Reversing crude oil cycle is bad for India

Ongoing protests in Iran have led to a hardening of crude prices to levels last seen in mid-2015. Threats of supply disruption caused by political trouble may add to upside pressures due to supply cuts agreed upon by other Opec members and Russia. This comes at a time when demand for oil is likely to rise due to growth recovery in the First World.

The benchmark Brent contract is trending at $67-plus/barrel while West Texas Intermediate (WTI) is at $60-plus. That’s about $12/barrel more than a year ago. If prices stay at these levels or spike higher, it could put pressure on India’s Balance of Payments and contribute to domestic inflation.

The Modi government was very lucky that crude oil prices fell in 2014. At the time of general elections in April-May 2014, Brent was trending between $105 and $110. It started dropping in September 2014 and it had fallen to $50 by January 2015. Prices have stayed low since. That enabled the government to free retail prices of petrol and diesel, and place high excise duties on petro-products.

As a result, instead of paying out subsidies to the PSU oil-marketers for retailing at a loss, the government had surpluses in terms of tax collection and also profits from PSU energy sector companies. What’s more, inflation was down and private sector refiners such as Reliance Industries and Essar (now bought by Rosneft) were making higher profits from exports of refined products. (The refining margin rises as the price of crude falls, benefiting refiners and marketers). The Trade Balance benefited both ways since imports cost less and the differential between crude imports and petro-product exports increased. 

If crude prices swing the other way, these variables turn adverse. Domestic inflation rises. The Trade Balance worsens. Private sector product exporters make less profits. The government is also faced with a ticklish problem: Does it maintain tax imposts and pass on price increases to the public? If it does, there could be a political backlash. If it doesn't pass on price increases, there could be pressure on the Fiscal Deficit at a time when tax collections are wobbly due to teething troubles in the GST.

Iran is a major exporter despite the best efforts of the US government and the Saudis to choke it off. It also sits on the Northern shore of the Straits of Hormuz, which means that major trouble could mean an interdiction of shipments out of the Persian Gulf, affecting UAE, Iraq, Qatar, etc.

But, quite apart from what happens in Iran, if the Opec agreement holds, crude prices may rise. Production cuts by oil exporters started in January 2017 and recently, Opec and Russia agreed to continue with a supply squeeze until December 2018. It's estimated that crude inventories have fallen by 15 per cent or so in the last six months as demand has increased due to growth. But, this is partly seasonal due to heating demands. There is also a ceiling on crude prices since North American shale production increases if prices are elevated for a while.

Overall, higher crude prices are bad for India. A few companies — primary producers such as ONGC and OIL — could benefit, since their realisations are linked to international prices. But, this assumes that PSU oil producers will not be forced to share the burden of subsidy if prices are controlled all over again.

There have been kneejerk market reactions, short-selling refining stocks. If Iran settles down, and crude prices dip, there will be a short-term buying opportunity. But, this sector could see further selling since crude prices will probably be elevated through calendar 2018. Investors will be watching the Budget assumptions on this front like a hawk due to the broader macroeconomic implications.