Posted in Finance Articles, Total Reads: 2594
, Published on 20 February 2015
The plummeting of global crude prices has impacted all major economies of the world and India is no exception. As oil forms the bulk of import payments, a drop in prices is highly favorable (with few exceptions) for an economy like India.
Since January last year, the price has dipped nearly 40%. At $110 a barrel in June 2014, the current price has taken a nosedive to $60 per barrel.
Figure 1: Graph showing global crude prices per barrel since January 2014
So why this steep drop in global oil prices? Has a new source of energy been discovered? Have people finally started to realize the detrimental effects of oil usage on the environment? Or the fact that we need to use oil judiciously in order to save it for the succeeding generations? Well sadly the reason is none from the above.
The decrease in oil prices can perhaps be understood by simple economics. The price of any commodity depends upon its demand and supply. A decrease in demand or an increase in supply (other parameters remaining same) will exert a downward force on price. But what happens if both of the above changes in demand and supply occur simultaneously? Obviously, it will generate a magnified effect on decrease in price and this is what the current oil scenario is.
Figure 2: Changes in demand and supply impacting crude oil prices.
The global growth is weak. The Chinese economy has slowed 2% points from its peak. The scenario is no different in the European economies with inflation at around 0.3%. Thus on the demand side, most of the largest oil gulping economies like Russia, Japan, Brazil, South Korea etc. (except America) are registering a growth that is far less than what it was a year ago. Japan, for instance has reported its change in GDP at -1.9% and -0.5% in the second and third quarter of 2014 compared to 0.8% and 0.6% an year ago.
The scenario has also altered vastly on the supply side. OPEC (organization of the petroleum exporting countries) produces about 40% of the world’s crude oil. But lately there has bean a new player in the industry, USA. Owing to the Shale and Gas revolution, America has won the crown of third largest oil producer in the world. OPEC wants to maintain its competitive advantage over USA and hence is not cutting its supply that is ultimately driving the oil prices down.
But amid all this, many nations like India are extremely delighted with the fall in crude prices and its influence on so many sectors. Following section of the article sheds some light on the repercussions of fall in crude price on India.
Figure 3: Repercussions of fall in crude prices on India
Narrowing Current Account Deficit
To start with, current account deficit is an important indicator about an economy’s health and global oil crisis has had a tremendous impact on it. India is a net borrower of goods and services that makes its current account balance in deficit. Decrease in oil prices is shrinking India’s import bill, which in turn is narrowing this deficit. As per data, CAD stood at $17.9bn in the first half year of FY 2014-15 compared to $26.9bn a year ago. This is a 33% decrease in deficit compared to previous year and would have been even more had there been less of gold imports and better monsoon.
Oil is used in several critical activities like fueling transportation etc. that directly impacts the price of many commodities. Inflation and price of oil often depict a cause and effect relationship and are positively correlated. In November last year, oil prices hit a low of $78 per barrel leading to no change in prices at wholesale level. A similar trend is demonstrated through the table below.
In October last year, NDA government deregulated the diesel prices linking it directly with the market prices just like petrol. This in turn would also lower the subsidiary bill. So has falling oil prices laid a helping hand in taking this decision? The answer is Yes! The decline in fuel prices has actually led to decrease in diesel prices after deregulation (a scenario rarely or never observed). This has solved two purposes for the government. It has given confidence to the government for taking this bold decision without hurting the sentiments of the people.
Many research organizations are making positive projections about India’s future gross domestic product. The World Bank for instance has projected a growth of 6.4% in 2015 compared to 5.6% in 2014. The global crude oil crisis is partially responsible for this higher projection along with other factors like lower inflation, deficits etc.
Adverse effect on Oil Exploration and Production companies
In exemplifying an instance of negative impact of fall in crude prices, the oil exploration and production companies are adversely hit. Many companies are reporting profits that are far less than a year ago. Cairn India, for example saw its profit fall to Rs.2278 crores in the second quarter of 2014-15. This reported profit is roughly 33% less than the profit from the previous fiscal year. Same projections (less profits compared to previous fiscal year) are being made for other oil explorations companies like ONGC. The stocks of these firms too have tumbled and remained highly volatile throughout the year.
* Over 52 Week High
Table 2: Comparison of current market price with 52-week High for various oil firms
Lower Revenue Deficit
Moving further, government earns revenue by taxing oil. India’s revenue account has always been in deficit implying that the government always spends more than what it earns during a fiscal year. The government is using both the tools (increasing revenues and lowering expenditure) to combat this gap. Using the fall in crude prices as armor, the government raised the excise duty on petrol and diesel by Rs.2.25 and Rs.1 per litre respectively. The hike is expected to generate additional revenue of Rs.10,000 crores to the exchequer helping it to meet the fiscal deficit target of 4.1% of GDP. On the flip side, the government is limiting its holding in various public companies (reducing expenditure) which will further wither this deficit.
Fall in oil prices acts as a double-edged sword when it comes to Power Sector. On one hand, it reduces the cost of electricity from oil and fuel powered power plants benefiting various gas fired power plant operators like GVK power, Lanco infra, GMR infra, NTPC etc. But on the other it also leads to narrowing the difference between the cost of producing electricity from oil/coal fired plants and renewable sources like solar energy (cost of electricity production is still less through solar but the difference is getting smaller). This reduces the attractiveness of renewable energy sector and is thus delaying many renewable projects by hurting the much-needed investor’s confidence.
Boosting Make in India Campaign
The Modi government has bought a lot of surprises and is usually exerting itself setting new targets. The ‘Make in India’ is one such target. Launched on September 25, 2014 the national program is designed to transform India into a global manufacturing hub by facilitating investments, fostering innovation, enhancing skill development and building best-in-class infrastructure. The main goal of the program is to manufacture 25% of the India’s GDP domestically which currently accounts a mere 15%. The falling oil prices is laying a helping hand in achieving this target by bringing the prices of many essential commodities like coal, iron ore, raw rubber etc. down and thereby encouraging industrial production.
Sentiments towards Modi Government
Lastly, external factors like oil prices have played a big role in improving many macroeconomic indictors that in turn is helping the government to develop people’s sentiments towards them. Just the other day, I was doing daily shopping adjacent to a shop being constructed. I heard the laborers talking that “chahe jo bhi hai, Modi sarkar ne kam se kam petrol aur sabzion ke daam toh kum krdiye” (at least the government has been able to ease the prices on petrol and vegetables). Many people with usually lower financial literacy are giving the credit of many of these improving macroeconomic indictors to the government without understanding the role played by external factors.
The global oil crisis has impacted several economic indicators like CAD, inflation, GDP, revenue etc. and have thus generated a vast opportunity for the government to ignite!
This article has been authored by Shukrant Jagotra from University Business School, Panjab University