India’s finances can ill-afford spike in oil prices

oil spill

India has many domestic headwinds to worry about. Industrial sector output has been declining, one of the biggest employers and the largest contributor to manufacturing – the vehicle makers -- are in doldrums as their sales have plunged, tax revenues are slowing and banks have slowed down lending to sectors across the economy. It appears no growth engines are firing at the moment.

The last thing India would want now is an increase in world crude prices. If that happens, then the possibility of the economy slipping into a recession in the near future cannot be ruled out.

Brent crude futures, the global oil benchmark, has already gone above $60 per barrel. The last hike of about 2% came after missile strikes on an Iranian tanker in Saudi Arabia last week. The baseline scenario for crude oil that the Reserve Bank of India and the Centre are working with is $63-$64 per barrel.

They are not comfortable with the crude prices going above that level. Beyond $63-$64, there are macro-economic risks to be taken into account. A rise in crude oil prices poses an upside risk to inflation as the country is a net importer of the commodity.

Higher oil prices also restricts RBI from cutting interest rates. But most of all, it raises the current account deficit, which beyond a point starts impacting exchange rates, significantly increasing India’s import bill. The tolerance level of CAD is 2.5% of GDP.

RBI Governor Shaktikanta Das has flagged the crude oil worry on more than one occasion in the past month after the crude oil prices hardened temporarily in the second half of September, following disruptions to production in Saudi Arabia.

India may face an identical situation after the explosion that set Iranian oil tanker on fire near the Saudi port city of Jeddah. The explosion has caused heavy damages and oil is spilling in the Red Sea. Though India’s oil imports from Iran are negligible after the US sanctions, experts believe, if the situation escalates, it can lead to tensions in the Strait of Hormuz, considered the most important oil chokepoint in the world.

More than a third of global seaborne crude oil exports travel through the Strait of Hormuz, funnelling almost 21 million barrels per day. Out of total crude that travels through the Strait of Hormuz, 80% is exported to Asian countries.

Crude sourced by India from Iraq and Saudi Arabia travel through the Strait of Hormuz. Geopolitical tensions, rising trade protectionism can have upside risks to the baseline assumption. The Indian basket of crude oil prices has exhibited high volatility in the first half of 2019-20 and the outlook remains uncertain.

Compounding worries of a net oil importer like India, OPEC and its allies are already in the midst of a production cut deal till March to trim output by 1.2 million barrels per day.

Saudi Arabia has told OPEC its monthly oil output fell by 6,60,000 bpd(barrels per day) in September after major attacks on its energy facilities.

According to RBI’s latest projections, if crude oil prices increase to $73 per barrel, inflation could be higher by around 30 bps and growth weaker by around 20 bps from the baseline.

If the rupee depreciated vis-à-vis the US dollar reflecting global developments of rising trade protectionism, with slowing global trade and global output, inflation could edge up further.

The nominal exchange rate of the rupee vis-a-vis US dollar has depreciated from its April level, impacted by an escalation in US-China trade actions.

India saw a steep jump in its crude oil basket price after the attacks on two oil facilities of state-owned Saudi Aramco, one of the world’s biggest energy companies. Indian basket price went up to $67.34 a barrel on September 17, before a partial retreat. Given India’s heavy dependence on crude imports, a rise in its prices can impact India’s external balances and weighs on the rupee.

The rupee already shed some of its gains due to the rise in crude oil prices late last week. The RBI may not be comfortable with the rupee below the current level of 71 to a dollar. Any further spike in crude will increase the chances of rupee going down further.

Hence, an oil spike can fuel the economic growth worries further. India’s economy has expanded only 5% in the April-June quarter and the private estimates suggest the September quarter growth could be much lower.

This year, so far, the average price of India’s crude oil basket has hovered around $64 per barrel. Any significant rise due to disruption in the supply chain would push the prices above the Centre’s comfortable range.

The Indian basket of crude oil comprises sour grade (Oman and Dubai average) and sweet grade (Brent) crude oil.