India’s New Oil Decision: What You Need to Know

by | published July 2nd, 2010

In this new oil market, global interdependence is becoming the standard.

Developed markets like the U.S. will often feel effects from an event elsewhere… even from a developing country halfway around the world. Case in point: what took place in India late last week.

After eight years of heavy subsidies, New Delhi has decided to deregulate domestic oil products. It’s an effort to ease government deficits. Both the central budget and oil companies racked up considerable losses from the artificially low retail prices, so the government last week decided to phase in a “let the market decide the price” approach.

Adherents of free market capitalism will obviously support the move. But it’s likely to have less advantageous consequences in other global markets.

Like ours.

It just might have as much of an impact on U.S. market prices as on those back in India. And in a moment, I’ll reveal two potential results that will be of much interest in your future oil investments.

First, let me explain how all this will play out.

India Can’t Afford to Keep Up Support for Fuel Prices

Indian suppliers are now openly talking about “dynamic pricing,” much like what already exists in the States. They will start to practice regional variations in pricing, increasing the attractiveness of sales.

The country is experiencing a rapid industrial expansion right alongside China. In fact, both countries are driving accelerating energy usage throughout the developing world.

It used to be that, when prices started increasing, pressure would emerge (in capitals like New Delhi and Beijing) to suppress demand, either by restricting supply or taxing sales more heavily. Any further spike in (already disconcerting) inflation fears would probably prompt both actions. In fact, Washington would assume that such brake-pumping would take place elsewhere. That way, we could continue to feed our expanding demand without worrying about rapid rises in our own domestic market.

That ended several years ago.

Entering into rapid industrial expansion, India and China were suddenly in the position of needing to encourage the availability of energy. To put the kibosh on expanding oil and oil product sales would be to shoot themselves in the foot. Both countries now needed expanding energy availability to sustain a widening production base. Otherwise, the result would be an economic implosion.

Fortunately, both the Chinese renminbi (yuan) and the Indian rupee benefited from the decline in the U.S. dollar, and that benefit was augmented by some rather aggressive central bank policies in both capitals. While inflationary pressures were increasing, they had been tempered. Still, the domestic market facing the enhanced pressures of open trade would have developed another round of serious inflation worries. New Delhi, in 2002, introduced a full range of subsidies on all oil products – from gasoline through kerosene, cooking oil, and especially diesel (the primary fuel for private electricity generation across the country).

That helped to offset some of the inflationary pressure building in the economy… but at a significant cost.

The government has been running an increasing budget deficit because of the subsidies, while local oil companies have been forced to sell product at low prices – sometimes below cost. This is unsustainable, and the government knows that. So on June 25th, they announced they will begin phasing out the subsidies.

The first to go will be support for gasoline; the last the support for diesel. But go they will… and over a relatively short period of time.

Two Outcomes for Investors to Follow

First, as its industrial expansion continues, India is importing both more crude oil and more finished products. It is also showing signs of increasing its domestic energy stockpiling system, similar to that already seen at much higher levels in neighboring China. That means it is intensifying competition for imports.

The Indian government dropping pricing subsidies will make rising retail prices more attractive to foreign providers. That will increase pricing dynamics and may well lead to rising pressure on prices in the U.S. Of course, so long as we continue to have a declining stock market and perceptions of continued lagging demand levels, that pressure will have no immediate impact.

Once the markets stabilize, however, the increasing import needs of the world’s second-largest population will pressure up prices elsewhere. And the availability of supply to meet such global demand increases is suspect anyway. This Indian decision simply augments the problem. Imports of gasoline, diesel, jet fuel and other processed oil products into the U.S. have been rising quicker than the importing of crude oil. Rising competition caused by markets that will offer a premium to U.S. pricing will put an upward pressure on price levels here, as well.

Second, the drop of subsidies will dramatically improve the bottom line of some major Indian companies. Currently, the main beneficiaries are domestically traded providers of refiner product – Indian Oil, Bharat Petroleum, and Hindustan Petroleum – having only thinly liquid global depository receipts (GDRs) trading rarely in London.

On the production side, state major Oil and Natural Gas Corp. (NYSE:ONGC) will benefit directly from the subsidy cut. It currently has to sell its crude to refiners at low state-mandated prices, guaranteeing losses and further drains on the state budget. The result has been quick in coming. In three trading sessions, ONGC has increased stock price on the Mumbai exchange by almost 10%.

The dropping of subsidies will also improve companies’ share liquidity and reduce company interest rates. Oh yes, one other thing will be coming quickly: Shares of these large Indian companies will now be more attractive for wider global trade. Expect new initiatives on placement offers coming shortly. And that will allow investors over here to begin participating in what is going to be a considerable upside in the Indian market.

One caution in all of this. Even with government subsidies, consumer prices in India had still been rising faster than in any other G-20 nation. The balancing act is hardly over. Yet don’t be surprised if the Indian move is mirrored in other developing countries in the near future.

I’ll keep an ear to the ground for any such tremors.


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