Deja vu

What prompted me to write this post is that suddenly all the talks about the use and production of alternative sources of fuel and conservation of energy have disappeared because Oil although not in the 2-digit territory but is well below $ 147 a barrel. As usual the talks of alternative fuel , electric car , nuclear energy all started with a wham and ended in a whimper.We all know that the oil crisis is not new to the world we had seen it in 70's and times earlier than that . So why are we faltering again and again and stumbling due to high oil prices,what has prevented a radical shift to the alternative source of energy and a radical shift in the demand for crude oil?

This time its no different , now since oil price is easing off we are back to the square one.No wonder ,the day crude oil came down by $5 from its high of $ 147 , the coal stocks came down too , indicating the market is discounting the potential of coal stocks , although I agree it is just indicative but it does suggest the historical behavior.So if the history is anything to go by then this easing crude oil prices is neither due to the result of radical shift in the demand nor due to the surfacing of new alternative source of energy.This is just the temporary suppression in the demand which will surface again once the crude oil is back to the normal and stops visiting the high price territory. Why this happens ? Let us take a simple example:electric car came into existence but never was improvised or its not even seen frequently . The reason , the car is appealing till the time , oil prices are obscenely high but once prices go down we switch back to the conventional form of energy , this is not radical shift,but this is a temporary suppression of demand.Hence it is also difficult for the auto companies to rely on the temporary demand of electric car to invest in some serious technology to build a more efficient electric engine.

The demand suppression that I mentioned above is the short run effect of increase in prices but in the long run either the supply needs to get adjusted or the demand needs to take a permanent shift. When we zero in the long term supply situation , first if we consider the supply of oil , no new incremental refinery has been invested in although we had oil crisis before numerous times and second , investment in new sources of energy , has not caught required consistent attention so as to become a substitute for the oil. Demand has also refused to take a leftward shift . So we have seen several oil spikes and their evil effects on economies.

This whole thought was running in my mind for not to make a prediction of crude oil prices but to ponder over the thought that what will push the serious and the real efforts to improvise, produce the alternative sources of energy and reduce the dependency on oil or on second thought does it mean that once again the currently easing of oil price does not bode well or to be more precise does not bode something different in the long run ??

Ergo I have question to the reader that do you think that this time the high oil prices , rattled economy would bring about a significant and long lasting shift in the demand or a shift to the alternative sources of energy ?????

Should India have a Sovereign Wealth Fund (SWF)?

Before going on to the topic that whether India needs a SWF or not let’s first try to understand what is a SWF. A sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals or other financial assets. These funds are run by professionals and buy assets in other countries on behalf of the parent country. Most of the SWF owns financial assets like stocks and bonds, one of the well known, sovereign fund having its strong hold in India is Temasek owned by the government of Singapore. In fact recently SWF’s have proved to be a big saviour to the cash starved global markets. The ongoing financial and subprime crisis eroded networth of giants like Citibank and UBS to name few. These banks were in dire need to raise funds and were bailed out by SWF.

So now since we have got a brief idea of SWF’s the question is in the world of globalisation does India require a SWF? I put this question to you’ll my readers what do you think? Do we require a SWF? Do we have enough money to have a SWF. Average size of a good SWF at the start would be atleast $20-30$ billion. Can we use nearly 10% of our forex reserve for SWF.

The above question was recently raised in the Lok Sabha by a MP and as usual there was a uproar. Taking cue from this couple of months ago Iasked this question in front of a close friend, who also happens to be in the financial market. He is of the view that India should not have a SWF as we don’t have enough money for ourselves and our development so it would not make sense to waste 10% of our reserves in SWF. Instead he suggested that part of the forex reserves should be deployed in infrastructural development. Something Chidambaram has mentioned in his book a compilation of his articles between 2002/2004. But alas he himself has not followed what he preached. I think the point made by my friend is valid and is something that most of the economists are suggesting.

But I have a different perspective on this topic. I think India requires a SWF. I know if Mr.Karat or Mr.Yechury would read this they would be fuming with anger but the fact is that we are in need of a SWF. Lot of you would ask me why and what would be this SWF be of use. Well my idea of SWF is a bit different from the one that the government of Singapore or Kuwait has. I guess the government of India needs to have an investment management company of its own u can name it as a SWF or Special Purpose Vehicle (SPV). The way this Investment Company would be different from others would be the nature of the company. India doesn’t need a SWF to buy stocks and bonds of companies abroad I think we have enough world class companies in the country itself. But India needs a SWF to buy assets abroad. Now what do you have to say do we need it or not?

Well let’s look it this way India is growing at 8% requires energy to fuel this demand, needs food to meet the ever increasing appetite of its people, requires industrial metals for infrastructure, needs more coal than what we use today to fulfil the dream of power for all. If I summarise all these things one thing that comes out is the demand for commodities from India is bound northwards. So if we need more oil we need to import it which means higher deficit for the government, if we need more coal we have bottlenecks in our country so will have to import, more food grains imports. Over all the import burden would rise.

What would this $20 bn (size of SWF is always debatable) do is that it will give us good opportunity to buy assets overseas. For eg: I have read lot of times that ONGC bids for oil blocks in Sudan but looses out to Sinopec. If we are able to use out forex reserves in a concrete way it will make a difference. Buying oil blocks internationally would reduce our import bills. So is for any other metal India would require more Iron ore for steel there are enough iron ore mines in other countries which can be bought. I could give ample amount of examples to support my stance but the fact is that we need more commodities to meet our growing needs and this is likely to increase the conundrum. This can only be solved either by importing more which means higher deficit and large subsidy bill or by increasing supply something which is not in India’s hand at least for some of the important commodities. Which means the only way India could solve the problem is by assets internationally and this can be solved by a SWF.

I leave you my readers with this question that should India have a SWF? I would like to read your views on it. We could have diverse views but this is a topic of debate and something that needs to be taken up in corridors of power.

Revenge of the old economy

Today, as I sit down to write this article, someone (preferably a Central Banker) somewhere would be worried and thinking about the strategies to combat an evil called inflation. Inflation has today become a global phenomenon and has stopped the wheel of growth in many emerging economies like China and India. It has also managed to send developed economies into the recessionary phases. To me, this is the revenge of the old economy. Inflation is today fuelled by commodities like energy, food and primary articles sectors which were neglected for nearly two decades. The old economy was neglected due to the resurgence of the new economy sectors like retail, IT & ITES. Commodities like metals and energy have been reeling under the pressure of underinvestment for nearly two decades.

This decade definitely belongs to commodities, which has witnessed one of its best bull run in the recent times. It was their time to take revenge, it was their time to get noticed and the revenge has not been sudden but gradual. Early part of the decade saw interest developing in commodities when the demand started to pick up as the wheel of economic growth started to move and countries like India and China started to demand more to meet their consumption needs. The second phase came during the middle part of the decade when demand from the industries grew and we saw investments growing in the manufacturing sector pushing the prices further up. The third phase has left the policy makers worried and have led them to make certain policy changes which has hampered growth.

Commodity prices cannot go up forever and breaks will have to be applied either for good or for worse. There has to be a conclusive policy to stop commodities prices from rising to levels which can threaten world economy. So far, central banks have just been mere spectators and their steps to curb inflation and control prices have failed miserably. The solution is not so easy and we will not be able to achieve it if we take short term steps. The solution to this problem lies in the cause of the problem. Cause: a) Underinvestment & b) Food prices have risen due to usage of food products for fuel.

Also the issue with regards to global commodity crisis is such that it requires efforts from the global community to combat the current situation. Lone efforts from India, China or US won’t work. It will have to be a conclusive plan and something that all of them needs to work together. There has to be an UN backed policy on food and food products. Usage of Agricultural products for energy purpose would solve our short term energy crisis but it would spiral into a food crisis for our coming generations. This would then make us more dependent on GM foods and that is not a good sign. Farming has been neglected for a while and most of the farm land is been used for SEZ in various countries this is something that is calling for a dooms day scenario. Our current hunger to grow at any cost is going to affect our coming generations.

The second problem is that of underinvestment for nearly decades commodities have been under the phase of lack on investment. We haven’t heard of any big investment done in any oil field or we did not hear of any big ticket investment in the mining of metals. It is only now that we are hearing mining and oil companies doing investment in natural resources. These investments would bear fruits only after 4-5 years till then it would be too late by then. Just to put it into perspective crude oil one of the most important commodity on the planet earth is in a demand supply conundrum. Right now oil demand is around 87-88 million barrels per day. Total production capacity available is at 90 mbpd. Which means currently we have a spare capacity of 2 mbpd all of it been in Saudi Arabia. By 2013 it is estimated that oil demand shall cross 95 mbpd and in the next 5 years additional capacities of 6 mbpd would likely to be on track. This means that the spare capacities would be reduced by 50%. This situation is not only in oil but in other natural resources also. What we need today is a spate of public and private investments in the natural resources sector. There are other concerns grappling this sector it is capacity concerns with allied industries like rail and port. There are capacity issues which lead to artificial shortages just like what we are facing in coal market. These also have to be addressed by one and all.

Sometimes these price movements’ leads to countries taking extreme policy measures like curbing exports and this leads to shortage in another country. Since this is now becoming a global phenomenon it actually requires policy measure that incorporates interest of all countries. I think the UN has to be more proactive and involve World Bank to undertake projects in countries where there is dearth of investment but ample resources.

If we don’t take notice of it today than it would be too late for us. The “Revenge of the old economy” would lead to disaster.

ECB needs to put Inflation on back burner:

The US Fed has kept the rates unchanged ,as expected ,and let it on the markets to put up with weak dollars.The logic behind raising the interest rates would have been to the strengthen the dollar and to rectify the oil path.But as the Fed didn't raise the interest rate , the oil reached to another life-time high and also it is quite clear that Fed is not going to increase interest rates any time soon so the funds are channelized into the oil and gold.

Fed has reservations regarding the growth prospects of US , which is known to the universe now and although the dollars has been weak for quite sometime ,the weakness in dollar has been a boon in the form of export surge that has given a boost to the US GDP(which is expected to be ,thank gosh!!,at least around 1% , thanks to the Emerging economies)but this is not due to the internal growth (mentioned in my last post that US is expected to slow down or shrink ) but due to the growth in emerging economies ,which has led to the exports from US to the Emerging Economies.US is some how though not markedly sustaining in the wake of the weak dollars.

The other giant central bank to be watched is the ECB meeting coming up this week. The ECB has couple of stark differences when compared with US Fed in ways that ECB 's the main motto is to contain inflation while US fed mandate is not only to control inflation but to have sustained economic growth as well and also ECB is working as the umbrella for more than dozens of countries unlike US Fed that stands only for one country.All these traits are important to be considered when the gambit of the ECB is predicted.So far,ECB has tried to contain inflation and and hence increased interest rates , reducing the attractiveness of European goods as a result the market expects western europe to slow down.Needless to say ECB has not been able to keep up with the various demands of the countries under its purview.The whole region has undergone a not-so-uniform growth.

In the background of above mentiomed scenario any further increase in the euro 's strength will further mar the performance of the euro region.So we have two scenarios to ponder on . Firstly,In case if ECB's Mr.Trichet and its co members increases the interest rates then it will unleash more problems for the macro economics. Euro region will be further pushed into slow down , weakening dollar will further boost oil prices and rest is history to all of us.
In case if the ECB ,the second scenario, does not increase the interest rates , the thing I m betting on, that might give a boost to the exports and may cool down the fired up crude oil and that would give boost to the stock markets across the board.Hence I feel that the remedy has to begin somewhere and Mr.Trichet can play a pivitol role.

I think that ECB although should remain cautious about inflation but it should keep the interest rates unchanged and now should focus on the growth prospects of the euro region.

Inflation more monstrous for the Emerging Economies:

Inflation is the new monster that every country is dreading. But there is a difference in the potential damage that inflation can do to the US and other emerging countries.Why ? That is because now the emerging countries are undergoing some fundamental changes that put the emerging countries in different perspective calls for individual actions on the part of each such economies as far as their monetary policies are concerned and how can this can be done..?By not pegging against the US dollar.

US endured the credit crunch, credit crunch affected the economic growth and consequently to relieve the situation ,the monetary policies were eased off in US. At that time the concern was growth and not inflation but now concern has shifted to inflation but still at this stage, in US, it seems like the easing would be stopped i.e.no more rate cuts but it does not make it apparent that the interest rates would be increased.There are two reasons for it ;firstly ,the imminent election and secondly the expectation of the shrinking of the US economy which will help in offsetting the inflationary pressure .As emerging economies like India and China have pegged their currency with US dollar ,this has led to the brewing of high inflationary situation in these countries too.

But ,this time around , Emerging Economies(EE) should react and behave in the manner suitable to their current economic situation.To be more precise-as i mentioned earlier that EE economies are undergoing sea change and so this change should be incorporated in their monetary policies. The internal demand curve in the countries like India and China has shifted rightwards and hence the equilibrium is expected to change and also it implies that the economic development of emerging countries is not only depended on the US and other developed countries but also on their own internal growth and so any measures that affect this growth should take into consideration both the factors. Logically it follows that the countries need to de-peg its currencies to US dollars to have more independence regarding its own interest rate policies.

To elaborate with example - If we take look at the investment in infrastructure , India is expected to invest 500 billion$ through its five year plan (data from Economist) and China along with other oil producing countries are expected to invest in fixed asset majorly .Investments in infrastructure translates into prosperity and lays path for the sustained economic development and the growth does not seem to be slowing down in the EE.While in US there is no major contribution to the infrastructure any time soon in other words it is expected to be flat .Hence, in India the RBI should start tightening the monetary policy regardless of how long US takes to tighten its own and India should smoothen the path of its own economic development.

It will take more than traditional method of pegging currencies to US dollar ,to combat the inflation, by the emerging economies as they have much more to loose by following the US dollar this time.

COAL-It doesn’t glitter but its gold

Another commodity which has caught my imagination over the past couple of months since the time I have started to track it. I have been fairly fortunate enough by sheer coincidence. My foray in the commodities research concurred with the Bull Run in global commodity markets. Over the last 4 years that I have been in this market each year have been exciting and every year there has been a new commodity which has become darling of the market। . 2008 is the year for Coal and Natural Gas. I will take up natural gas in my subsequent articles in the current one let’s look at coal. After crude oil by far one of the most important commodity in this world when you look at the energy composition.

Introduction

Coal can be classified in two categories broadly thermal and coking coal (hard and semi soft). Thermal coal is used for electric generation purpose where as coking coal is used for crude steel production. The demand for both these categories is fairly high. We would be focussing on thermal coal in this article. Over the years despite the fact that coal is of strategic importance it has never really been talk of the town or coal prices never flew of the roof just the way crude or some of the other commodities did. Unlike Crude oil coal is easily available and is also in abundance. Recently coal has become the talk of the town and just like other commodities coal is also witnessing supply side issues. These days’ supply side issues are something that every commodity is going through but hold you horses the supply issues in coal are a bit different from other commodities. Unlike Crude oil coal story is not about lack to reserves and new capacities to meet demand. According to estimates current coal reserves are around 908 billion metric tonnes with current supply been at 5.9 billion metric tonnes coal reserves can last for nearly 153 yrs.

Supply

On the supply side there are two big issues lingering a) mine damages and b) infrastructural issues. Coal is produced across the globe but nearly 70% of coal comes for 4-5 countries US, Russia, China, India and Australia. Other important producers are Indonesia and South Africa. There have been supply side issues with some of these big producers. Flooding in Queensland has significantly caused damage in the Australian mining area and has constrained coal supply. The mines in Queensland were flooded during the early part of the year and it would take couple of years to restore the mines to its full capacity. In the case of South Africa wet weather had struck the first blow to the coal mining industry. Due to the wet weather in South Africa coal could not be delivered to the power plants and there were brown outs (brown outs is a phenomenon of low voltage) in South Africa. The power utilities company could not produce required amount of power as they don’t have enough stocks of coal with them. Due to this the mines are receiving just 90% of its required power and they are running below capacity. It’s sort of a vicious circle in South Africa. China was another country where weather issues have hampered the deliveries of coal to power plants. Another big coal exporting country is Indonesia the central government is Indonesia has decided to reduce the exports as they themselves require coal to meet their indigenous requirement; this is likely to create tightness in the market.

The other issue on the supply side is infrastructure bottlenecks in some of the major coal producing countries. For example in India itself there are logistics issues apart from quality issues. There are significant rail and port capacity constraints in big exporting market where the capacities have not increased in line with demand for coal. In one of the recent instance, Newcastle one of the biggest coal exporting ports ships were lying for nearly 3 weeks and coal could not be exported. It’s much more severe issue than the weather concerns hampering supplies as the latter is a short term factor but the infrastructural bottlenecks stays for long time. My guess is if the governments of exporting nations take a stock of the situation today and start working on it would take at least 2-3 years to ramp up capacities till then every now and then the supply issues will crop up.

China and India driving demand

According to the IEA, developing countries, should contribute 74% of the increase in global primary energy use between 2005 and 2030. China and India alone will account for 45% of the increase mainly due to the robust demand in China and India where most of electricity is produced by coal. Until recently, China was able to meet its domestic coal needs from its own production. In 2007 however, China became a net importer of coal while traditionally it has been one of the major exporters in the coal market into a net importer. In order to meet its energy demands, India is increasingly dependent on imports. This has also affected the coal sector as India’s economy relies heavily on coal, which accounted for around 39% of total primary energy demand. The Indian Government now plans to build a number of huge or so called “ultra mega” coal-fired power stations, each with a capacity of 4,000 megawatts (MW). Each of these 4,000 MW power stations is expected to consume about 15 million tons of coal a year. India has large coal reserves, they typically comprise high ash content and thus imported coal is needed to reduce pollutants.

Rising Cost

Rising costs should support thermal coal prices over the longer term driven by higher personnel and maintenance costs. Also, the declining quality of coal deposits and less favourable geographic locations of coal mines will support costs. Having said that coal is an efficient source of energy than crude or gas.

Coal vs. Crude

As mentioned above Coal is far more efficient as a source of energy than crude oil. With crude oil prices expected to remain high it is likely to help coal demand where we could see demand substitution setting in. If we try to compare coal and crude, 1 tonne of coal produces 7,100 kilo watts of electricity where as 1 tonne of crude oil produces nearly 6,500 kilo watts of electricity. Which means in volume terms it produces 600 kw more. Even in cost terms coal is cheaper 1 tonne of coal costs USD 120-160 depending on the place from where one imports. Where as in terms of crude oil assuming that crude consolidates and remains at USD 100. 1 tonnes of crude oil would cost roughly USD 600. Which means crude oil is 3-4 times more expensive than coal. Even if coal prices increase by 100% over the next 2-3 years coal would continue to remain cheaper than oil.

Looking at the long term Coal to me looks like a lucrative investment. Over the next couple of years I expect coal prices to increase anywhere between 50% - 75%. Though coal prices have increased by nearly 30% this year but I believe and my conviction in the market makes a case of further more upside. Coal continues to remain a cheap source of energy and the power of the commodity has not been factored in the price.

Crude USD120- A bit too early

At the outset I would like to apologies for not updating the blog. Over the last couple of months there has been something that has been worrying me and it is the sporadic rise in the price of crude oil. By any stretch of imagination the recent rally looks out of place. I would not argue to the fact that yes crude oil market is in a secular bull run and the Bull Run in crude has always had its own share of hysteria but to me it has gone a bit too far this time. I have had an uneasy feeling since the time prices crossed USD90 and it has been growing since then. When I look at the fundamental situation at present in the market doesn't justify such a rally. It has been the financial flows which have been the largest culprit maybe a study of behavioral finance can put some light on the rally. The rally started with a free fall of the USD and as usually geo political tensions in the Middle East. These two have been the biggest driver and have also been supported by the tightness in the distillate markets, slowing imports and huge financial flows into the market.

According to me somewhere near 20-30% of the crude price is purely speculation and nothing else and I believe that it is largely driven today by large banks and hedge funds. I am not really a great exponent of the theory that weakness in the USD should strengthen the crude oil price. I tried to run regression on the time series of USD and Oil and even by historical standards it looks 10% over stretched. Going by the dollar weakness theory with the recent strength in dollar crude oil prices should be coming down but it continues to go up. Which means that is not a full proof theory to trade crude oil with.

Another thing that worries me is the excessive geopolitical premium in the price of crude which never seems to go off even when the geopolitical tension has subsided. Over the last 6 months or so there were events in Middle East and Africa and currently there is peace in both these places but the premium has not shaved off from the price of oil. When you look at both these factors alone there is nearly 20-25% excessive premium in the price of oil. Which means that oil price should have been around 100$ when I remove excessive premium out of the price. Still I haven’t really analysed speculative premium in the market though there has been a brief consensus amongst lot of participants off the record that there is some speculation which has led to the price rise. This trend is pretty evident with the CFTC data released every week.

When I look at the fundamentals of the market it surely gives me a sense of tightness in demand and supply but not as tight as the prices are showing them to be. The price rise in oil is a function of what is going to happen to supply and demand in future. When I look at the data available from various oil producing countries there is nearly 11-12 million barrels of oil is likely to come on track. In 2008 alone it is estimated that nearly 5 million barrels of oil would be on track. So honestly its not as tight as it has been shown to be. Yes there is peak supply on the cards but things are moving too fast in terms of prices. Even with the estimate that 25% of the projects are behind schedule at least 3.5 million barrels would be on track and that is likely to take the spare capacities above 3 million barrels. Also to some extent there has been artificial demand supply tightness created by some parties. There is a catch when you look closely at the demand supply and refinery throughputs figures. The overall crude supply in the market is 87 million barrels per day whereas the demand is at 86.6 mbpd and only 74 mbpd goes into refineries for refining into products which means that nearly 12 mbpd of oil is going into various coffers as inventories. We have already seen oil been stocked by US and China into their strategic petroleum reserves (SPR). The question is that why does US who has increased their SPR from 500 mb to 700 mb in 2-3 years needs to be buying oil above USD 100 for their SPR. Also the economics of business is playing an important role since the refineries are not making profits as it was making earlier due to high crude prices they r not refining enough products and creating shortage of products which has led to rise in price of crude and products. Also with prices consistently above USD 80 it gives lot of space for the non traditional oil producers to come out with the new kind of oil where the cost of production is roughly 40-50$ and an IRR of 17% it would still give them handsome profits. One more point is worth looking at is when crude was at USD 70 there was a huge cry about alternate source of energy and ethanol now when crude is above USD 100 I haven’t heard anything about them.

When I look at all these factors it surely feels that there is more to demand and supply in this market that is driving prices. I feel it’s the financial flow and the need for an alternate investment avenue for investors in wake of global financial turmoil is pushing prices. I feel the the realistic price of oil should be between $85-$90