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What is crude-sensitive? - Views on News from Equitymaster

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What is crude-sensitive?

Jun 17, 2008

Crude oil prices have been hitting new highs time and again causing sleepless nights for the policy makers across the globe. Indians particularly have a reason to worry as we import nearly 70% of our crude requirement making it the largest component of our import bill. The key reason for the upward movement in crude prices is the imbalance in demand and supply. The price of oil has gone up 600% in these last 10 years (the average price of oil in the late 1990s was US$ 20 a barrel). Robust economic growth of India and China, existing consumption habits of the US and rising income levels leading to demand for better lifestyles have led to higher demand for oil. On the supply side, drying up of the existing oil fields, few new discoveries and uncertainty regarding the existing oil inventory are the concerns. However, the current spike in the prices seems to be an effect of speculation as well. In this article, we give an insight into the impact on the Indian economy if oil prices continue to surge.

Inflation: The rise in the crude oil prices, which if passed to the consumers directly, leads to higher inflation. Crude oil is the chief influencing factor of inflation in the country, as it constitutes 14.2% of the WPI and around 5% of CPI. Inflation for the week ended 31st May 2008 came in at 8.75%, which is likely to rise further as the impact of fuel price hikes will be reflected in the numbers to be released next week.

Interest rates: Inflation currently witnessed is largely supply driven but is much higher than the comfort level of Reserve Bank of India (RBI). In order to anchor inflation, there was a repo rate hike effected last week. This will increase cost of funds and will thus tone down demand for funds, which will lead to a slowdown in the banking system. Also, in order to curtail liquidity, which can fuel inflation, the RBI may resort to further CRR hike.

Trade deficit: The trade deficit soared to an estimated US$ 80.4 bn in FY08 against US$ 59.3 bn in FY07, mainly due to oil imports that went up by 38.3%. Consequently, the share of crude oil imports in the total import bill increased to 32.7% in FY08 from 25% in FY91. Further, the yawning deficit would keep the government's aim of trimming the trade deficit to 2% of GDP far from reaching. This will also increase the government's borrowing need further impacting liquidity in the markets.

Rupee: With 70% of crude requirement being imported, rising prices increases the demand for dollars. Rupee tends to depreciate on account of huge demand for dollar. Since May 2008, the Indian currency has depreciated by nearly 6%. Further, a falling rupee increases the cost of imports. The crude imports are expected to touch 85% in the coming years considering the 10% increase in demand for crude oil every year and stagnant supply from domestic oil fields.

  • Whom does the rupee hurt?

    Oil marketing companies: On account of the higher crude oil prices and the government's policy of providing subsidies to keep the consumer prices fixed, the OMCs are losing about Rs 5.8 bn per day. Though the government in recent times has hiked the prices of petrol, diesel and LPG besides reducing the customs and excise duty on oil products to offset the losses of public sector oil companies, the under recoveries still continue to remain high. The under-recovery is to the tune of Rs 16/litre on petrol, Rs 28/litre on diesel and Rs 303/cylinder for LPG. According to estimates, the under-recoveries of the oil marketing companies could touch Rs 2,000 bn this fiscal. The government would have to compensate them by taking a cut on revenue and issuing oil bonds at a much higher interest rate. Also the interest payments and final repayment are postponed. Further, the OMCs cannot use these bonds to buy or fund expenses, which affect their growth.

    Oil prices not only affect the OMCs but also have a cascading impact on overall prices in the economy. Rising oil prices have also put indirect upward pressure on prices of other products, even though the government has not hiked domestic fuel prices in tandem with global oil prices. Companies using the derivatives of crude oil also witness a hike in their input costs. Further, the transportation, freight and packaging costs also increase, thereby pressuring their margins. Shipping, airline, power and FMCG companies are currently facing hard times.

  • Fuel price hike: Impact on OMCs

    What's in store?
    Goldman Sachs has raised its forecast for the average price of crude oil for the second half of 2008 to US$141 a barrel. It also does not rule out the possibility of the price touching US $200 a barrel in near future. This could worsen inflation and fiscal deficit through a mounting subsidy bill and rapidly depreciating domestic currency. Not to mention that this may bring about some political instability. Reduction of consumption and wasteful spending in addition to greater efforts towards use of alternative energy is the need of the day to make us Indian less crude-sensitive.

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