India will have a macro challenge if crude oil moves higher

What has driven this rally in crude oil and why it is not great news for India?

February 24, 2021 8:27 IST | India Infoline News Service
In the last few months, the one commodity that has been on a steep upswing is crude oil. Even in early Nov-20, Brent Crude was trading at a level of $37/bbl. Between Nov-20 and Feb-21, Crude rallied from $37/bbl to $67/bbl. That is a rise of 81% in a span of less than 4 months. What has driven this rally in crude oil and why it is not great news for India?

Figure 1 - One Year Price Chart of Brent Crude ($ per bbl)

Chart Source: Bloomberg
The above 1-year chart of Brent Crude can be divided into three time-partitions.

• The first part is the crash in crude prices between February and April 2020 when crude crashed from $52/bbl to $18/bbl. Of course, WTI crude even went into negative but we will not get into that. The crash was driven by the COVID driven lockdowns.

• The second phase was the short covering and consolidation between May and October. Short covering took crude prices to above $40/bbl but it really did not have the steam for much more and hovered around that level till late October.

• The most important phase has been between Nov-20 and Feb-21 which saw an 81% rally in crude prices to $67/bbl. This was driven by demand expectations but more importantly, there were a series of supply side shocks.

Supply side shocks pushed crude up 81% in 4 months

GDP growth and crude prices tend to be positively correlated. Higher GDP normally leads to more crude demand resulting in better prices. With IMF upgrading global growth in 2021 and 2022, hopes of a sharp spike in crude demand were getting built in. But the real boost to oil prices came from supply shocks.

a) The first supply shock came from the OPEC plus Russia. In its last OPEC meet in Jan-21, the OPEC and Russia committed to sustain their supply cuts to the tune of 7.7 million barrels per day (bpd) at least till the end of March and longer if required. That was a supply shock as the markets were expecting a supply boost from OPEC.

b) The bigger supply shock came from the recent Arctic burst in Texas. The surprisingly freezing temperatures in Texas blocked most of its waterway outlets connecting the rest of the US. Texas produces 4 million bpd of crude and accounts for 40% of the total US oil output. The supply shock is because the recovery could be long drawn.

What does this oil price shock mean for Indian economy?

There are a number of implications that a sharp spike in oil has for the Indian economy in general and Indian markets in particular. Here is a quick impact analysis.

• The first impact of this spike in oil prices will be on the trade deficit. For the month of Dec-20 and Jan-21, the merchandise trade deficit crossed the $15 billion monthly average. This was largely driven by higher crude prices. India relies on crude imports to meet ~85% of its daily oil needs. Every one-dollar rise in crude prices raises the landed cost and negatively impacts the trade deficit.

• A sharp spike in crude prices can throw household budgets in disarray. We need to understand this with reference to the stickiness of petrol and diesel prices. In many states, price of petrol has crossed Rs100/litre and diesel is hot on its heels. Nearly 60% of this price paid goes towards central and state taxes and duties. When crude prices were falling, the government opted to monetize the fall by raising excise duties on petrol and diesel. Now that crude is rising, the government fiscal constraints do not permit any duty reduction. Hence every hike in crude price is being passed on to the consumer as higher prices of petrol and diesel throwing household budgets into a quandary.

• Crude is inflationary at a primary and secondary level. We have seen how higher crude prices means higher cost of petrol and diesel. There is also the secondary impact. A spike in prices of petrol and diesel means higher cost of transport and that builds inflation into almost every product and service. In addition, oil is an important input for industries like paints, chemicals, power generation and plastics. These add to cost-push inflation.

• Have you wondered why stock markets tend to do well when oil prices rising? That is because sectors like oil extraction, oil refining, oil marketing, petrochemicals, gas extraction, gas distribution all gain when crude prices are high. Since these sectors have a substantial weightage in the Nifty and Sensex, they appear to be conducive to stock markets. However, this argument would only work up to a point.

In short, the India has a lot to lose fundamentally from sustained high oil prices, even though stock markets may appear to cheer. This remains the one single risk for the Indian economy as it sets optimistic GDP recovery targets for FY22!

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