Indian Economy And Oil Prices

Indian Economy and Oil Prices

 

Why do Crude Oil Prices increase?

Increase in demand of crude oil is one of the most essential causes of rise in price of oil. It is seen that the demand for crude oil around the world since 1994 till 2006 grew at an average rate of 1.76% per annum, reaching a height of 3.4% in 2003-2004. The demand in the developing countries is irresistible due to their economic development increasingly depending on mechanization. The increase in demand for crude oil has been already predicted and the developing economies including China and India may be the greatest contributors to demands owing to their progressively more urbanized lifestyle and increasing urbanization . With the rapidly increasingly economy, the sector which is considered to be the highest consumer of oil is the transportation sector in the form of new demand for vehicles of personal use. These vehicles are powered by internal combustion engines running on petrol/diesel. Growth in population also causes an increasing demand of oil.

 Reduction or deduction of the state fuel subsidies in order to reduce the government’s cost of subsidization also can be treated as a reason behind rising and falling oil price as the state subsidies were responsible to protect consumers from price rises in many countries.

 Also an increasingly short supply of oil in the world is the major cause for rises in prices. According to statistics the world has been demanding and consuming more oil than can be produced. Presently, production of oil in most countries will soon be reducing and has already gone down – leaving less of a surplus to use – but at the same time, demand also keeps increasing. The supply remains tight and prices keep rising despite OPEC’s decision to increase crude oil production by 500,000 barrels per day. With little price elasticity from both demand and supply, any trivial event will send prices skyrocketing.

 Since oil is being traded in US dollars, the changes in values of US dollars are also said to have impact on the oil prices.. According to studies, when the dollar devalues by 1 percent, it causes an oil price hike of the same degree. In addition, technical, meteorological and political elements also affect prices.

 Loose monetary policies may also be blamed for the increase in oil price and devaluation of dollar. Labor strikes, threats from hurricane to oil platforms, threats or challenges faced by risks of fires and terrorist at the refineries and similar other factors are also considered as the causes of short term price rise but these have no significance to long term increase in the price of oil.

 How does increase in oil prices affect Indian economy –

 Higher prices: adverse impact on fiscal deficit:

India imports 1.5 billion barrels of crude oil each year . This comes up to around 86% of its annual crude oil requirement. So, the surge in crude oil prices could increase India’s expenditure, thus adversely affecting India’s fiscal deficit - the difference between the government’s total revenue and total expenditure. Fiscal deficit indicates the amount of money the government has to borrow to meet its expenses. A rise in fiscal deficit could negatively affect the economy as well as markets. The fall in crude oil prices was a major contributing factor in the reduction of India’s fiscal deficit between 2014 and 2016, according to a report by Livemint . A few years back, we explained the impact of a falling crude oil price on fiscal deficit. To know more, click here.

 

Impact on Current Account Deficit (CAD):

India’s dependency on crude oil imports has only been increasing over the past few years. The dependency rose from 77.3% in FY2014 to 83.7% in FY2018. The rise in crude oil price has a big impact on the Indian Current Account Deficit (CAD). CAD is a measure of India’s trade where the value of goods and services imported exceeds the value of goods and services exported. CAD essentially indicates how much India owes the world in foreign currency. An SBI report suggests that Indian’s CAD could cross 2.5% of GDP for FY2019 (providing oil price continues at $80 per barrel). Currently CAD is estimated at 1.9% for 2017-18.Widening CAD further puts pressure on the rupee’s value as well as the rest of the economy.

 

Oil spike and the rupee impact

If you have seen sharp spikes in oil prices in late 2018, you would have noticed that the rupee also weakens simultaneously. That is because, a sharp spike in oil (as we saw on Monday) makes the rupee extremely vulnerable. Not only the trade deficit and the CAD will be higher and weaken the rupee, but higher oil prices also makes importers and foreign currency borrowers rush for forward cover. That creates a sudden spike in demand for dollar and weakens the rupee.

 

How is oil likely to impact equities?

There are a number of ways oil impacts equities. Firstly, sharply higher oil prices mean that inflation goes up and that is generally negative for equities as a whole. Secondly, there are a number of specific sectors like tires, paints, oil marketing companies, etc. that use crude oil as inputs. For them it means compression of margins due to higher input costs. Thirdly, demand for automobiles, transport services are all dependent on oil prices and a spike in oil prices could further dent demand. Auto demand has fallen over 30% consistently on a monthly basis and could exacerbate with the spike in oil prices.

 

Impact on inflation:

Oil is a very important commodity and it is required to meet domestic fuel needs. And in addition to that, it is a necessary raw material used in a number of industries. An increase in the price of crude oil means that would increase the cost of producing goods. This price rise would finally be passed on to consumers resulting in inflation. Experts believe that an increase of $10/barrel in crude oil prices could raise inflation by 10 basis points (0.1%).

 

Does oil really impact interest rates?

There may not be a direct impact but there is an indirect impact of oil on interest rates. For example, higher oil prices mean higher inflation and that would push up bond yields, hinting at RBI going slow on rate cuts. Secondly, real interest rates would come down. In the last few years, India has attracted global bond investors due to its high real rates. Spike in oil prices could mean either FPI outflows or higher rates to compensate. Quite often, the RBI has also used repo rate hikes as a strategy to protect the rupee when oil spikes.

 

Fact File -

India imports 3 million barrels of crude oil per day. This is a huge quantity of crude oil import. A rise in crude oil prices by $10 per barrel could lead to an increase of $2.5 billion (or Rs 17,000 crore) in fuel subsidies, according to a report by Livemint.