Looming oil risk

Volatility in crude oil markets threatens macro stability

Volatility in global crude oil markets has always been bad news for India. On Friday, the first deputy managing director of the International Monetary Fund, Gita Gopinath, warned there was the risk of a “severe oil shock”. The backdrop for her warning is heightened tensions in West Asia. Israel’s war in Gaza smoulders on; the worst-case scenario, a broader conflict that renders it impossible for crude oil exports to be fulfilled, seemed more likely for part of last week as Israel and Iran exchanged missile salvoes. The immediate danger seemed to be avoided when Iranian state media downplayed the effects of the Israeli response. While some in Hamas (and probably in Tel Aviv) might be willing to see the expansion of the battlefield, the United States and Arab powers seem to want to keep it contained.
 

However, the enhanced risks caused turmoil in the oil markets. News of the Israeli strike sent the price of a barrel of Brent crude oil, the international benchmark, over $90; it retreated following the Iranian media response. This is considerably higher than the “expected” level — which is relatively high following production cuts agreed to by the Organization of Petroleum Exporting Countries (Opec) and its partners. Big oil producers are likely under-producing by almost two million barrels a day. Crude oil prices are more than 10 per cent higher than at the beginning of 2024.

A deeper examination provides more insights. While the headline price of a barrel of Brent crude oil is now at $87, the second- and third-order responses are worth noting. Oil futures have not spiked upwards noticeably. In fact, they were at their highest before Iran sent its first set of missiles towards Israel. Lower futures prices suggest traders continue to be confident that a broader conflict, and thus an oil supply crisis, can be prevented. Part of this is because there is considerable spare petroleum production capacity in the system following the cuts by Opec-plus. Muted demand projections also provide some support to those who believe there is a ceiling on crude oil prices. A large buffer of crude oil has also been built up, including by large consumers such as China. But underlying this confident stability in futures prices is a scramble to insure against risk. Such risk is visible in unusually high intraday trading and volatility. The overall Vix index, which measures volatility and the cost of hedging on Wall Street, hit its highest level since the week after Hamas’ attack on Israel in October last year. The volume of trading of option derivatives based on the Vix index hit a six-year high on Friday. Similar records are visible in oil options trading. The amount of options that bet on a price rise has reached the highest since the disruptions of 2020, the first pandemic year.  
 

Indian policymakers cannot afford to be too sanguine about the future path of oil prices. The data shows India is ever more dependent on energy imports. High crude oil prices — especially if they go above $110 a barrel — will create inflationary pressures, stress the fisc, and cause instability on the external account. The dangers of an oil price spike must be planned for now.