The recent rise in crude oil prices has made as many headlines as the fall in Indian equity market since the start of 2011. Given that crude oil prices are sensitive to any geopolitical unrest, as a reaction to the recent agitation in Egypt, Brent crude oil, European benchmark surpassed $100 a barrel mark last Wednesday, first time since October 2008. Similar was the case with WTI (West Texas Intermediary) crude oil, the most widely followed benchmark for the international crude oil prices which in 2011 so far has already gained more than 11% from an average price of $79.6 in 2010.

An analysis of the quarterly movement of crude oil prices and returns provided by the broader equity market index shows that a sustained upward trajectory of crude oil prices hereon could have a further negative bearing on the equity market.

Any significant rebound in the equity market could be a major challenge if the average crude oil prices for the quarter remain on a higher side. Higher crude oil prices could eat into India Inc?s earnings in the coming quarters by further escalating inflation which in turn puts pressure on the interest rates. This is over and above the fundamental pressure higher crude oil prices can have on input costs for corporates.

Forbidden zone

The average price of WTI crude oil gained 22% in 2010 after falling by almost 70% in 2009. For the last quarter of 2009, prices averaged close to $85, which is historically the highest for any quarter since Q3 of 2008. Furthermore, it is barely a month into 2011 and the average price for WTI crude oil is already touching $90.

The historic data suggests that for the quarters when crude oil sustained above $70, the return on Sensex either remained muted or was negative. On comparing the quarterly return on Sensex against the quarterly average prices of crude oil between 2003 and 2010, we observed that there were 12 quarters in the duration when the average price of crude oil was greater than or equal to $70 mark. Notably, for nine out of these 12 quarters or 75% of time, the return on Sensex was lesser than or equal to 2%.

As can be seen from the chart, in the second quarter of 2006, when the crude oil touched $70 a barrel mark for the first time, the Sensex fell 6%. Similarly for the first three quarters of 2008, when crude oil was marching towards its all time high, the Sensex on an average declined by 14% every quarter.

A similar pattern was observed since the fourth quarter of 2009, when oil prices went up consistently and in four out of five quarters Sensex managed a return of upto 2%. Moreover, in the first month of 2011 the index has already declined 10% with the oil prices rising by 11%.

Cause and effect

On the face of it while this analysis depicts the outcome of increasingly higher crude oil price, the cause of such decline lies in the fundamental effect of the same. The fundamental outcome being a decline in net corporate earnings following higher inflation caused by higher crude oil prices and a subsequent rise in interest costs.

Even as the energy component known as the fuel and power component directly account for only 14% of the India?s benchmark of inflation?WPI ( Wholesale Price Index)? the same can have a significant indirect effect on the inflation gauge and more importantly on the macro-economic situation.

As can be seen from the second chart, when put together, the positioning of WPI with respect to crude oil prices between early 2010 and now appear similar to that between May 2006 and December 2007. During that period the overall inflation was initially spiked by higher food prices and subsequently it started to rev up following an increase in both the energy (crude oil) and food prices. This escalation then had a mounting effect on interest rate in the six months following December 2007, reflected by a more than 170 bps rise in the yield of benchmark 10-year bond in the period.

If we assume a a similar jump (150 bps) in the interest rate from hereon over the next six months, the Sensex earnings could fall by close to 5.6% bringing down its 2012 earnings per share by Rs 67 to Rs 1,133. This is turn could affect its valuations and return givings.

This calculation is based on a scenario wherein the crude oil prices manage to sustain the upward momentum. There seems a substantial case for this development, given that in the near to medium term, crude oil is expected to remain in the range of $100-80 a barrel. This in turn could spell bad news for equity markets.