How much should we worry about oil prices?

Indian policymakers need to watch the sector carefully but maybe there's no reason to get into a deep funk

Credit rating upgrade or not, there is enough reason to worry about the new googly that global markets have bowled at us – the sharp rise in crude oil prices. Eighty per cent of India’s oil needs have to be imported and even the bravest policymaker or economist will have to concede that 40 per cent cumulative increase in oil prices since June is bound to have do some damage to our macros. Thumb rules abound. A $10 increase in the price of oil per barrel jacks up our current account deficit by 4-45 basis points (bps); inflation moves up by 45 bps if initial and second round effects are considered. Thus not only has the “windfall” of the collapse in oil prices, that supported the economy in the period between 2014 and 2016, we now have to navigate the headwinds that their rise have powered.

It might be useful (despite the inherent flaws in these simplistic back of the envelope calculations) to figure out how much damage this oil rally could do? That would depend on two things — first, an estimate of the “damage” already done and second, the additional damage that would happen if oil keeps going up?  Let’s focus on the second issue here. The additional damage will depend on how much more the price will go up before settling. Will we pay $65, $70 or (god forbid) $100 for a barrel of crude on average over the next 12 months?  

My colleague Tanvi Garg, who tracks this market, tells me that while we certainly can’t rule out a very short-term blip over $65 a barrel, we see $65 to a barrel as a medium-term cap.  She also argues that the demand-supply dynamic of the oil market suggests that prices will see a floor of around $55. Thus the range for these prices has shifted up, pulling the average along with it to around $60 for at least the next six months.

Why the cap? Oil prices have moved up a one way street since June partly because “compliance” or adherence to cuts agreed upon by the Organization of the Petroleum Exporting Countries (OPEC) has moved up. In June, for instance, actual cuts were around 80 per cent of the cuts agreed upon by members. In October, producers together cut more than their commitments. Since the OPEC is primarily a Saudi-led West Asian cartel, this could reflect growing tensions in the region. This would compel each producer government to ensure that their citizens are well-fed and happy through government expenditure on things such as job creating infrastructure projects to social schemes. As they flog their “fisc” the need to ensure that oil prices hit their fiscal breakeven levels intensifies. Oil is the dominant source of revenue for these producers so one can easily calculate backwards to figure out the required level of prices. 

The good news is that the fiscal break-even price has fallen over time for most of the West Asian producers. And here’s the surprise! The break-even level has dropped the most for Saudi Arabia .That suggests that the Saudi economy has diversified its product base significantly, making its government less reliant on oil. Some analysts claim that the Saudis can balance their budget at price lower than the $70 that they have been touting. The $70 number is driven more by the immediate need to push up valuations of Saudi Aramco as it heads into its massive IPO in 2018. 

Illustration by Binay Sinha

So where’s the price likely to settle? The street sense is that as the price moves close to 65, non-OPEC heavyweights such as Russia would start supplying in huge quantities. Funnily enough, Iran has the lowest fiscal break-even price of around 55 to the dollar. Thus if tension were to escalate with the Sunni world, they might think of reneging on their commitment.

However, the big market mover would be the US as some of the temporary disruptions (like weather) dissipate putting supplies from the US back on track. The International Energy Agency (IEA) sees a steady build up in the US supply over 2018 both from conventional sources as well as shale. Shale production came under a cloud of uncertainty in the last couple of years but the consensus is that there will be a steady rise in supply over the next few years. The fear that the break-even prices for shale production and hence the shale supply-driven cap on crude oil prices might have risen is also unfounded. The Dallas Federal Reserve conducted an interesting survey in March this year in which it asked existing shale extractors as well as prospective new entrant the following question, “at price (WTI) does your business break even?”.  Existing producers responded that it is $38 to a barrel for WTI crude (that’s roughly $41 for Brent), while new entrants estimate it at $55 a barrel. 

All this should suggest that oil prices could fall sharply. However, demand is also growing as a more confident China (having decisively averted a slowdown) is back to guzzling oil. As it has become more consumption-oriented, the mix of oil products it demands has shifted to the lighter end (think gasoline for cars more than fuel-oil for heavy industries). However, its appetite is huge and it’s expected to contribute about half of incremental demand going forward. China incidentally upped the limits for its small-scale teapot refiners recently to keep pace with local demand.

That should get us a band for oil prices of around $55-65 per barrel and an average of $60. Eternal oil bulls who see the beginnings of a super-rally whenever oil perks up should keep a watch on the market for renewables. A couple of factoids might be pertinent here. In 2016, power capacity additions through solar photovoltaic technology surpassed that of thermal power. Auction prices for solar and wind energy generate power have dropped precipitously over the last five years. Thus, their case is somewhat weak as renewable energy will progressively grab a growing piece of the pie.  

Indian policymakers need to watch the oil space carefully but maybe there’s no reason to get into a deep funk.

The writer is chief economist, HDFC Bank