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International Crude Oil Prices and its implications for Indian Economy

Posted in Finance Articles, Total Reads: 2687 , Published on March 14, 2015

The fall in crude oil price in the international market is because of both weak demand by China, Europe and Japan and excess supply by U.S. and OPEC (Organisation of Petroleum Exporting Countries). For huge oil importing countries particularly India, this windfall gain will help to reduce Current Account deficit (CAD), to contain Fiscal budget deficit within 4.1% of GDP, to lower the cost of living and to revive dwindling sectors like airlines. However, in longer time frame, weakening global demand and reduction in excess cash abroad will reduce India’s exports and capital inflows in stock markets.

The crude oil price in the international market has fallen from $110 per barrel in June 2014 to less than $60 per barrel by the end of year and the one line reason for it is the mismatch of demand-supply. This simple microeconomics principle even explains the world’s most remarkable phenomenon. For oil exporting countries like Russia, Saudi Arabia, Iraq and Venezuela, this is a nightmare. But, on the other hand, oil importing countries like India, China and Indonesia enjoy this windfall as it comes.

As opposed to fall of prices because of lack of demand in the aftermath of the financial crisis (2008), this time the situation is more worrisome- increase in supply accompanied by fall in demand. World’s biggest importer of crude oil, China has slowed down. Japan and Eurozone are on the verge of falling into recession. As the global economy is slowing down, lesser fuel is required to run the train at lower speed. Internal conflict among OPEC (Organisation of Petroleum Exporting Countries) members, to retain the market share and increase in U.S. oil production, are principle contributors of over-supply of crude oil.

On the onset, a positive oil shock seems a good thing for the world economy as a whole and especially for large oil importing countries like India this shock has numerous direct and indirect implications.

Current account deficit (CAD), difference between imports and exports, which has always been a problem for India could easily be contained within 2% of GDP in FY15. India imports 70% percent of its petroleum needs that constitute 37% of its import basket. So any reduction in oil price in the international market directly reduces the import bill. Financial research company Nomura estimated that every $40 per barrel drop in crude oil price saves India nearly $36 billion per year.

The newly formed Narendra Modi government can meet its fiscal budget deficit (difference between government spending and revenue) target of 4.1% of GDP for this year. Fiscal deficit is being condensed from both ends- decrease in expenditure and increase in income. Due to lower international price of petroleum, government has reduced fuel subsidies (nearly 2% of GDP) and has also increased taxes on petrol and diesel. This gain can be further amplified if the government wisely spends this windfall money on halted infrastructure projects.

Wholesale price index- a measure of inflation of doing business- is likely to fall since fuel contributes 8.6% to its basket. As per the data released in Nov, 2014 by RBI the growth in WPI index was 0% that took everybody by surprise.

Although petrol and diesel constitute only 2% of CPI (Consumer Price Index- an indicator of cost of living) basket but due to domino effect of savings from fuel cost, CPI inflation will come down at a faster pace. Reserve Bank of India governor, Raghuram Rajan, increased interest rates thrice after assuming office in 2013 to bring CPI growth rate down. His target of CPI growth rate of 8% for Jan 2015 and 6% for Jan 2016 will easily remain met extrapolating from recently released figures for Oct 2014 of 5.5%. Because of the fall in inflation he could reduce the interest rates earlier than expected (around mid-2015) to boost the economy with the money supply. In this unique situation where government can provide fiscal drive (as explained earlier), and central banker can provide monetary drive, India could enter into “India Shinning” period (2002-2007) again but this time with a dream combination of high growth with low inflation.

The timing of fall of prices is most opportune for the airline industry that is dwindling to fund its working capital requirements. Fuel costs are a big proportion of the price we pay for the air travel. The recent reduction of 12.5% in air fuel prices might be the only thing which may save SpiceJet (recently cancelled 1800+ flights due to fuel shortage) from going down the Kingfisher’s path (ended flying in 2012 due to bankruptcy).

However, the interplay between short-run (microeconomics) actions and long-run (macroeconomics) phenomena may dampen India’s forecasted growth path on increase of time frame. What is beneficial for India right now may not be good for the world at an aggregate level which through the intertwined functioning of economies will affect India.

Firstly, falling demand in developed economies of Europe and Japan implies lower purchasing power for people abroad which will lead to India’s export reduction resulting in big CAD deficit again.

Secondly, India’s stock markets may tumble because of lack of capital inflows from oil producing countries. Lower oil prices will give lower profits to countries like Saudi Arabia, which will deplete their excess cash reserves that have been parked into emerging economies stock markets especially India.

Thirdly, remittance from Indians living in Gulf, which contributes nearly $80 billion per year to the current account, will take a hit.

Fourthly, the viability of commercial production of our abundant alternate source of fuel, Shale gas, will take a plunge. It is entirely possible that OPEC may raise prices in the near future once the companies, that have invested money in Shale gas projects, get their money out because of non-viability of Shale gas production at $60 per barrel oil price. India being among top 5 countries in Shale gas reserves identified will lose out.

To end, which way the pendulum will swing depends immensely on the sustainability of low oil prices. There is no unanimity among analysts upon this; speculations vary from months to years. The prices may bounce back even after next OPEC meeting or may stay below $100 till 2018 as Nomura predicts. Best for Indian government and the Central banker is to accept fall of oil prices as a gift from Saudi Arabia and make the most of it right now but do not base any long term strategic decision taking lower oil prices as granted.

This article has been authored by Pritpal Singh from IIMA


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