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Crude prices: Matter of concern! - Views on News from Equitymaster
 
 
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  • Nov 9, 2004

    Crude prices: Matter of concern!

    'India is on a higher growth trajectory', is what we hear all around us and increasingly, our investment decision, (especially in equities) is being impacted by this new line of thinking. No doubt, India is on a new and higher growth trajectory and this has continues to be recognized by foreign investors also as they pump in more money in to the Indian capital markets. However, a stark reality faces the Indian economic growth story and that is of high crude oil prices.

    High crude prices have the ability to derail economic growth and this has been amply exhibited in most of the major economic downturns in the 1970s in the western world (US and Europe). High crude prices have the ability to impact the Indian growth story also and this was the basis of our poll a few weeks back. We had asked our audience, whether the market is underestimating the negative impact of high oil prices.

    The response we received has been in line with our view on this issue. We believe, and so does a large majority (nearly 77%) of the audience, that higher crude prices will have a more adverse impact than thought before. Some of the respondents (22%), however, felt that the markets are not underestimating the negative impact of high oil prices. A small number (1%) also indicated that they were not in a position to decide on this question.

    India is one of the largest consumers of crude (imports nearly 70% of the crude requirements) and a growing economy like ours needs a regular and cheap supply of this valuable commodity. Higher oil prices lead to inflation, increased input costs, reduced non-oil demand and lower investment in net oil-importing countries. Tax revenues fall and the budget deficit increases, due to rigidities in government expenditure, which drives interest rates up. Because of resistance to real declines in wages, an oil price increase typically leads to upward pressure on nominal wage levels. Wage pressures together with reduced demand tend to lead to higher unemployment, at least in the short term.

    All these factors take a toll on the growth of an economy. An IEA (International Energy Agency) study indicates that for a US$ 10 rise in crude prices (from US$ 25 to US$35), the Indian economy is likely to face a 1% (as a percentage of GDP) fall in its output. Simply put, the Indian GDP growth figure will be negatively impacted by 1% if crude sustain at US$ 35. Considering that the current crude prices are over US$ 42 (for the Indian mix), the negative impact on economic growth would be even more profound.

    The above figures are based on various factors like the import dependency for any country and its oil intensity (primary oil consumption per unit of GDP, essentially measures energy usage efficiency). The extent of use of gaseous fuels like CNG also plays an important role in the estimation of the impact of higher crude prices on economic growth of any country. On all these counts (factors) India fares poorly, as it has a very high dependency on oil imports, its oil intensity is one of the highest (indicating India is one of the most inefficient users of crude oil). Also, the usage on natural gas as an alternate fuel is only gaining ground. All these factors put together highlight the vulnerability of the Indian economy to higher crude prices.

    While no one can safely predict the direction where crude prices are headed, the need of the hour is to derisk the country's energy needs from its dependence on crude oil. Alternate energy sources like nuclear power, hydel power and wind power should be exploited amply, not to mention the further push towards substitution of fuels like petrol and diesel in automobiles with natural gas. If the government is determined to grow the economy at a growth rate of over 7%, it needs to have a firm view regarding how the economy is going to meet its energy needs in an inflationary (crude prices) environment.

     

     

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