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Dealing with high oil prices

Nov 6, 2007

As far as global events go, much has been said about the subprime mess, the impact of the same on global corporates and the US Fed cutting interest rates. But what about the fact that oil prices continue to scale higher practically everyday? In fact, oil prices soared to touch an intraday high of US$ 96 per barrel on Friday. Juxtapose this against the fact that the Indian economy has been moving like a juggernaut in the past couple of years logging in growth rates of 8.5% to 9% per annum. Despite reports that have cited China and India as the prominent guzzlers of oil to fuel their respective economies, India as yet remains relatively unscathed from the impact of high oil prices. In this article, we shall examine some of the factors that have led to higher crude prices and the impact of the same on India.Global scenario
Predicting crude prices in the future is a tall exercise given that it is dependent upon global demand and supply, geopolitical events, incidence of natural disasters and availability of alternative sources of fuel. The recent volatility in crude prices has been a result of various factors. One is the escalating tension in the Middle East where the military activity on the border between Turkey and Iraq has raised the spectre of a possible obstruction in the flow of oil from the Kurdish region, stifling supply. Besides this, Iran's nuclear aspirations have added to the jitters. Mounting demand for oil in China and India, the approaching winter and reduced stockpiles in the US have also played a role in keeping the oil prices firm. A declining dollar has not helped matters either and countries whose currencies have appreciated against the dollar are stepping up oil imports causing demand to remain firm. And on the supply side, while the OPEC committed to pump an extra 500,000 barrels of oil a day from Nov 1 onwards, the same did not have a major impact in terms of easing the pressure.

On a long-term basis, concerns have been raised with respect to the declining productivity of oilfields and lack of the requisite technology and labour to extract the maximum oil from the present existing oilfields. Countries in the Middle East, North Africa and Latin America where oil is in abundance as compared to the rest of the world continue to remain hotbeds of conflict and political turmoil and this is expected to sustain the volatility in crude prices going forward.

India not feeling the pinch
As a thumb rule, advanced economies witness a 0.25% decline in their GDP growth due to a rise in crude prices by US$ 10 per barrel. The same for emerging economies like India stands at nearly 1%! With their respective economies growing at a scorching pace, China and India have been responsible for the strong growth in demand for oil. However, India has not been facing a huge impact despite importing around 70% of its crude requirements. This is largely due to oil subsidies and an appreciating rupee. Oil prices being a politically sensitive issue, the government has so far refrained from aligning domestic oil prices with international prices. As a result, oil in the form of petrol, LPG and kerosene is being made available to Indian consumers at subsidized rates and in the process is causing state oil companies to bleed.

Given that India's trade deficit widened to US$ 32.5 bn in 1HFY08 (April to August), it would certainly challenge the government's capability to protect the domestic economy from further rise in oil prices. Infact, recently China announced an increase in fuel prices by 10% to help the country's oil refiners curb rising costs. Will India follow suit is anybody's guess.

An appreciating rupee has also likely cushioned the blow for India. While the rupee generally tends to depreciate at the end of every month as the demand for dollar increases to meet the oil import payments, strong growth in the Indian economy, rising interest rate differential between India and the US and as a consequence, surging Foreign Institutional Investors (FIIs) inflows have led to a stronger rupee possibly softening the impact of higher crude prices.

Having said that, Indian corporates dependent on crude and crude based derivatives have been facing the heat, which is being reflected in the rise in raw material costs and subsequent pressure on operating margins (paint companies among others are an example).

To conclude...
The Indian economy has been growing at a faster clip and the rising crude prices may not have an immediate impact on the economy, due to the prevalence of oil subsidies. Having said that, given that India imports a substantial portion of its energy requirements, the negative impact of the same on the current account cannot be undermined. While an appreciating rupee has eased pressure to a certain extent, long-term concerns still exist. In such a scenario, efforts by Indian energy majors to invest in oil assets overseas to meet the rising oil demand in India are a positive sign. But on the whole, while there are sufficient reasons to harbour a positive outlook towards the Indian economy, it would not be prudent to ignore the long-term impact of high crude prices.

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