Mounting cost of a stalemate

India must again prepare for higher oil prices

The benchmark Brent crude-oil prices have been hovering around $100 per barrel for the past few days owing to renewed tensions in West Asia and the continued exchange of fire between the United States (US) and Iranian allies. The US reported destroying five Iranian tankers on Tuesday, saying it was a response to Iranian attacks on US assets in the region. Meanwhile, Iran-backed Houthi rebels in Yemen have carried out attacks in Saudi Arabia. The Houthis intend to target Saudi oil exports. They are also fighting their government, which is backed by Saudi Arabia. An escalation could further destabilise the region, impacting global energy markets. 

Oil prices have been extremely volatile since the conflict between Iran and the US began at the end of February. The blockades imposed by both sides in the Strait of Hormuz, a critical route for crude-oil supply, have roiled global energy markets. Brent crude-oil prices were $70-75 per barrel in the second half of February. The war pushed prices above $100 in March, and they remained elevated till the June ceasefire. But the ceasefire quickly unravelled, pushing oil prices higher. The flow of oil from the Strait of Hormuz, which facilitated about one-fifth of the global crude-oil movement before the war, has again been reported to have declined substantially over the past few days. The US is aiming to increase the economic cost of war for Iran by preventing it from selling oil, which went mainly to China. It is uncertain whether a higher economic cost will force Iran to agree to US terms. 

Notably, the cost of war is not limited to Iran. Higher energy prices are affecting the whole world, including US consumers and businesses. The inflation rate in the US has been running above the central bank’s target for years and higher energy prices will further complicate things. A section of the market expects the US central bank to raise interest rates, which will have its own set of implications. Sustained higher oil prices complicate macroeconomic management for a country like India, which depends on imports for most of its requirements. Although the situation has been managed well so far, and the first-quarter national accounts data showed that the Indian economy expanded by 7.8 per cent, pressure was on the external accounts despite robust export performance. Expecting the pressure to continue, the Reserve Bank of India (RBI) announced a concessional swap scheme in June to attract foreign capital flows, including deposits from non-resident Indians. The response has been encouraging and will help the RBI manage the external account in the near term. However, the underlying problem of a potentially wider current-account deficit and pressure on capital flows will remain, given elevated oil prices and uncertain global economic conditions. 

The inflation rate in India is expected to increase in the coming quarters, and even a partial pass-through of higher energy prices will push it further, requiring monetary tightening. Gas prices, for instance, were increased recently. As this newspaper reported this week, oil-marketing companies (OMCs) are incurring underrecoveries on the sale of both petrol and diesel, and it’s not clear how they will be compensated. Indian Oil Corporation, for instance, posted losses worth over ₹1,100 crore in the June quarter. OMCs may not be able to absorb losses for an extended period. The Budget outgo on subsidies has also shown a sharp increase in the first four months this financial year and poses challenges to fiscal management. Thus, with no clarity on how long the renewed conflict will last, India will again need to prepare to deal with the fallout.