The oil crash

Govt should seize the opportunity to improve its finances

Brent crude prices cracked 30 per cent in the early hours of trade on Monday, extending the decline to over 45 per cent since the beginning of the year. Oil prices are likely to remain soft in the foreseeable future and analysts are predicting that the Brent crude prices could fall to $20 per barrel from the present level of about $35. The immediate trigger for the fall is the disagreement between the Organization of the Petroleum Exporting Countries (Opec) and Russia over cutting output. Saudi Arabia, as a result, slashed prices and is likely to increase production. It is likely that Russia and other producers too would ramp up production. However, at the fundamental level, the need to cut production rose because of weak demand globally. It is possible that the impact of a simultaneous demand and supply shock to the global economy could last much longer even after coronavirus is contained.

The crash will affect all oil-producing countries. The US is the largest producer of crude oil. This will not only affect investment, but could also tighten credit conditions, which can have wider implications. Countries in West Asia are heavily dependent on oil revenues. According to the International Monetary Fund, Saudi Arabia needs oil to remain above $80 per barrel to balance its budget. Since the oil prices are significantly below the level desired, it will need to cut expenditure. This would not only affect global demand but remittances in countries such as India would take a hit. While lower oil prices help consumers, the overall impact on growth could be limited because of wider uncertainties in the system.

As a large importer of crude oil, India benefits from the decline in prices. At the macro level, a better position in terms of net exports will add to overall growth. Even in the third quarter of the current fiscal year, growth in gross domestic product was significantly driven by net exports and government expenditure. However, the fall in prices would need careful policy management. The government should use this opportunity to strengthen its finances, as was done after the 2014 crash. Given the weak economic environment, its finances are likely to remain under pressure even in the next fiscal year. So, higher taxes on petroleum products will help contain the fiscal deficit. However, the government should recognise that the gains would be temporary; lower oil prices and uncertainties in global markets can also result in significant volatility in the currency market and a rise in risk aversion can lead to large capital outflows. Besides, research shows that a lower current account deficit owing to lower oil prices resulted in significant real appreciation in the rupee last time, which affected exports. Therefore, it is important that the Reserve Bank of India actively manages the currency and avoids a similar outcome. 

The government can also make a beginning in oil-pricing reforms and direct oil-marketing companies to change their pricing mechanism from trade parity price (TPP) to one based on market realities. TPP is based on product prices in the international market, assuming that 80 per cent of the petrol and diesel is imported and 20 per cent is exported. It is high time the oil-marketing companies started pricing their products independently and transparently based on market principles.