Oil price fluctuations and their impact on BRIC countries

Table of Contents

List of abbreviations

Table of figures

List of tables

1 Introduction

2 Overview of Emerging Markets
2.1 What is an Emerging Market?
2.2 Emerging Markets vs. Developed Countries

3 The BRIC Nation
3.1 Introduction
3.1.1 Economic Growth and Development of BRICs
3.1.2 BRICs and Growing Middle Class
3.1.3 BRICs and Global Autos Markets
3.1.4 BRICs and Global Capital Markets
3.1.5 BRICs and Global Energy Markets
3.2 BRIC as a political club

4 BRIC and the Crude Oil Market
4.1 Brazil
4.2 Russia
4.3 India
4.4 China
4.5 MSCI Indices and the Sharpe Ratio

5 BRIC and Crude oil price fluctuations
5.1 Oil price determinants and the oil shock of 2007-2008
5.1.1 Demand Factors
5.1.2 Supply
5.1.3 Market Power
5.1.4 Investor Behaviour
5.2 The 2000s shock
5.3 Impact of oil price fluctuations on stock returns in BRICs
5.4 Risk measures
5.4.1 Volatility
5.4.2 Value at Risk (VaR)
5.4.3 Maximum Drawdown

6 Conclusion

Appendix I

Appendix II

References

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

Table of figures

Figure 1: Annual GDP Growth Rate in % for BRIC and G6 countries

Figure 2: World’s Middle Class

Figure 3: China’s crude oil imports by source, 2011

Figure 4: Histogram for MSCI Indices

Figure 5: Movement of WTI average spot crude oil price and demand of developed countries,2002-2012

Figure 6: Crude Oil Spot Prices for WTI in USD per barrel

Figure 7: Market Price of PetroChina, Lukoil, Petrobras and ONGC from 2002-2012

List of tables

Table 1: Economic Indicators for Brazil

Table 2: Economic Indicators for Russia

Table 3: Economic Indicators for India

Table 4: Economic Indicators for China

Table 5: Returns and Volatility for MSCI Indices

Table 6: Sharpe Ratio (SR) for MSCI Indices

Table 7: Summary of Statistics

Table 8: Volatility

Table 9: Value at Risk

Table 10: Maximum Drawdown

1 Introduction

The last decade was marked by the global financial crisis, the biggest recession since World War II, which led to turmoil on financial markets, bankruptcies of investment banks and slow growth in nearly all developed countries. With only an average annual growth rate of 1.5% since 2010¹ the biggest developed economies recovered only moderately from the crisis. Back in 2001 Jim O’Neill had already realized it was time to focus on new countries. In his opinion the four largest fast growing emerging economies were Brazil, Russia, China and India. Thus he created the acronym BRIC which symbolizes a power shift from developed countries to developing ones. In 2010, the year after the crisis their annual growth rate was about 8.2%² compared to the weak 2.7% of developed countries. This goes along with forecasts that sug- gested a rise in capital, automotive and oil market leading each of the BRICs to overtake the major developed countries.

Among these the most important market seems to be the oil market and more specifically the crude oil market. Crude oil has a share of 34%³ of the world’s primary energy consumption and is likely to remain the same for many more decades. BRIC countries are large oil con- sumers and since 2011 have surpassed the United States (US) in oil consumption. Their strong representation in the crude oil market justifies a further analysis on each country’s status. Ac- cording to Hamilton (2009) the crude oil price development was strongly correlated to the financial meltdown. Thus, understanding the impact of oil price fluctuations can create a path towards a sustainable future growth The target of this paper is to examine O’Neill’s growing theory by investigating the crude oil market for Brazil, Russia, India and China. Furthermore analysing the effect of oil price fluc- tuations on each country’s financial market completes the assumptions in a quantitative man- ner.

The first part is a short introduction to future predictions in order to understand the power of BRICs. The second part shows the vital status of oil for each BRIC country in conjunction with some economical background. A spotlight is put on the financial crisis years because they act just like an examination for the resistance of these countries against turmoil. Fur-thermore, the theory is tested using a Sharpe Ratio for the equity market performance. The last part deals more precisely with the latest oil price shock. Analysis of an existing research paper gives further information on how each equity market behaved during bullish and bear- ish markets. As this study only comprises years up to 2007, a more precise quantitative re- search is added that includes years of the shock and years in the aftermath of the shock. Thus, the periods of 2002-2007 and 2002-2012 are compared using several risk measures for stocks of oil leading companies.

Finally, the conclusion summarizes the qualitative and quantitative findings.

The research material is derived from journals, articles and internet sources from economic organizations

2 Overview of Emerging Markets

2.1 What is an Emerging Market?

The term “Emerging Country ” or “Emerging Market ” was coined by a World Bank econo- mist in the 1980s expressed as a country to be temporary in a phase between developing and developed status. Fifty years later the definition emerging market has been extended in many ways from political to financial ones. For example, an investor would describe it as a country, in which an investment would achieve higher returns but is affiliated to greater risk.⁴ A more generic expression would be that emerging countries are characterized by rapid growth and an industrialization process, which transforms a civilization from an agrarian society into an in- dustrial one. However, a practical definition for an emerging economy was suggested by a French economics professor, Julien Vercueil, who gave the term the following characteris- tics.⁵

Intermediate income: A country’s purchasing power parity (PPP) per capita income lies between 10% and 75% of the average European Union (EU) per capita income. Catching up growth: A country has experienced a vigorous economic growth during at least the last decade and having the effect of diminishing the gap to more advanced economies.

Institutional transformations and economic opening: An institutional transformation has taken place during the last decade as well, which integrated a country more deeply into the world economy. Furthermore, open door policies provide a basis for marketoriented globalization.

Although there is no standard list of emerging countries, the most commonly used come from investment information sources such as the Morgan Stanley Capital International (MSCI) Emerging Market Index, International Monetary Fund (IMF) and ISI Emerging Markets. However, the MSCI Emerging Market Index represents a combined stock performance of the following 23 emerging market country indices: Brazil, Chile, China, Columbia, Czech Repub- lic, Egypt, Greece (reclassified from developed market since 2013), Hungary, India, Indone- sia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.⁶ In addition, IMF considers smaller economies like Bulgaria, Estonia, Latvia, Lithuania, Pakistan, Romania and Venezuela of being emerging markets as well.⁷

2.2 Emerging Markets vs. Developed Countries

An export-driven strategy makes an emerging country stand out from a developed country as domestic demand in emerging countries is low or does not even exist. Hence, the production of lower-cost consumer goods and commodities for their industrialized counterparts leads to higher profits for these companies. Furthermore, higher revenues lead to higher stock prices making them more attractive to investors.⁸

While the US, Japan and Europe are faced with a prolonged period of slow growth caused by several crises in the last decade, the performance of emerging countries outgrows. In 2009 when the crisis hit the whole world the gross domestic product (GDP) of developed countries dipped by 3.4%. Whilst in contrast GDP of emerging countries still registered a 2.6% growth, mainly caused by developing Asia. In particular China and India boosted the world economy while other economies, developed and developing ones, languished at lower levels. Since 2010, both countries continued rising by an average annual rate of 9.1% and 7.1% respec- tively.⁹

Previously in 2001, chief economist of Goldman Sachs, Jim O’Neill, had in mind grouping China and India together with Brazil and Russia. As these countries deemed to be at a similar stage of newly advanced economic development, he created with its initials the term BRIC.

3 The BRIC Nation

3.1 Introduction

Jim O’Neill firstly coined the term BRIC in his work “ Building Better Global Economic BRICs ”, published in the Global Economic Paper for Goldman Sachs in 2001. He used it as an acronym for four rapidly growing developing countries, namely Brazil, Russia, India and China. Furthermore, BRIC is a symbol of the shift in global economic power away from the US, Japan, Germany, France, Italy and the United Kingdom (G6) towards the developing world. In general BRICs turned out to be a pillar of stability, which captures attention of scholars, managers, investors and traders.

However, what highlights these four countries from other encouraging emerging markets are their demographic and economic potential, which even diversified among them, makes them the main contributors to the world’s economic growth. Nevertheless, according to Goldman Sachs, BRIC countries will overtake the G6 by 2032 in US Dollar (USD) terms. India’s econ- omy is expected to overtake Japan’s by 2028 and China’s that of the US by 2026.¹⁰ Further- more, by 2050 BRICs will have reached 40% of global GDP (PPP weighted).¹¹

These projections are optimistic as the BRICs show reasonably successful development. In the article “ The BRICs and Global Markets: Crude, Cars and Capital ” ¹² five main topics were listed with each one of them explaining why the BRICs will be the most influential countries. As these ideas came from 2004, the topics were adopted with latest possible data and forecasts.

3.1.1 Economic Growth and Development of BRICs

Currently the BRIC countries encompass a quarter of the world’s land and about 42% of the world’s population. Moreover, IMF cited that GDP (based on PPP) of BRICs was 22 trillion USD in 2012, which accounted for 26.4% of the world’s total GDP.¹³

Abbildung in dieser Leseprobe nicht enthalten

Source: Own figure based on data from World Bank: GDP Growth (annual %) [online]

Looking at the development of the BRICs and comparing them with the world’s leading G6 it is obvious that since 2001 both groups have been moving parallel but with the difference that BRICs show a sharper GDP increase than the G6 countries. However, between 2001 and 2007 there was a steady increase in GDP growth for BRICs, hitting a peak of 9.7% in 2007. Al- though the financial crisis had caused a steep fall for the G6 in 2009, BRICs still grew by an annual rate of 2.4%. In 2010 a sharp rise of 8.2% occurred for the BRICs but only a 2.7% for the G6. Since 2011 both growth rates are gradually declining, though the margin between BRICs and G6 is still significantly big.

3.1.2 BRICs and Growing Middle Class

The Middle Class includes those with income between 6,000 USD and 30,000 USD¹⁴ per capita and per year¹⁵ and is considered to be an engine for growth and the source of demand. Thus growth in BRICs middle class will strengthen the domestic market of each country and drive global consumption in the meanwhile stagnating world.

Although inequality has been rising within countries, there is a convergence and narrowing of inequality across the world. Therefore, the cross country distribution is likely to move from a twin-peaked distribution, centring countries on high and low GDP per capita, to a more single peaked one by 2050. The peak will move on the upper band of the middle class.¹⁶ While China is now considered to be the main driver for this trend India will push this ladder in the next decade. Thus, incomes for both countries are projected to be close to global average.

Figure 2: World’s Middle Class

Abbildung in dieser Leseprobe nicht enthalten

Source: Wilson D., Dragusanu R. (2008), pp.5-6 [online]

Currently 29% of the world population can be said belongs in the middle class, whereas this figure will soar to 57% by 2050.¹⁷ Afterwards share of the middle class on population will fall as that share of the middle class will shift towards the higher income class.

Nevertheless, it has to be noticed that despite BRICs high growth rate and great future projections, income per capita is more likely to remain far below the level of the richest economies. Thus a high contribution rate on global growth of BRICs is faced with a lower income per capita compared to G6 countries.

3.1.3 BRICs and Global Autos Markets

While the financial crisis made the developed world’s automotive industry struggle with dramatic revenue and sale falls, markets in the BRIC countries were less and differently affected. Total sales in 2009 in China, India and Brazil significantly grew by 31%, 12% and 10% respectively. Only Russia’s total sale fell back by 102%.¹⁸ As a consequence, the increase in demand of China and India brought as well a rise in demand for oil.

Nevertheless, according to Boston Consulting Group BRICs will account for 30% of the world’s automotive sales in 2014¹⁹ and in addition to the automotive industry this provides opportunities for cost effective research and development, sourcing and manufacturing.

Moreover, Dargay et al. (2010) supports this growing market with a quantitative oriented study and shows the development and change in vehicle ownership for 45 countries from 1960 to 2030. As a result it can be seen that higher growth rate in vehicle ownership applies to China (10.6%), India (7.0%) and Brazil (4.1%)²⁰, which is caused by the increasing demand, as a consequence of the expanding middle class. Together with other emerging markets their share of the world vehicles will more than double, from 24% in 2002 to 56% in 2030.²¹

3.1.4 BRICs and Global Capital Markets

In general capital markets provide medium to long-term (more than a year) financing by pro- viding the possibility of trade with securities such as bonds, shares and other derivates.²² Within the BRIC nations capital markets vary. China and India have relatively closed and state controlled capital markets, whereas Russia and Brazil show an open and low state con- trolled capital market.

In terms of market capitalization (market cap), which represents the market value of out- standing equities of firms quoted on stock markets²³, BRIC countries market cap fivefold from 1.4 trillion USD in 2003 to 7 trillion USD in 2012.²⁴ Furthermore, based on the forecasts for future annual GDP growth rates, Goldman Sachs created three scenarios of how BRICs weight in global market cap might develop by 2050. Depending on whether capital markets stay the same or switch to a more bank based model or a more market based model²⁵, they can reach a share of global market cap of 22%, 39% or even 46%.²⁶ It has to be stressed out that a market based model in the case of BRICs show better figures than the bank based one. Even if this is the case, both models have their reasonable advantages and disadvantages.²⁷

3.1.5 BRICs and Global Energy Markets

Energy markets are commodity markets, which deal with trade and supply of electricity, natu- ral gas and oil. As BRIC countries are in several stages of industrialization they have caused high contribution to global energy demand, especially in crude oil. Whilst crude oil consump- tion of G6 countries dropped by 10% between 2002 and 2012, each of the BRIC countries increased their consumption sharply. Especially China and India, with a rise of 49% and 34% respectively, drove the world’s crude oil consumption.²⁸ Furthermore, China is the second largest consumer of crude oil after the US. On the production side Russia has increased its production in crude oil by 27% since 2002 making it the second largest crude oil producer after Saudi Arabia. Because crude oil has a share of 34%²⁹ of the world’s primary energy con- sumption and is a critical factor for economies, the following chapters will deal with crude oil markets from the BRIC countries.

As suggested by Jim O’Neill these five factors will be the driving force for the shift of power from developed to developing countries. In order to achieve these forecasts a further step was taken and BRIC as a political club was founded.

3.2 BRIC as a political club

In order to improve the global economic situation, to reform financial institutions and to strengthen the co-operation of the four countries, BRIC leaders founded BRIC as a political organization. The first summit was held in Yekaterinburg in 2009.

The next step was taken in 2010 when China’s representative welcomed South Africa to join the BRICs and changed the term into BRICS. South Africa is considered to be a gateway to the African continent and the largest trading partner of China. Likewise India is constantly increasing activities with South Africa.

South Africa became a member of the BRICs even though it was dismissed by Jim O’Neill on the grounds that it is a small economy and it has a small share and impact on the world’s global economy.³⁰ Thus, South Africa is not included in the analysis because it only joined the BRICs in 2010.

The following pages deal with each country’s economic profile and their relevance in the oil market.

4 BRIC and the Crude Oil Market

Until now only a short introduction has been given about the impact BRICs will have on the world’s economy and how this might change. In order to support these projections each coun- try’s economy with its strengths and weaknesses has to be stressed out. Also the global finan- cial crisis has to be included in order to understand each countries growth potential because global financial instability is still in sight. Furthermore, the focus will be on the crude oil market as crude oil is a vital source of energy and is likely to remain the same for many more decades. Thus, of greater interest is the crude oil market within the BRICs and each country’s policy to strengthen its position in the market. Moreover, the division of the BRICs into crude oil exporters and crude oil importers is enthralling when looking at consequences caused by the crisis.

Data

GDP growth as annual percentage.³¹
Inflation consumer prices (CPI) as annual percentage.³²
The official exchange rate of the local currency in relation to the USD as the period average.³³

4.1 Brazil

Brazil’s Economy

Table 1: Economic Indicators for Brazil

Abbildung in dieser Leseprobe nicht enthalten

Brazil’s economy is based on three main pillars, namely a floating exchange rate, an inflationtargeting regime and a tight fiscal policy.³⁴ While other big economies were struggling during the great recession with dramatic declines in economic growth, the combination of these three regimes saved the country with a contraction of 0.3%. Since 2012 Brazil has again showed a weak domestic and global economic performance with a growth of only 1%. Hence, to increase international trade and become more competitive the Brazilian government is letting its currency, the Real, to depreciate.³⁵ Nevertheless, Brazil’s biggest problem still remains the high corporate tax (34%) that slows down capital inflow.

Brazil’s Crude Oil Market

Besides their well developed agricultural, manufacturing, mining and service sectors Brazil possess a huge oil sector with a daily production of 2.15 million barrels (2012). The long term goal of the Brazilian government is to increase domestic oil production as domestic demand is constantly growing and refineries are operating at full capacity.³⁶ According to BP, Brazil has 15.3 billion barrels of proven oil reserves and is producing mainly heavy graded oil³⁷, which is sold at a lower price than light graded oil.³⁸

In 2007 Brazil was announced as being a net exporter and domestically self-sufficient, al- though still importing expensive light crude oil from the Middle East making it more vulner- able to unfavourable crude oil price fluctuations. However, import of light crude oil is neces- sary as less costly refining processes can be achieved for the production of heavy crude oil.

A recent discovery of large pre-salt fields³⁹ could break the dependency from the Middle East as it consists of sweet and light recoverable oil, which is the most valuable quality of oil. Though no confirmation has been made yet, the estimation for the whole pre-salt field ranges between 30 billion and 100 billion barrels of oil equivalent.⁴⁰ The first company to utilize parts of these pre-salt fields is Petrobras, one of Brazil’s leading oil companies.⁴¹

Nevertheless, the location of the crude oil is in deep waters and under huge salt layers which gives space for newer technologies and processes. These new challenges already attracted companies like Siemens, IBM, GE, ABB, which are building research and development cen- tres in Brazil. Also, Petrobras switched its internationally oriented strategy to a domestically one and expects to create one thousand hundred new jobs in order to carry out its huge in- vestment plans.⁴² For the next decade total investments of $330 billion USD are expected.⁴³

4.2 Russia

Abbildung in dieser Leseprobe nicht enthalten

Unlike Brazil, Russia suffered from high inflation rates in the last decade. The main reason was a relaxation in monetary and fiscal policy of previous years, which furthermore caused a sharp increase in inflation by 14.1% in 2008. Besides, a 29% increase in general imports dur- ing the spike in food prices and the increase in oil prices made the country vulnerable to the crisis.⁴⁴ As a consequence economic growth felt dramatically by 7.8% hitting Russia harder than any other BRIC country. Several fiscal and monetary policies were suggested to get out of the crisis, like those from Kudrin (2009).⁴⁵ Russian’s government chose to devaluate its currency, the Rubble, in favour of the country’s competiveness. Indeed, since the invention of the depreciation policy annual GDP growth recovered by up to 4.5% and inflation showed significantly lower levels. In particular, consumption was the main driver for recovery rather than investments as investors were aware of the heavy crisis impacts.

In conclusion, Russian’s economy is less diversified than its BRIC counterparts and is highly dependent on natural resources like oil.

[...]

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¹ Average growth rate of France, Germany, Italy, Japan, United Kingdom and United States derived from World Bank, GDP Growth (annual %) [online]

² Average growth rate of Brazil, Russia, India and China derived from World Bank, GDP Growth (annual %) [online]

³ Vgl. Deutsche Rohstoffagentur: Reserven, Ressourcen und Verfügbarkeit von Energierohstoffen 2011, p.18 [online]

⁴ Vgl. Financial Times Lexicon, Emerging Markets [online]

⁵ Vgl. Vercueil, J. 2012, p 232

⁶ Vgl. MSCI, MSCI Emerging Market Indices [online]

⁷ Vgl. International Monetary Fund: World Economic Outlook Update, p.3 [online]

⁸ Vgl. U.S. Economy: What are Emerging Markets? [online]

⁹ Mean of 2010-2012 from World Bank: GDP Growth (annual %) [online]

¹⁰ Vgl. Wilson et al. (2011), p.3 [online]

¹¹ Vgl. Wilson et al. (2011), p.8 [online]

¹² Vgl. Wilson et al. (2004)

¹³ Vgl. International Monetary Fund, World Economic Outlook Database April [online]

¹⁴ in 2007 PPP terms

¹⁵ Vgl. Wilson, D./ Dragusanu, R. (2008), p.7 [online]

¹⁶ Vgl. Wilson et al. (2011), p. 10 [online]

¹⁷ Vgl. Wilson, D./ Dragusanu, R. (2008), p.4 [online]

¹⁸ Vgl. OICA: World Sales - All Vehicles [online]

¹⁹ Vgl. The Boston Consulting Group: Winning the BRIC Auto Market, p.4 [online]

²⁰ Vgl. Dargay et al. (2007), p.18 [online]

²¹ Vgl. Dargay et al. (2007), p. 19 [online]

²² Vgl. Financial Times Lexicon, Capital Markets [online]

²³ Vgl. Investopedia, Market Capitalization [online]

²⁴ Vgl. World Bank, Market Capitalization of Listed Companies [online]

²⁵ This model refers to corporate governance which focuses on shareholders rather than stakeholders.

²⁶ Vgl. Goldman Sachs: BRICs and Beyond, p.232 [online]

²⁷ Ross Levine (2002) shows the relevance of both models in his working paper [online]

²⁸ Vgl. BP: BP Statistical Review of World Energy June 2013, p.9 [online]

²⁹ Vgl. Deutsche Rohstoffagentur: Reserven, Ressourcen und Verfügbarkeit von Energierohstoffen 2011, p.18 [online]

³⁰ Vgl. Globalpost: South Africa to be a BRIC [online]

³¹ Vgl. World Bank, GDP Growth (annual %) [online]

³² Vgl. World Bank, Inflation, Consumer Prices [online]

³³ Vgl. World Bank, Official Exchange Rate [online]

³⁴ Vgl. Araújo et al. (2012) p.93 [online]

³⁵ Vgl. Financial Times: Brasília cheers the real’s decline [online]

³⁶ Vgl. U.S. Energy Information Administration, Brazil [online]

³⁷ “Heavy” or “light” refers to density or specific gravity of oil and further determines the price of the oil. Thus, the higher the density and lower the gravity the heavier the oil and hence the cheaper the price for the oil.

³⁸ Vgl. BP: BP Statistical Review of World Energy June 2013, p.6 [online]

³⁹ Oil reserves, which are located very deep under thick layers of rock and salt.

⁴⁰ Vgl. Offshore Center Denmark: Overview of the Brazilian Oil and Gas Industry, p.12 [online]

⁴¹ Vgl. BBC News (2007): Brazil announces new oil reserves [online]

⁴² Vgl. U.S. Energy Information Administration, Brazil [online]

⁴³ Vgl. Portal Brazil, Strategic sectors [online]

⁴⁴ Vgl. Kudrin, A. (2009), p.13

⁴⁵ Vgl. Kudrin, A. (2009), p.23ff