>INDIA STRATEGY (MORGAN STANLEY)

Hedge the Risk: Buy Energy

■ To say crude oil prices are important to India’s macro is an understatement. After all, oil prices affect inflation, private consumption, growth, external balances, liquidity, and the fiscal deficit. Our estimates indicate that every US$5/bbl increase in oil prices above US$57/bbl increases the fuel oil subsidy in India by US$3 billion (0.25% of GDP) if domestic fuel prices are unchanged. However, the impact on equity prices depends on the state of capital flows. If flows are strong, Indian equities can overcome rising oil prices (i.e., they correlate positively with crude oil prices as we have seen in recent months). However, if flows weaken, rising oil prices can derail the markets (correlation becomes negative like in 2Q2008). A sudden spike up in oil prices is what investors need to worry about, in our view, especially if it comes with a slowdown in capital flows.

■ That said, the longer-term situation with crude oil is getting better for India. Indeed, we forecast that India’s net crude oil import bill will remain at US$100-130 billion. That is, we see oil imports declining as a percentage of GDP from 4.2% in F2009 to 3.9% in F2013, despite a rise in demand. This is due to the shift to gas, rising domestic production as well as rising exports from refineries. Rising gas output has other positive macro implications – increased infrastructure investments, lower fiscal deficit, and higher productivity due to lower energy costs.

■ The most critical factors influencing the energy sector’s price performance seem to be industrial growth and the short bond yield. Given our positive view on industrial growth going into 2010, the sector’s absolute performance is likely to continue for the coming months. Likewise, rising rates will favor the sector’s performance.

■ Valuations and earnings look to be in good shape for the sector as well. Valuations are around historical averages whereas earnings revisions have been leading the market for the past three months.

■ Technical factors also favor the sector. Most important, the sector’s six-month trailing relative performance is at a level from where it usually rallies versus the market.

■ Our global commodities team recently highlighted improving near-term fundamentals in the oil market. Jonathan Garner has turned significantly bullish on the energy sector in both his EM and APXJ model portfolios. Our European strategy team has made Energy the biggest overweight. The Indian Energy sector correlates strongly with EM Energy, and hence these positive views are important. We recommend investors overweight Energy to hedge against the ill effects of a sudden spike in crude oil prices on Indian equities.

■ Our top pick in the energy sector is Reliance Industries (RELI.BO, Rs2,101). The stock has underperformed the market and we believe that a lot of bad news is in the price. At 11.6x F2011 earnings, we find the stock attractively valued. We are also adding Cairn India (CAIL.BO, Rs262) to our Focus List. Cairn India is a direct play on crude oil prices, which our global commodities team believes are likely to rise. Cairn has underperformed the market year to date. We are funding this change by removing ONGC (ONGC.BO, Rs1,161) which has been a stellar performer.

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