Indonesia Strategy - Assessing higher oil price - Deutsche Bank

Deutsche Bank commodity team has raised its forecasts for oil and coal prices. Oil price forecasts have been revised up by 16% and 15% from previous forecasts to US$117.5 for both FY11 and FY12. Our assessment is that the impact on companies' earnings and at the macro level is likely to be rather muted.

At macro level, technical factor is more prevalent than fundamental impact As a reminder, the fundamental impact of a higher oil price on current account, inflation and budget is manageable. However it makes sense to watch the bond price and the rupiah, as substantial weakness there could trigger a vicious cycle of capital reversal. However, we attached a low probability to this event. FX reserves build-up has been consistently close to 2x capital inflow (portfolio inflow of US$17bn in the past 14 months is dwarfed by a jump in FX reserves of c.US$34bn, thanks to record FDI and current account surplus). At US$103.3bn, FX reserves should be able to withstand a reversal, if any, as seen earlier in the year.

1) Current account: Indonesia ran a net oil deficit of US$12bn last year on US$80/bbl oil price. At US$117.5/bbl, this deficit could touch US$17bn. Importantly, Indonesia runs a much larger surplus of US$65-70bn on its Top 5 commodities, along with a surplus of US$13bn from gas. As long as commodity prices move in the same direction, the risk of a higher oil price is neutralised.

2) Inflation: The bulk of fuel consumption goes towards transport and electricity, so a higher oil price would be absorbed by the budget. Only 20% of fuel consumed in Indonesia is marked to market for industrial use; mainly impacting power plants and coal transport, or through indirect cost pass-through. Our estimates suggest that every 20% price increase would need less than 1% cost pass-through. As long as energy subsidy remains, this ratio holds. Note however the plan to remove fuel subsidy for private cars, which is delayed until mid-year, but as it aims at the 'haves' and only to private cars, the spill-over effect is muted.

3) Budget deficit: Given the lower fuel volume subsidized, and an increase of c.150% in tax revenue since FY05, the budget is much better positioned to absorb higher costs. At US$117.5/bbl, budget deficit should stay below 2.2% against the current target of 1.8%. Energy subsidy amounts to 1.9% of GDP at US$80/bbl and is estimated to increase by 0.1% for every US$10/bbl increase. In any case, since government spending accounts for only 13% of GDP, any scale-back in spending to make room for larger energy subsidy shouldn't have material impact on the broader economy. Note that the leftover fund from FY10 under-spending is around 0.7% of GDP. A caveat here is if fuel smuggling picks up dramatically, volumes could be pushed well above the subsidized level.

Companies impact – Coal, Consumer, Cement and Tire industries

Coal: Coal companies are most exposed to a higher oil price, but as we also increased our thermal coal price forecasts by 10% and 4% for FY11 and FY12 to US$126 and US$140, the net impact would generally be positive; earnings would increase by 9% and 1% for FY11 and FY12. Our top pick in the sector is HRUM due to its stronger production growth profile (35% CAGR FY10-12F vs. 12% peers) and strong leverage to higher coal prices (c. 1:2 ratio).

Consumer: In general, plastic packaging (flexible and rigid) accounts for some 10% of sales; so ceteris paribus, the c.16% increase in oil price forecasts would require less than a 2% price increase to pass-through. Least impacted being GGRM and most is ICBP, both of which should have pricing power to pass on less than 1% and 2.5% price hikes respectively. Both are our top picks for the sector.

Cement: Most exposed would be INTP, about 2% of sales equivalent; so for the c.16% higher oil price forecast, 0.5% price hike would suffice. Impact would be negligible on SMCB and SMGR given their lower dependence on oil as a fuel source. We expect the sector performance to recover as price hikes should be more apparent in the coming months. SMGR is our top pick in the sector.

Tire: Oil-related costs, primarily synthetic rubber and carbon black, account for c.30% of sales equivalent; as such, the 16% higher oil price forecast would require a 5% price hike. The almost 30% volume growth last year would suggest pricing power, but compounded by 40% higher rubber prices, suggests margin contraction is inevitable. However the attractive growth prospect suggests any stock weakness would be a buying opportunity