On 30th November 2017, the Organization of Petroleum Exporting Countries (OPEC) and its non-OPEC friends decided to extend the output cuts till the end of 2018. OPEC and its allies started withholding supplies since January 2017 and currently plan to continue doing so throughout 2018. The cut in production led to the decrease in supply of oil from OPEC and other supporting countries, which has helped it rally in the last six months.
The recent political tensions in Iran has contributed to the rise in oil prices above USD 65 per barrel. Anti-government demonstrations swept across Iran in recent days, which has been the factor for oil to stay above US 65 per barrel.
Brent Crude oil price has rallied from USD 44 per barrel in the month of June 2017 to USD 68 per barrel in the first week of January 2018. Brent Crude oil price had reached a high of USD 65 per barrel in the month of December 2017 due to the decision of OPEC to extend output cuts.
Any significant rise in the price of crude oil can have impact on the raw material costs for petroleum and petroleum derivative products. There are many sectors that depend directly or indirectly on crude oil as many of its fractional distillates and derivatives are used as raw materials in manufacturing of different varieties of chemicals.
Paints and Lubricants
For the Paint industry, crude derivatives form a third of raw materials. A sharp rise in crude prices will reduce gross margins of paints companies. On an average, a 10%rise in crude prices will reduce gross margins of paint makers by 200-300 basis points.
Crude oil forms 56% of the raw materials required to produce lubricants. This would increase the production costs for the lubricant companies. This should lead to operating margin contraction for lubricant companies from Q3FY18.
Tyre manufacturing raw material consists of approximately 40% of rubber while crude oil derivatives form a lower percentage of inputs. Any rise in the crude oil price would tend to dent margins for even the tyre industry to some extent.
Fuel expenses form 34-46% of total revenues of airlines companies. For every USD 10-rise in crude oil prices, airline companies spend approximately 5% more of the current total expenses. So, a rise in crude oil price would hurt earnings growth for the aviation sector.
The FMCG sector would also feel the heat from rising crude oil prices. Petroleum derivatives form the raw material for packaging items such as tubes, bottles and covers. Petroleum derivatives are also used in diapers, detergents, shampoos, cosmetics and perfumes.
The Automobile industry is not directly dependent on crude oil prices in terms of rise in costs due to increased raw material prices but the lower consumption of fuel tends to reduce purchases of Automobiles if petrol and diesel prices continue to rise on a consistent basis.
The effect of increase in the price of crude oil would be reflected in the financial performance of the above sector companies in third and fourth quarter of the financial year 2017-18. The EBITDA and the Profit After Tax margins would tend to decrease for Q3FY18 and they would fall further if crude oil prices continue to trend higher in Q4FY18.
The base effect due to demonetization is expected to result in sharper increase in revenues and profitability for most of the sectors in the economy for Q3FY18. The rise in profitability would be mostly compensated by the rise in raw material prices for companies that depend on crude oil derivatives. The rise in profitability would tend to have a neutral effect for crude oil dependent companies in the third and fourth quarter of the FY 2017-18.
Investors need to be careful in looking for investment opportunities in above companies as valuations are expensive for most of the companies and they tend to correct sharply if any particular industry faces any significant rise in costs on a sustained basis.