.6 0.1/1.5 0.1/1.5
29-Jun-07 12.75-13.25 7.5-9.6 .30/9.5 .30/9.5
25-May-07 12.75-13.25 7.5-9.0 1.95/8.25 1.95/8.25
27-Apr-07 12.75-13.25 7.5-9.0 4.0/15 4.0/15
30-Mar-07 12.25-12.50 7.5-9.0 6.0/80 6.0/80
23-Feb-07 12.25-12.50 7.5-9.0 3.0/8.25 3.0/8.25
26-Jan-07 11.50-12 7.5-8.5 5.6/8.15 5.6/8.15

This has affected the credit off take from the commercial banks in the last year. This
was a conscious policy adopted by RBI to keep the inflation in control. But even after
hiking the policy rates several times in the past year, the rate of inflation has overshot
the limit set up by the RBI. We can see the hikes in Repo and Reverse Repo rates in
the past one year below:

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This was done in response to the rising inflation, especially in the food prices. The
steady increase in reverse Repo rates indicates that the cost of funds is deliberately
being pushed up so that it goes mostly to the productive sectors.

VI. What is the impact on the markets?

The inflationary concerns force the regulator and the government to take harsh actions
to contain inflation. Inflationary concerns force the RBI to go for tight Monetary Policy. It
means:
 RBI may take measures to reduce liquidity
 Lower liquidity may push the interest rates higher
 It may set the stage for lower economic growth
 Lower corporate top line and bottom-line
Inflation control is necessary for long term growth and stability but in the short-term, it
impacts corporate profitability. The markets anticipate the inflation control measures as

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soon as inflation breaches the upper limit of 5%. It is taken as negative signal for the
short to medium term.
The finance minister did his part in the budget to spur the growth in the economy. He
did it in two ways, first, by reducing direct taxes, increasing the disposable income to
boost consumption. Second, reduced duties on consumer goods to make them cheaper
and spur the demand. However, now with inflation numbers so high, the chances of
reducing interest rates to boost consumption and investment in the economy are
remote. It is likely that the high interest rates would depress the demand for consumer
durables, automobiles, houses etc. It would be difficult to maintain the tempo of growth
in 2008-09 if inflation continues to remain an irritant.

Crude is all over the place. All talk everywhere of nothing, but the crude. Crude oil is
generally considered to be the king of all the commodities as it is the only major
influential factor to the economies of the world to a great extent. Crude now is the base
for all the economies of the world. That is why our work starts with analyzing crude oil
as a basic ingredient influencing world economies and market including India.

Recently we have seen crude prices touching a record nearly $140 mark which has
increased pressure on most of the world economies along with India. Higher crude
prices fuels inflation then in turn supports price rise, increasing input cost and squeezing
companies‟ profits which is then reflected in the companies‟ stock price and the market
sentiments.

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INDIA AND THE CRUDE

The composition of Indian crude basket majorly includes the mixes of OMAN and
DUBAI for sour grades and BRENT (DATED) for sweet grades in the ratio of 59.8: 40.2
since April 2006.India imports around 70 to 76 % of its crude oil requirements for which
we spend $50 bn. It is not hard to guess that how crucial oil is for India.

Crude has rushed from $50 to $ 140 but Indian prices reflect only $ 60 which has
caused total under recoveries of Rs 245000 crore and subsidy of $8.7 billion which is
0.7% of total GDP in 2007 and estimated to be $29.2 billion in 2008.

We have seen a dramatic increase in the oil prices. It is not the price rise which is the
worrying factor but the speed at which it has risen or is rising. As graph is indicating
that the price of oil has increased 2.5 times in the period between 2003 and 2007 and
again a great most significant , gigantic 2.7 times increase in oil prices in 2008 till now
form 2007 which has shaken the world economy.

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Causes of rise in crude oil prices

Global oil demand:

Increasing oil consumption is one of the factor influencing the rise in oil prices.
According to EIA world oil consumption is expected to grow by 1.4 million bbl/d in 2008
The demand from India and china is rising considerably as the govt. is subsidizing the
oil prices in these countries creating the demand for the oil artificially high even at high
prices. In the 1st quarter of 2008 Chinese imports have increased by 14.8% compared to
previous year and Indian crude imports have increased by 9.1%.

Source: EIA report world oil consumption

From the graph seen above it is clear that the annual demand for the crude is on the
rise in 2008. The growth in the world oil consumption was on the significant decline
since 2004 from 2.8 million barrel per day to 0.6 million barrel per day but in 2008 and
2009 we are expecting it to grow to 1.4 barrel per day which is very significant. This
indicates that the global oil demand remains fundamentally tight.

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Weak dollar:

Another and most significant reason of spurt in the prices of the crude oil is the
weakening of the dollar against the euro. This has supported crude prices as OPEC
countries sell crude in dollars and purchase goods in euros. Dollar depreciation reduces
these countries purchasing power and increases domestic inflation levels, countries
then in turn increase oil prices to maintain their real purchasing power at par. All other
things being equal, dollar devaluation also reduces drilling activities in areas where
most of the cost are denominated in non dollar appreciating currencies such as the
North Sea as they need to pay relatively more dollar for the same work. Dollar
devaluation on its own can have the effect of tightening supplies, in creasing demand
and thereby increasing the oil prices.

This graph shows the average Euro rates in terms of the US$. It can be clearly seen
from the graph that dollar depreciated a lot since the beginning of the 2002. The
increase in the euro price against dollar was even more steep in the 2007 and specially
during this oil price upsurge of 2008. It is true that the depreciating dollar in effect
means a reduction (compared to potential) in real income of oil exporters, especially

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those that import substantially from other non-dollar areas (such as the European Union
and increasingly China) which puts oil prices high to compensate the weakening dollar
income loss.

Speculative buying:

Analysts believe that it is speculation not the realistic demand the main reason behind
the unprecedented oil price upsurge. Big speculation on the part of big investors is
causing increase in prices. Many believe that big institutions have entered and they are
causing for demand and there is something more than consumption in oil prices. There
is no as significant upsurge in the demand of oil and also there is no big supply
disruption. OPEC Secretary-General Abdullah al-Badri had said that the cartel could do
nothing to curb the hike in oil prices as speculation and the weak U.S. dollar, rather than
insufficient output, should be held responsible.

Federal reserve officials have no sign of big increase in inventories in inventories of

commodities, so no fundamental cause of rise in crude prices (as if investors would
have expected more prices they would have stored more in inventories ). The main
indicator of speculation could be – investment in indices based on commodities futures
have risen from $13 billion five years ago to $ 260 billion now, this is a 2000% increase.
The rise in investors demand in oil future is more of a speculative nature then any
hedging against the commodity. Such speculation could boost oil prices to one record
high after another, or cause acute market turbulence as the price bubble finally bursts.
And when oil bubble burst and they have to sell it, the margin money will increase and
the position will be squared off and huge selling will come. Also, the open interest in
crude oil has been increased from 13% to 58% .So; we can say that at the moment we
are sitting on an oil bubble.

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Geo political tensions:

Supply disruption in Nigeria , tension between IRAN and US over nuclear programe ,
supply disruption in Iraq, threats of strike etc have raised supply concerns and have
thus supported the price to a great extent.

Unwillingness of opec to increase supply:

OPEC has been very reluctant to increase crude oil supplies on the grounds that oil
market remains well supplied and there is no need to add additional supply to market.
This in turn is also supporting the prices in the market.

Impact of crude oil prices hike

INFLATION

Oil prices are determined by the demand and the supply factor in the open market,
although it is regulated by the local governments in some countries. Increase prices will
fuel the inflation which in turn will cause increase in all essential commodities prices.
High in oil prices increase shipping cost, it has increased 300%since 2000for a
container.

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As it can be seen above inflation has increased dramatically with the rise in the crude
prices in fact the increase in inflation is much bigger than in oil. Impact would be in the
form of rise in freight charges leading to increase in the price of many commodities like
automobile, FMCG, fruits and vegetables, iron and steel.

GDP growth rate

Rise in the oil prices will negatively impact the growth of the economy by increasing
burden on the prices of the other commodities, weaker consumption, rising input costs,
decreasing companies profits and markets, which decreases the savings, investments
and the real income of the people, in turn slows down the growth. India estimate for
GDP growth has been declined from as high as 9% to 8.5-7.5 %.

Subsidy burden and pressure on fiscal deficit:

India‟s oil subsidy may shoot up to 3 times to 2.2% of the GDP this year even as the
government dithers on raising fuel prices in step with the rise in crude‟s cost. In 2008
when GDP is slated to grow to $1.34 trillion, the subsidy may jump to $29.2 billion,
which puts pressure on the fiscal deficit of the economy as govt. cannot pass on this
price hike to the consumer. Govt. imposes more than 50% of the tax on the petrol and
30% on diesel on the retail selling prices. Increased prices will put pressure on

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government tax collection and thus fiscal deficit as the oil sector is the largest tax payer
to the central exchequer, paying close to Rs 7000 crores on account of customs and
excise duty.

Small and medium businesses:

Mostly hit by the crude hike is the small and medium businesses (SMBs).

Energy costs will zoom for thousands of SMBs which work under frequent power
outages as they have to run and operate on a generator which consumes oil.

The spurt in price of aviation fuel, by about 15-20% translates in to lesser foreign
travel for most firms.

Investors are losing their money:

All the public sector refineries and oil marketing firms were facing huge losses as the
selling prices remaining stable and the input and raw material cost has risen
dramatically whish has caused investors of these firms a huge loss by artificially raising
the demand by providing subsidies on retail prices to consumers.

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Conclusions

Though these two factors seem to be small but they have become the major concerns
for each and every nation.

All global economies are under their impact. Now crude has replaced gold on
commodities market. Earlier gold used to control the markets and today crude does
that. Crude is deciding currencies‟ exchange though its not visible.

Inflation on the other hand has become a dangerous pick pocket. Salaries of common
man are not increasing at pace at which prices are inflating. Inflation has forced
government to take serious steps but in vain. Government also resorted to increasing
money supply which according to me is not the solution for this problem. Supply should
be increased and distribution has to be improved.

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References:

1. Business outlook magazine

2. Economic times
3. www.bp.com,
4. Weekly handout of Ventura securities limited.
5. www.Inflationdata.com

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