Posted in Finance Articles, Total Reads: 1051
, Published on 31 March 2015
In a year filled with geopolitical and economic instability crude oil prices were by far the story of the year. Falling to record lows in the past year, crossing the $50 mark and breaking the traditional business cycle. With a constant production and stagnant demand the low price regime looks to be set for the near future. Thus, world economies are faced with different challenges and opportunities to act on the sliding prices. It remains to be seen how the Indian economy will react to the window of depressed crude oil prices.
Brent crude the benchmark for oil prices fell 48% in 2014 to $51.36 as of 8th January 2015 I. The last time, Brent prices were at this level was 5 years ago in 2009. The precipitous fall in oil prices is attributed to the rise in production of shale gas in the US II, slowing down of the European economies III, and Organization of the Petroleum Exporting Countries’ (OPEC), which controls 40% of the world market decision to not alter production volumes in its 27th November meeting in Vienna IV. In this article, I shall analysis the reasons for the fall in crude oil prices and its effects on the Indian economy.
Why did the collapse happen?
First, US shale gas production has witnessed phenomenal growth from 1.6% of total national natural gas production in 2000, 4.1% in 2005 to 23.1% by 2010 V. The rise in production has been mainly due to innovation in technology, which has tripled production volumes from 1 million barrels per day (bpd) in 2010 to 3 million bpd in 2013 VI. This trend has decreased the demand for crude oil and thus has decreased its price.
Second, the financial crisis of 2008 caused European economies and the US to pull back oil consumption to pre-2000 levels. This contraction of oil consumption caused crude oil prices to fall. Lastly, the biggest producers of crude oil in the world, OPEC, decided to not roll back production in spite of decreasing demand. This caused a supply glut leading to a further depreciation of crude oil price.
Impact on the Indian economy
India is the fourth largest importer of oil VII and meets 70% of its crude oil requirements through imports VIII. This large dependence on oil producing nations makes it extremely susceptible to price variances. With oil prices plummeting to less than half in 2014, the Indian economy has been subject to both positive and negative pressures from the international oil market. I shall first analyse the positive and then the negative effects of oil prices on the economy.
Starting with the positives, first, in 2013/14 India imported oil worth $168 billion at $105 per barrel. The reduction in oil prices leads to a direct saving of $85.82 billion. This capital, which was previously used for either working capital or raw material, can now be used for investing in long-term assets that have a minimal market return of 7.8% IX. This could lead to increased earnings of up to $181.87 billion.
Second, oil is a major component of the Consumer Price Index (CPI), a measure of inflation in India, with a direct weight of 21% X. The decrease in oil price has caused inflation to fall from 9.87% to 4.38% since January 2014. Lower inflation leads to lower interest rates as the holding cost of money reduces, and lower interest rates in turn lead to higher investments as debt servicing becomes more affordable. The buoyancy in investment improves the Gross Domestic Product (GDP) of the economy and induces higher Foreign Direct and Indirect Investments (FDI & FII) as the economy becomes a viable investing destination due to its growth rate. This creates a multiplier effect for the growth of the economy.
Third, oil and gas subsidies had burdened the Indian budget with debt to insulate marginalized households from high crude oil and gas prices. With the reduction in prices, petrol, diesel, and gas subsidies have either been reduced or removed entirely. This has freed up a minimum capital of $10 billion XI for investments in key industries like roads, power, education, health, telecommunication etc. Thus, instead of being used as consumption expenditure this amount can be deployed to fuel growth in the economy.
Moving on to the negatives, first, oil-producing nations are major markets for India’s investors and products. A decline in their imports or currency valuation will have an adverse effect on Indian companies. Companies like Bharti Airtel and Bajaj Auto that have investments and market share in oil producing nations like Nigeria have witnessed a slide in their share price due to the devaluation of the Nigerian Naira VII. This example exhibits the relationship between the Indian economy and oil producing nations.
Second, India is the sixth largest petroleum product exporter with revenues over $60 billion annually VII, which is nearly a 5th of global exports. The dampening demand will reduce unit prices and emaciate margins, negatively affecting petroleum product manufacturers.
Third, whenever oil revenues take a hit, oil-producing regions like the Gulf emphasize on local manufacturing and production and downsize their foreign labour force. Since large parts of the workforce in the Gulf are Indians, an estimated 5 million, states like Goa and Kerala that are heavily dependent on remittances will take a significant toll. The inflow of cash due to remittances standing at $ 70 billion in 2013 made India the largest recipient of remittances in the world. As remittances contribute more to the Indian GDP than the flagship software sector exports XII, halving oil prices would be equivalent to downsizing the IT sector by half.
Fourth, commodity and agriculture prices are heavily linked with crude oil prices, averaging a correlation index of 0.27 XIII. India is a major exporter of both and would see a significant drop in contribution from these industries with falling crude oil prices.
The net effect
As we can see there will be a mixed response on the Indian economy due to the crude oil price crash. Most of the negative effects are structure in nature in so far as they are a product of globalization and India’s competitive advantage in the global market. Changing them to counteract the oil price trends would be difficult, as it would require a restructuring of the economy. The positive effects, on the other hand, are more susceptible to policy measures by the government, thus India should use this window of low prices to reduce its debt and finance infrastructure projects that yield high returns.
This article has been authored by Karma Tshering from IIM Ahmedabad
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XIII. What Drives Crude Oil Prices, (n.d.). US Energy Information Administration, Retrieved from http://www.eia.gov/finance/markets/financial_markets.cfm
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