Brent Crude is getting closer to its 2018 peak
Oil has been on a roll in the last few months. It has more than doubled since November last year and remains the best performing commodity.
Of course, crude is still way below the pre-2014 levels of $100 plus but oil has rallied close to the 2018 peak of $78/bbl. In fact, oil experts have been estimating that oil could once again breach $100/bbl in 2022, after a gap of 8 years. The wager is that as economies recover from the pandemic, the demand for oil would rise much faster. However, OPEC is likely to keep supply restrained in the near future. That means; the world is likely to be undersupplied making crude prices stronger.
Not great news for India, then
Rising oil prices has never been good news for India. That is hardly surprising considering the 80-85% dependency on oil imports. Of course, that percentage has reduced but it will take quite some time before it can come down significantly. For example, a rise in oil prices can result in a spike in the current account deficit. Remember, India reported a small 0.9% current account surplus in FY21, after a very long time. A higher current account deficit has never been good for the rupee. Inflation has normally been quite vulnerable to crude prices and with inflation close to the RBI upper band of 6%, the margin for error is limited. Above all, the policy options for India to tackle higher oil prices are limited at this point of time.
It could be back to current account deficit in FY22
If oil stays the way it is, it could be back to current account deficit. The pressure was already visible in the Mar-21 quarter and the Jun-21 quarter could only get worse. Remember, it is estimated that $10/bbl spike in the price of Brent Crude adds nearly $12.5 billion to the current account deficit. In other words, if crude prices get close to $100/bbl, we are talking of another $30/bbl upside in crude and a $37 billion impact on the fiscal deficit. Even if nothing else changes, this oil spike alone will spike the current account deficit by 1.3% of GDP. In short, it can wipe out the entire current account surplus of the first half of FY21 and more. A forex chest of $600 billion may be some comfort, but it can do little to change the fundamental impact of oil prices. A sharp spike in CAD risks weakening the rupee as well as a possible sovereign downgrade warning.
Inflation and price instability
Inflation is a much bigger concern for the Indian economy compared to current account deficit. It is estimated that a $10/bbl spike in crude oil prices impacts inflation by about 50 bps, of which half is direct impact and the other half is indirect. While the direct impact will hit fuel inflation, the indirect impact will hit food inflation and core inflation. If we talk about $100 level for Brent Crude, it implies a $30/bbl spike in oil prices and an inflation impact of nearly 150 basis points or 1.50%. With headline inflation close to the RBI upper band of 6%, inflation could pose a huge policy challenge. Impact on real rates of return is the other issue.
Problem is that policy options are limited
It is not like India has not seen oil spike above $100/bbl. It happened ahead of the sub-prime crisis in 2007. Again, between 2012 and 2014, oil was consistently above $100/bbl. Back then, the government had policy options. There was the option of temporarily loading the subsidy burden on OMCs or even the government absorbing via lower duties. Both options look difficult now.
Firstly, India has aggressive plans to privatize OMCs, so loading subsidy losses on them would send the wrong signal and impact valuations. Secondly, government has made the best of the price fall in crude since 2015 by hiking duties consistently. Today 65-70% of the cost of 1 litre of petrol and diesel goes towards central and state duties. However, with fiscal deficit at 9.3% and threatening to beat that in FY22, one can forget about any support from the government. It looks like India may have to live with higher oil prices and that is a problem!