Brent crude prices hit a three-month high to trade at $68.07 per barrel on Friday, impacting the rupee, which depreciated 4 paise to close at 71.35 against the US dollar.
Crude oil prices have risen about 3% this week and 13% since December 2, threatening to roil India's rupee, inflation and current account deficit metrics and impacting the overall economy, whose growth has hit a six-and-half year low of 4.5% in July-September quarter.
A 10% rise in crude prices roughly widens the CAD by 0.40%, plays out into a 3-4% depreciation in the rupee and pushes up inflation by 0.24%.
A potential breakthrough in the Sino-US trade war and OPEC-led efforts to constrain supply has kept the crude prices up, although, on Friday, trading was quiet as many markets were in holiday mode on Friday.
Lower demand also rendered supply cuts by the Organization of Petroleum Exporting Countries (OPEC) and allies including Russia less effective in supporting the market.
The OPEC+ grouping agreed in November to extend and deepen production cuts that would take as much as 2.1 million barrels per day (bpd) of supply off the market, or roughly 2% of global demand.
A spike in crude prices impacts inflation in a major way because oil is a significant input in the economy. Since India is the net importer of the commodity and ships 80% of its domestic consumption, the impact on the domestic economy is also through a rising CAD. But this is a second-round impact, the first being a sharp increase in petrol and diesel prices, which hit the common man.
A higher crude, on the contrary, is good for oil marketing companies, who earn higher profit due to a pass-through of prices to people. It also means higher revenues for state governments, which impose an ad valorem tax. But the Centre does not earn much as their taxes (excise and customs) are fixed.
Since higher oil prices hit the headline inflation in a significant way, they also limit the Reserve Bank of India's ability to cut policy interest rates even if there is a demand from a slowing economy.