Declining Oil Price -Implications for Indian Economy and the World

"Declining Oil Price :
Implications for Indian
Economy and the
World"
[Type the document subtitle]
Submitted to : Urvanki Shah
By
Abhigyan
2/4/2015
EXECUTIVE SUMMARY
The price of crude oil has plummeted in the recent months from $115 a barrel in June
2014 to about $53 in February 2015. Oil, considered to be the most important fossil
fuel in the modern era, has been one of the most heavily traded commodities and
prices are mostly dependent on Supply-Demand and speculation. The major global
supply is fulfilled by OPEC which is a cartel of 12 oil exporting countries and
accounts for about 40% of global production followed by US and Russia. Saudi
Arabia is the major player dictating the actions of OPEC and has been adamant about
not reducing supply to curb the supply surplus and this has led to a continued fall in
prices. In fact Saudi has reduced oil prices for some of its major Asian buyers in order
to retain them and this has caused a further slide in prices. This move from Saudi is
being seen as a ploy to destroy the shale oil producers of North America, especially
US, who by means of innovative drilling technologies like fracking and horizontal
drilling, have been able to increase their production to an all-time high, thereby
reducing its dependence on imports from OPEC. Experts have signalled that shale gas
exploration is not economically feasible at below $60/barrel levels and this is seen to
be the reason of Saudi‟s insistence of letting the oil prices fall, which as it may be
noted, has amassed huge foreign reserves and can take the slump in prices for a
considerable amount of time. The falling prices of crude have major global
implications. While countries like Russia, Venezuela, Libya etc. may break down
economically under its pressure, emerging economies like India and European
countries which have been hit hard by the recent global recession have much to gain
from this slump in prices. India,the fourth largest importer of crude in 2014, has a
major opportunity to boost its economy and take full advantage of this low price level
and close down its current account deficit which has been exposed because of huge oil
imports. Moreover, with a rare stable and majority government at the centre, the time
is ripe to employ measures and laws to ensure that maximum advantage is taken of
this short window of opportunity and reserves and relationships be built for the future.
The recent slump in oil prices has provided an excellent opportunity for a shift in
global dominance and makes for an excellent study of who would emerge the winner.
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Contents
FALL IN OIL PRICES: WHY??..................................................................................................................... 3
IMPACT OF THE FALLING PRICES ............................................................................................................ 4
INDIA: IMPACT AND OPPURTUNITIES ..................................................................................................... 6
HOW FAR WILL IT FALL ?? ....................................................................................................................... 8
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FALL IN OIL PRICES: WHY??
Crude oil price has fallen by more than 50% since June 2014 when it was being traded
at $115 a barrel. It is now hovering around the $50 mark and this comes after nearly
five years of stability after the last price dip in 2008.
Prices are determined by the global supply-demand and also by speculation. The
demand side is closely linked to the infrastructure development activities around the
world and also on the prevalent economic environment. Also, demand has been seen
to spike in the winter in the northern hemisphere, and during summers in countries
which use air conditioning. Constraints in the supply side are mostly weather (which
prevents tankers loading) and geopolitical issues and instabilities. If producers expect
the price to remain high, they put in further investment which leads to an increase in
supply. Similarly, fear of long-run low prices lead to an investment drought.
A closer look into the world economy and the oil players throws light on the following
possible reasons for a continued fall in oil prices BOOMING US PRODUCTION- Innovative drilling techniques like Fracking
and horizontal drilling has transformed the US, one of the world‟s leading oil
consumers into one of its leading producers as well; so much so that it has
overtaken Saudi Arabia to become the largest oil producer in the world
standing at over 13million bbl/day(barrels/day).This has provided a healthy
cushion to the global market from the geopolitical issues in the Middle East
and Ukraine and is pushing down gas prices.
 SAUDI and OPEC- Saudi Arabia, the single largest oil exporter and de facto
OPEC leader, has historically persuaded other cartel members to cut production
to control World market prices. OPEC or rather Saudi has always been in
favour of and the most vociferous advocate of high price levels by cutting
down supply, this time around there has been no cut down in exports and Saudi
has convinced OPEC to maintain current levels of production and exports.
Moreover, Saudi has cut the export prices for some of its biggest customers
including the Asian markets.
 DECLINE IN GLOBAL DEMAND- The US production has been consistently
increasing and there has been no export cut from OPEC and Russia. However
there‟s not enough global demand to balance out the supply. Austerity
measures and decreased consumption across Europe are curbing oil demand
throughout that continent. Moreover, demand from the Asian giants, INDIA
and CHINA, has also plateaued. A global recession has left Asian demand
weaker than expected and this has hurt demand as it is seen as one of the major
drivers of world demand.
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 RESURGENCE OF THE FALLEN- On top of burgeoning US output, oil
production from typically volatile regions has been surprisingly stable.
Libya, Iraq, South Sudan, and Nigeria have all maintained production despite
the threat of instability, flooding the market with oil at a time when demand is
low. The threat of disruptions in oil production hasn‟t caused tremors in the
market like it used to, either. Even when the US began airstrikes against ISIS in
Iraq, oil markets remained unchanged, suggesting oil markets are increasingly
cushioned by production growth in the US and elsewhere.
IMPACT OF THE FALLING PRICES
The decline of oil prices to $50 a barrel has an undeniably positive effect on the global
economy. From the U.S. to China, people are driving more and spending more, a
much needed economic boost in the recent gloomy times. However, all is not well
everywhere and also the positives aren‟t going to be all that to crave for in the long
run.
Saudi Arabia, the world's largest oil exporter and OPEC‟s most influential member,
could support global oil prices by cutting back its own production, but is not doing it
and analysts believe there are two reasons for it to try to instil some discipline among fellow OPEC oil producers
 to put the US's burgeoning shale oil and gas industry under pressure; experts
have estimated that shale oil exploration wouldn‟t be competitive below the
$60 barrel mark
Although Saudi Arabia needs oil prices to be around $85 in the longer term, it has
deep pockets with a reserve fund of some $900BN and hence can withstand lower
prices for some time. If a period of lower prices were to force some higher cost
producers to shut down, then Riyadh might hope to pick up market share in the longer
run. Alongside Saudi Arabia, Gulf producers such as the United Arab Emirates and
Kuwait have also amassed huge foreign currency reserves which would enable them
to run deficits for several years if necessary.
Other OPEC members such as Iran, Iraq and Nigeria, with greater domestic budgetary
demands because of their large population sizes in relation to their oil revenues, have
less room for manoeuvring. They have combined foreign currency reserves of less
than $200bn, and are already under pressure from increased US competition
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Venezuela is one of the world's largest oil exporters, but thanks to economic
mismanagement it was already finding it difficult to pay its way even before the oil
price started falling. Inflation is running at about 60% and the economy is on the brink
of recession. The country already has some of the world's cheapest petrol prices - fuel
subsidies cost Caracas about $12.5bn a year - but subsidy cuts and higher petrol prices
have been ruled out by the government.
Russia is one of the world's largest oil producers and its economy heavily depends on
energy revenues, with oil and gas accounting for 70% of export incomes. Russia loses
about $2bn in revenues for every dollar fall in the oil price and the World Bank has
warned that Russia's economy would shrink by at least 0.7% in 2015 if oil prices do
not recover. Falling oil prices coupled with western sanctions over Russia's support
for separatists in eastern Ukraine have hit the country hard. This twin impact has led
to Russia abandoning a number of infrastructure projects and has resulted in a rise in
the interest rate to 17% which could cripple the economy.
The growth of oil production in North America, particularly in the US, has been
staggering. US oil production levels are at their highest since 1982 when the
production level started being documented. It has been this growth in US energy
production, where gas and oil is extracted from shale formations using hydraulic
fracturing or fracking, which has been one of the main drivers of low oil prices. Even
though many US shale oil producers have far higher costs than conventional rivals,
many need to carry on pumping to generate at least some revenue stream to pay off
debts and other costs. This growth in domestic production has also resulted in lower
demand for imported oil from the US which used to be over 9million bbl/day as it is
able to offset the import by its local production. However , the low costs of crude can
be a deterrent for the new and upcoming „frackers‟ as the cost structures of shale oil is
considerably higher than brent and this is seen as one of the reasons for Saudi being
adamant on not reducing exports and letting prices fall. All this has been very
beneficial for the US economy and is helping it surge ahead after the recent recession
phases.
With Europe's flagging economies characterised by low inflation and weak growth,
any benefits of lower prices is being welcomed by their governments. Watchers of
European markets predict that a 10% fall in oil prices would lead to a 0.1% increase in
economic output. In general consumers benefit through lower energy prices, but
eventually low oil prices do erode the conditions that brought them about.
China, which is set to become the largest net importer of oil, should gain from falling
prices. However, lower oil prices won't fully offset the far wider effects of a slowing
economy. Japan imports nearly all of the oil it uses. But lower prices are a mixed
blessing because high energy prices had helped to push inflation higher, which has
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been a key part of Japanese Prime Minister Shinzo Abe's growth strategy to combat
deflation. India imports 75% of its oil, and analysts say falling oil prices will ease its
current account deficit. At the same time, the cost of India's fuel subsidies could fall
by $2.5bn this year - but only if oil prices stay low.
INDIA: IMPACT AND OPPURTUNITIES
The slump in oil prices is providing a boost for India as the country emerges from one
of the worst economic slowdown in recent times. India, which is one of the biggest
importers of crude oil in the world, has arguably been the biggest beneficiaries of the
fall in crude oil prices. India was the world‟s fourth-largest consumer and importer of
crude oil in 2013, according to the US Energy Information Administration (EIA). Its
petroleum product demand reached almost 3.7 million barrels per day, while it
produced only about 1 million barrels per day.
Each decrease in the oil price by US$1 results in a 40 billion rupee drop in the
government‟s oil import bill. Oil accounts for more than a third of India‟s total
imports and the country‟s energy demands are continuously growing as its economy
expands and modernisation continues under the new regime of a majority government
at the centre. Heavy government subsidies of fuel for households and a large import
bill mean that a decline in oil prices reduces the trade and fiscal deficits for the
country. The fall in oil prices come as a welcome relief to households, with benefits
including lower prices at the petrol pump and although still far from the global market
rates, the government has been consistently transferring the benefit of low oil prices to
the consumers.
As well as bringing costs down of oil products directly, it also has a trickle-down
effect in reducing the cost of other goods for households, including food. Reduction in
transport costs, particularly of perishables, will help control inflation. Soaring
inflation has been a major headache over the past few years and it meant that
interest rates remained high. However, on January 16, the RBI cut its repo rate by 25
basis points to 7.75%. Further rate cuts are expected this year, which would bring
down the cost of borrowing, thereby encouraging consumer spending and bringing the
price of loans down for businesses.
The finance group Nomura has predicted that India could post its first current account
surplus for more than seven years this quarter because of the slump in oil import costs.
Specifically to the manufacturing sector, the price fall is expected to assist in a much6
needed turnaround which would be boosted by low energy costs. Speculation is that
this will mean increased demand for automotive vehicles which in turn will fuel the
overall growth of this sector and the allied industries that depend on it. The airline
industry is another sector that benefits from the fall in oil prices because one of its
major expenses, fuel, decreases. However, there are companies in India that are
negatively affected by lower oil prices. The companies that will be significantly
affected by the fall in crude oil prices are oil-producing companies such as ONGC,
IOC, whose revenues would get hit because of the drop in crude oil prices. Reliance
Industries, one of India‟s biggest conglomerates having heavy investments in the
energy sector, reported a 4.5 per cent drop in net profit in January because the decline
in oil prices hit the profitability of its refining operations. Also, India is heavily
dependent upon foreign institutional investors (FIIs) and foreign direct investment
(FDI) inflows and when bank funding of such a high magnitude and budgets of oil
exploring companies go haywire, Indian markets would get affected.
Apart from being the fourth largest oil importer, India is the world‟s sixth largest
refined petroleum product exporter earning over $60 billion annually, which is almost
20% of global exports. A bullish oil market would hurt this segment with reduced
demand, lower unit prices and lower margins.
However, India should substantially benefit from oil decline. In the recent days, the
price level, measured in Wholesale and Consumer Price Index has come down. This
has made it possible for the Finance Ministry to increase excise duty rates for petrol
and diesel for additional revenue of up to Rs15,000crore in 2015. India can leverage
the current low oil prices for long-term gains. For attaining this, the following
measures can be undertaken Foster long-term crude supply relationships with exporters in return for stable
prices, upstream engagements, inbound investments
 Enter into oil-for-infrastructure barter deals to boost project exports
 Restructure public sector oil companies to make them more productive and
globally proactive for leaner times ahead
 Channel some of the oil bonanza to mitigate the increased cost disadvantage of
renewable and alternative energy sources
 Build its own strategic oil reserves
But India needs to realise that such this window of opportunity would not last too
long. Therefore, policy makers should be alert that the space created in balance of
payments, and lower CAD should be used to enhance imports that promote growth. In
the recent years, India has been recording a decline in imports of capital goods, iron
and steel, project goods and machinery which did not augur well for investment and
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growth and it can enhance imports of capital goods given additional space created in
the current account.
Also, just because the cost of oil is low, India must not stop pursuing and expending
on research of renewable sources of energy like solar ,hydro etc. Neither should it get
into a temptation of liberalising gold imports and squander away the opportunity for
selectively increasing imports of capital goods to benefit long term growth prospects.
This looks ripe for economic activity in the country and India needs to capitalise on
this opportunity.
HOW FAR WILL IT FALL ??
The simple answer to this question is “no one knows”.
While many economists and speculators suggest that the worst has been over and that
crude oil will stabilise at about 70$ a barrel, no one has been willing to put a
timeframe to it. Minor spikes in the prices in the recent days have been viewed as
favourable by short term investors, but the long term visionaries are reluctant to say
that the price has bottomed and the only way from here is up.
When the king of Saudi Arabia passed away on January23, 2015, many believed that
the new king Salman would be more willing to accommodate the members of OPEC
in terms of reducing oil exports. However, people from inside the kingdom have
reported that King Salman, very much like the late King Abdullah, is willing to play
the waiting game and is not about to bow down in the near future in order to keep the
shale extractors non profitable. Industry experts say that with the massive foreign
reserves amassed by KSA, US producers might be the first to blink.
US oil production is also assumed to bottom out by the end of 2015 and this would be
a signal for OPEC to increase prices as by then the global demand is also expected to
rise banking on the resurgence of developing economies especially India. However, in
the near future, a steady rise in the prices of oil seem unlikely and it can also be safely
assumed that the oil prices won‟t go down below 45$ a barrel. Countries like Russia
and Venezuela may have to face the brunt of it but overall this short window of
opportunity could boost global economic growth and shift the balance of power in the
favour of emerging economies.
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