Insights into Editorial: India and Oil Prices
Summary:
Oil prices have gone up by about 15% in just one week. The recent monetary policy statement of the Reserve Bank of India also highlighted that crude oil prices may firm up in the coming months and could be a risk to the year-end inflation target.
Background:
Global commodity prices saw a dip but then started to rise after the global financial crisis. This is a counter-intuitive thing that happened due to a kind of a hysteresis and slowdown in demand, and thus the resulting price drop actually happened much later.
The prices peaked in 2012 when the OPEC average yearly crude oil price touched a high of almost $110. Intra-day prices reached much higher. Economies exporting oil at that time were making merry. But then prices began to plummet – touching a low of $40 in 2016. The intra-day prices dropped to much lower levels.
Why there was decrease in oil prices?
- Oversupply in the international markets due to decrease in Chinese demand.
- Slowdown in the developed world and the ensuing impact on world trade.
- Shale oil boom in the US which required less upfront investment and helped pushing up oil supply.
- Removal of economic sanctions against Iran and it consequently ramping up production.
- OPEC members not being able to reach an agreement was yet another factor for oversupply.
Why oil prices may go up now?
Recently, the Organization of the Petroleum Exporting Countries (Opec) decided to cut production for the first time in eight years. they have decided to reduce output by about 1.2 million barrels per day from January 2017.
Non-Opec members, including Russia, have also promised to cut production by another 600,000 barrels per day.
However, prices may not sustain at higher levels for long due to the following reasons:
- The first test for prices will be whether OPEC’s members, known for their penchant for breaching output caps, stick to the production levels set for them. The temptation to cheat for some such as Venezuela and Algeria, which are relatively smaller producers and whose economies are in the doldrums, will be high indeed.
- Global demand also continues to remain weak and growth is unlikely to accelerate in the near term.
- At higher levels, US shale oil production, which suffered because of lower prices, will once again become attractive.
- Even if Opec is able to keep a watch on the production levels of its members, it will be difficult to track a non-member country like Russia.
How low crude oil prices benefitted India?
India was a major gainer of the fall in crude oil prices as it depends on imports to cover over 75% of its requirement.
- While on the one hand, the low prices helped in containing the current account deficit and lowering inflation, on the other hand it augmented revenues.
- The government used this opportunity to impose higher taxes on petroleum products—which was instrumental in narrowing the fiscal deficit.
- In the last fiscal year, indirect tax revenue was estimated to have exceeded the target by over Rs54,000 crore.
How will rise in crude oil prices affect India?
- If prices continue to rise, the government may have to roll back a part of the tax hike on petroleum products. This will adversely affect the fiscal math and the ability of the government to push capital expenditure.
- Private consumption could also get affected because of higher fuel bills.
- Companies that benefited from lower oil prices may also see a margin erosion as passing higher input cost to the consumer could be difficult at this stage.
- If oil prices manage to move up, some of gains will also be reversed. When oil prices were coming down in 2014, every $10 fall in oil prices reduced inflation based on Wholesale Price Index and Consumer Price Index by 0.5 and 0.2 percentage points, respectively. The impact on current account deficit was 0.5% of the gross domestic product (GDP) and it improved fiscal balance by 0.1% of GDP. A price reversal is likely to have an opposite impact.
- Besides, oil prices have risen at a time when economic activity in India is expected to take a hit in the short run because of the ongoing currency crunch in the system. Higher oil prices will also widen the current account deficit while the rupee has been under pressure because of a strengthening dollar.
What needs to be done?
The OPEC deal has once again shown that strategic interests of nation states can converge (with both Saudi Arabia and Iran agreeing to the deal) and that OPEC as a cartel is not dead. It still is important in deciding the price of oil and impacting geopolitical outcomes in several countries. Countries like India must invest in cleaner technology development, reducing their overt dependence on oil – else they risk being adversely affected each time the price of crude oil starts to rise.
Way ahead:
But what is perhaps important at this stage is the fact that Opec has actually managed to reach an agreement to cut production with the support of non-members. Until recently, Opec’s most influential member Saudi Arabia was not willing to reduce production as it didn’t want to lose market share to other producers. But a deteriorating economic situation seems to have forced a rethink.
However, the real impact of the deal in the medium term will depend on how it is implemented and whether Opec is able to build on this agreement. Most analysts are of the view that oil prices will not sustain at higher levels because of the above mentioned reasons.
Conclusion:
Although oil prices have not reached threatening levels, Indian policymakers will do well to prepare for the underlying shift in the way prices are determined.
