The recent rally in stocks ? pushing up the benchmark indices by close to 12% since September 2012 ? may be cut short if the average crude oil prices stay elevated. After averaging $113 a barrel in 2012, prices have moved up to levels of $114/barrel and, on February 8, Brent crude closed at $118.9, its highest since May last year.

Data suggest that whenever Brent was above $70/barrel, the return on the Sensex was either muted or negative. Over the past decade, there have been 20 quarters during which the average price of Brent was higher than or equal to $70. In 12 of these quarters or 60% of the time, the return on the Sensex was less than or equal to 2% with the benchmark contracting in seven quarters.

Indeed, the recent rise in crude oil prices to a nine-month high could stall the recovery in corporate earnings, besides impacting the balance of payments and current account deficit.

Should the price of Brent ? a European benchmark ? head towards $125 a barrel, it would undo the government?s attempts to deregulate diesel prices by allowing oil marketing companies to raise retail prices in small doses.

Saurabh Mukherjee, head of institutional equities, Ambit Capital, says while the OMCs may up diesel prices for 6-8 months, even a 45-paise-a-month hike in diesel prices may get neutralised by a simultaneous $1-a-month increase in Brent.

Typically, every $10 increase in global crude oil prices strains the current account deficit (CAD) by $8-9 billion. In the quarter ended September 2012, CAD hit an all-time high of 5.4% of the GDP and is estimated at 4.7% for the fiscal 2012-13 by Citigroup.

Nirakar Pradhan, CIO of Future Generali Life Insurance, believes the recent diesel price deregulation, subsequent price hikes and a cap on the number of subsidised gas cylinders per household were the minimum measures required to manage the underrecoveries of OMCs. ?Rising prices hereon could subvert these steps since a $1 increase in crude oil can add nearly R4,000 crore to the current account deficit, which could further get aggravated if rupee regains weakness,? said Pradhan.

Elevated crude oil prices could also stall the Reserve Bank’s monetary easing plans in terms of interest rate cuts since headline inflation, represented by the wholesale price index (WPI), may bounce back above the 7%mark. ?Global crude oil prices and WPI have a tight correlation through both the oil and related products as well as manufactured products, that together form about 60% of the WPI,” said Mukherjee.

Data available since April 2005 show that the WPI has a strong positive correlation of about 55% with the price of Brent. Moreover, rising crude oil prices have displaced the receding trend of WPI inflation in more than once instance like March 2006, October 2007, July 2009 and January 2012.

Deutsche Bank expects the RBI to deliver a 25-bps cut in the repo rate in March 2013. Beyond that the RBI could be constrained in easing rates, as inflation risks could increase, led by factors like the increase in global oil prices, incomplete pass-through from recently implemented diesel, coal and electricity price increases, and a vulnerable rupee.

Higher inflation may also postpone the earnings recovery in the next fiscal, given the impact on raw material and interest costs. While earnings of Sensex companies are expected to expand 5- 6% in 2012-13, the consensus estimates are pinning for a 10-14% recovery in the same in the next fiscal. However, according to Rakesh Arora, MD & head of research with Macquarie Capital Securities, if oil prices go up due to a strong recovery in the global economy, India may not feel a negative impact since the domestic economy would also benefit from this improvement.

?If the rise stems from increased tension in West Asia, that could cripple the recovery. Thus, it remains a risk but not in the near term,? said Arora.