Oil puts India on slippery road
by Virendra Parekh on 17 Mar 2011 1 Comment

With unrest spreading wider in the Arab world, is the world in for another oil shock? The Arab oil embargo of 1973, the Iranian revolution in 1978-79, Saddam Hussein’s invasion of Kuwait in 1990, and now the so-called Jasmine Revolution, have shown that the inflammable mix of geopolitics and geology in West Asia and North Africa can play havoc with the world economy.

 

West Asia and North Africa produce more than one-third of the world’s oil. Libya’s turmoil shows that political unrest can quickly disrupt oil supply and send prices soaring. The market has so far reacted modestly. The price of Brent crude shot up to $120 a barrel on February 24 as Libyan violence flared up, but has eased $103 by now on Saudi Arabia’s promise of more production.

 

Most economists are optimistic that the global growth may fall by a fraction of a percentage but the recovery in the rich countries is unlikely to be jeopardised. Our finance minister is even more optimistic: he expects the Indian economy to clock 9 per cent growth in 2011-12.

 

The optimists however, leave two big risks out of reckoning. The first risk is that a serious disruption of supply, or even a genuine fear of it, could send oil prices through the roof. Secondly, costlier oil could fuel inflation which may in turn prompt monetary tightening that retards economic activity. India is especially vulnerable to both these risks. 

 

It is true that the global economy now is far better equipped to cope with an oil spike than it was in 1970s. Global output is less oil-intensive. Inflation is lower and wages are much less likely to follow energy-induced price rises. Many governments have large buffer stock, which they did not have back then. Commercial oil stocks are larger than they were when prices peaked in 2008. Saudi Arabia has enough spare capacity to replace Libya, Algeria and some other small producers. And it has expressed its willingness to pump more.

 

However, the turmoil is far from over. Muammar Gaddafi’s delusional determination to hang on to power has brought Libya to the brink of a civil war and may invite western intervention. Indian government has asked Indian nationals to leave Yemen ‘in view of the evolving situation’. And Saudi Arabia, the oilman of the last resort, itself has several characteristics that have generated unrest elsewhere, including an army of disillusioned youth. The fact that the Saudi king had to release a Shia cleric who had publicly called for constitutional monarchy in that country, indicates that it is not immune to trouble.

 

Moreover, oil prices may go up even if there is no disruption. With the world economy growing strongly, oil demand is far outpacing increases in readily available supply. The little spare capacity that is available is dwindling fast. Such a scenario can magnify the effect of any jitters in oil producing countries.

 

This crisis will have three-pronged fallout for India. First, India has the maximum exposure to the region as a share of total Asian exports (21.2 per cent). This could well take a hit if crisis persists. Second, India’s growth and balance of payments can be potentially hit by a possible terms of trade shock. Given renewed concerns about global growth, it is entirely possible that there could be a slowing down of global trade and increased volatility in capital flows. Third, costlier oil will stoke inflation, especially through higher food prices, forcing the Reserve Bank of India to increase key interest rates to curb inflation, hurting growth.

 

India’s growth is already under threat from the rising raw material costs and yawning fiscal deficit. A long drawn-out crisis in West Asia can derail it altogether. India does not face any supply disruption in near future. Libya is not a major source of oil imports for India: it accounts for less than 5 per cent of India’s crude imports. India’s primary sources are Saudi Arabia (around 20 per cent), Iran (around 15 per cent), Kuwait, Iraq and the United Arab Emirates (around 10 per cent each) account for almost two-thirds of India’s crude oil imports.

 

But India is vulnerable to a spike in oil prices. At the present rate of growth, India’s net oil imports in 2011-12 are estimated at 770 million barrels. If oil averages $110/bbl (compared to $85/bbl FY11 year to date), India’s oil import bill for 2011-12 will increase by $20 billion year-on-year.

 

Who will bear this burden? Either the government or the consumers. If the public sector oil companies are asked to bear it they will go bankrupt. If the government bravely decides to bear the burden through borrowings, it will crowd the private sector out of bank credit and hit investment and growth. Moreover, such bravado will put an end to all the hopes of reining in fiscal deficit.

 

Even without a future shock, India’s present oil subsidy has become too big to finance. There is no way Mr. Mukherjee can confine it to the budgeted figure. It is no longer possible to increase only petrol prices, without touching diesel, kerosene and LPG. The phrase oil subsidy is a misnomer: around 35-45 per cent of the price that we pay for petrol, diesel and other fuels is made of some tax or other. A reduction in taxes on petroleum goods can enable oil companies to fully absorb a further rise in the oil import bill and obviate the need for fuel price hike. But any duty cut will send the government’s carefully crafted fiscal consolidation strategy into a tailspin.

 

It is only a matter of time before the government is forced to increase prices of petrol, diesel, LPG and kerosene. It is not an altogether bad idea. Higher prices tend to discourage excessive consumption and encourage efficiency.

 

But the story does not end here. What is more worrying is the sensitivity of food prices to oil prices. Increasingly, food prices have become correlated to oil as agriculture has become more energy-intensive, relying on fertilizers, pumps, cold storage and transportation. If food prices are driven up further, RBI will probably have no choice but to increase key rates to curb inflation. Whichever way one looks at, higher oil prices means a lot more than higher subsidies and government borrowing. Its effect will be felt both by the consumers and corporates.

 

India urgently needs to put in place a medium-term energy security strategy to deal with high oil prices. It has to confront them more smartly than it has done before. One short term measure is to explore the scope for oil-for-food swaps with nations that simultaneously import food and export oil and today face rising food prices and consequent rising food subsidies. India has stocks of grain in excess of the buffer stocking norm and it makes eminent sense to put them to work to hedge against rising oil prices, instead of letting them rot. Secondly, like developed countries, India should start building oil stocks as a buffer to cushion its economy against short-term supply disruptions.

 

Going ahead, India must bring all petroleum products under the proposed Goods and Service Tax. This will automatically moderate the taxes that can be levied on them and stop the unconscionable daylight official robbery that the consumers are daily subjected to. This should be accompanied by a total decontrol of prices, so oil subsidy becomes a thing of the past both for the government and the oil companies.


In the medium term, the public policy should be consciously geared to substitute electricity for oil energy wherever possible. Thus, there has to be a stepped-up effort to run rural pumps on electricity rather than on diesel. This will need political courage to stamp out power theft, invest in transmission and distribution networks as required and free up coal mining. India should also take advantage of the global doubling of natural gas reserves, thanks to shale gas, by investing in LNG terminals and pipeline networks. The railways should seek to substitute power for diesel in traction. More importantly, railways should lure more traffic away from diesel-driven road transport. Blending ethanol into petrol is another measure that should kick in without delay.

 

In short, fire-fighting for the present has to be matched by initiating remedial action of a long-term nature.

 

The author is Executive Editor, Corporate India, and lives in Mumbai

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