Fall in oil prices: A short window of opportunity

The rapid fall in oil prices is important for India and its slow growth economy. While both supply and demand-side factors have contributed to this oil price slump, supply-side factors are key.

While the faster than expected recovery in Libya and Iraq has definitely caused the oil production to increase more than what was estimated earlier, it has been the fast paced shale production in the North Dakota and Texas regions of USA which has exacerbated this supply glut. Some have also blamed financialisation of oil and speculation as contributory factors in oil price decline.

Globally, consequent to decline in oil prices, capital expenditure on oil production has already begun to shrink. Upstream oil companies incur expenses such as cost of oil exploration, building rigs, drilling, and marketing, among other costs. Accounting breakeven which is the price to make oil drilling projects profitable includes all the costs whereas the cash breakeven is the price required to keep an existing well operating.

According to experts, a Brent crude price below $50 a barrel will start causing considerable pain to a majority of oil producers especially shale players. However, the cash breakeven suggests that to drive out the US shale producers, a price lower than $30 a barrel may be required. This has an important implication on how long the prices may stay low. Shale well remains operational for 2-3 years during which it loses more than 70 per cent reserves.

Undoubtedly, shale producers are hurt but they will continue production till they remain operationally efficient. Additionally, many crude oil producers might have hedged their output when the prices were significantly higher. Hence, it may result in crude prices staying low for a few years but not too long as can be anticipated from the rebound reflected in crude futures which shows an average price of $50-55 per barrel for 2015, $60 per barrel for 2016 and $73 per barrel by 2019.

Therefore, decline in the crude oil price has to be analysed in different dimensions. First, the impact in the long run will be different than in the short run. In the long run, the prices of crude oil are not expected to go up to earlier heights of $ 120-140. This is for various reasons – slowdown in demand due to lower growth in China and India, and substantial increase in supply as discussed earlier.

Second, in the short run, expecting prices to continue to be around $40-50, as prevailing now, is also not a correct stance for the future. Some experts expect the oil prices to stabilise in the range of $70 per barrel and that shall be the equilibrium price even before 2018. At that price level, oil exporters would continue to benefit and renew exploratory exercises ensuring a steady flow of oil for the global economy to grow. 

India should substantially benefit from oil decline. Already, the price level, measured in Wholesale and Consumer Price Index has come down. Consequently, interest rates have already been adjusted downwards by the Reserve Bank of India which is expected to continue to be lowered in the next few months.

The oil import bill of Rs 10 lakh crore in 2013-14, can be expected to significantly lower in 2014-15. In view of the decline in prices by nearly one-third of the peak level in July 2014, a similarly lower oil bill could substantially contribute in reducing current account deficit. And as lower prices of energy are always useful for global growth, India’s exports should be expected to find robust markets abroad further supporting current account.

Since last two years, in keeping with the recommendations of the Kirit Parikh Committee Report (2013), oil prices in India are getting market determined and subsidy has accordingly been declining without any resistance. Therefore, on the fiscal front, the fiscal deficits will decline further because  expenditure on petroleum subsidy would be significantly lower than the budgeted amount of Rs 63,427 crore for 2014-15.

Higher profits, better investment

India is a major crude oil consumer and share of oil consumption in GDP is about 7.5 per
cent while dependence on crude oil imports stands around 80 per cent of the total domestic requirements. The lower input costs for productive units should result in higher profits and enhanced investment.

The reduction in oil prices is also expected to raise household income which would result in higher expenditure on other goods as well as higher savings, as marginal propensity to consume is generally less than one.

Thus, there is a short window of benefit and India needs to maximise from this available opportunity. The only aspect that India needs to focus on is that such a bonanza would not last too long. Therefore, policy makers should be alert that the space created in balance of payments, and lower CAD should be used to enhance imports that promote growth. To elaborate, India had been recording a decline in imports of capital goods, iron and steel, project goods and machinery which did not augur well for investment and growth. Thus, India can enhance imports of capital goods given additional space created in the current account.

Also, given that cost of oil is low, India should not let go pursuit and expenditure on research on renewable sources of energy like solar, hydro and wind power. Neither should it get into a temptation of liberalising gold imports and squander away the opportunity for selectively increasing imports of capital goods to benefit long term growth prospects. Lower energy costs, coupled with lower interest rates, will translate into higher investment and growth. This augurs well for economic activity in the country and India needs to capitalise on this opportunity.

(Singh is RBI Chair Professor of Economics, and Sinha and Ghosh are two Post-Graduate students working extensively on oil prices, at IIM-Bangalore)