Tick-tock, tick-tock, tick-tock...

On June 4, US Federal Reserve Governor, Ben Bernanke, was at his alma mater, Harvard University, delivering a talk to graduating students. There’s no danger of a 1970sstyle oil shock, the Harvard alumnus assured his listeners. Just two days later, oil prices reported their sharpest ever single-day gain of $11, coming within spitting distance of $150 a barrel, which some analysts think will be reached by July 4, America’s Independence Day and when more cars than usual are out on the roads.

Don’t blame Bernanke, though. At present, no one has any clue where oil prices are headed, except that they look set to move only in one direction— north. $200 is what at least one analyst, Arjun Murti of Goldman Sachs, thinks a barrel of crude oil may cost in another six to 24 months.

For India, which imports two-thirds of the oil it consumes every year, the implications are staggering. For now, the government has screwed up enough courage to permit only a partial increase in fuel prices—the highest ever at one go, though—and cut taxes on fuels and issued more bonds, worth Rs 96,000 crore, to stem the losses of oil marketing companies. In a televised address to the nation to explain the oil price hikes, an anxious Prime Minister Manmohan Singh did some plain talking: “It must be appreciated that the price hike has been a bare minimum with the government and oil companies still shouldering the bulk of the burden.”

As Rajiv Kumar, Director and CEO of think-tank ICRIER, points out: “It’s a brave step in an election year. But the reality is that even this is not enough to deal with the situation.” It’s an accurate assessment, given that the government even now subsidises fuel prices—especially kerosene, LPG, diesel and petrol—by a huge amount. The net under-recoveries after factoring in the revised prices and the duty cuts still work out to over Rs 2,00,000 crore.

State-owned oil marketing companies (OMCs) such as Indian Oil, Hindustan Petroleum and Bharat Petroleum are grateful for the small concession. Says Sarthak Behuria, Chairman, IOC: “It’s certainly more than what we expected. Now only a small fraction of the under-recoveries is to be borne by us.” That’s about Rs 20,000 crore against the Rs 16,000 crore that burned into their balance sheets in 2007-08. The rest will be picked up by the government through oil bonds (68 per cent) and upstream companies such as ONGC, Oil India and GAIL (22 per cent).

Universal pain

By keeping prices artificially low, the government has temporarily postponed the pain that consumers, businesses and the economy must inevitably go through. But tax cuts and oil bonds will boomerang on the government sooner than later and take their toll on the economy. We’ll explain how exactly in a bit, but for the moment it’s important to understand what’s driving up global crude prices. OPEC (Organisation of Petroleum Exporting Countries), for one, has blamed market speculators and the weak US dollar for the crisis.

The UAE’s OPEC governor, Al Obaid Al Yabhouni, says that market fundamentals do not justify the current high global oil prices. He also says that he’s concerned that oil prices are rising “too fast too high”, adding that the UAE is prepared to produce more oil to meet its “commitment and responsibilities” as a producer.

Analysts concede that there is some justification in OPEC’s line of reasoning. Says ICRIER’s Kumar: “Certainly, a part of the price rise seems to be due to speculative activity. With the dollar weakening against other major currencies, speculators are moving into commodities like crude.” This year already the euro and the yen have risen against the dollar by over 7 and 10 per cent, respectively. Then, since oil is priced globally in dollars, a falling dollar is an incentive for oil exporters to charge higher dollar prices. Not everyone buys this argument.

The US feels that it’s growing demand that is driving prices up and has urged OPEC to produce more oil. It also wants the major oil-producing nations to open their markets to foreign investments. Indeed, there is a growing feeling among the major oil-consuming countries around the world that OPEC and other oil producing nations are not increasing their output as much as they otherwise might because they don’t need to. Says Subir Gokarn, Chief Economist, Asia Pacific, Standard & Poor’s: “Producers are keeping production pegged to levels where prices can remain high.”

In short, rising oil prices have poured billions of dollars back into the producer economies and reduced their need to produce more oil. The only OPEC country that has agreed to significantly increase its oil production capacity is Saudi Arabia, but that process is taking longer than anticipated. Instability in other countries of the region, such as Iraq, is causing production levels to stagnate.

Says Goldman Sachs’ oil analyst Arjun Murti in a recent report: “We believe the current energy crisis may be coming to a head as a lack of adequate supply growth is becoming apparent.” Other global investors such as George Soros think that a strong demand for oil is made worse by speculation in the commodity. “The bubble is superimposed on an upward trend in oil prices that has a strong foundation in reality,” Soros recently told the US Senate.

Analysts point out that the growing energy needs of the developing world like China and India are partly responsible for the oil shock. For instance, there are concerns that crude prices have risen in recent days especially due to strong demand for diesel in China, where power plants in some areas are running desperately short of coal after the recent earthquake. Chinese companies like PetroChina are reportedly purchasing crude in huge quantities.

Indian consumption of petroleum products, too, has been growing steadily. India’s domestic diesel sales rose 11.1 per cent in 2007-08, the biggest increase in 12 years, and petrol sales rose 11.2 per cent, the biggest increase in eight years. Experts say this trend is worrying, particularly in the face of potential oil shortage.

Says R.S. Sharma, Chairman, ONGC: “There are genuine supply constraints as well. This price spurt was anticipated as the global reserve replacement ratio (RRR) is less than one now.” Sharma points out that the world consumes 86 million barrels of crude per day (and 31 billion barrels a year) and the new reserves getting added work out to less than that.

High crude prices, then, is a reality we may have to live with. Indeed, experts expect prices to firm up further over the medium to long term. Says Goldman Sachs’ Murti in his report: “The possibility of $150-$200 per barrel seems increasingly likely over the next 6-24 months, though predicting the ultimate peak in oil prices as well as the remaining duration of the upcycle remains a major uncertainty. In our view, a gradual rally in prices is likely to be longer lasting than a sharp, sudden spike.”

Slippery growth

Despite India’s administered oil prices, it’s clear that further increases in global oil prices will put India’s growth at risk. Stock market investors have already turned wary. On the day the fuel price hikes were announced (June 4), the BSE Sensex crashed nearly 450 points as stocks corrected across the board. Investors were clearly concerned about the prospects of higher inflation eroding company bottom lines and hurting the India growth story. In particular, auto and metal counters took a pounding amid concerns that dearer oil will suppress demand for vehicles and, in turn, affect demand for steel—a key input for vehicle manufacturers.

Says Anil Advani, Head of Research, SBI Securities: “There are concerns that the worst-affected will be automobiles, both commercial and passenger car segments, and that overall corporate earnings will be affected.” Adds Sanjeev Patkar, Director (Research), Dolat Capital Market: “There will be an impact of 100-120 basis points on profit before tax due to increase in freight and power cost for BSE 200 companies.”

There seems to be a broad consensus among economists that for inflation the only way is up after the sharp and aggressive fuel price hikes. With the combined weight of petrol, diesel and LPG at 4 per cent in the wholesale price index (WPI) the direct and indirect impact on inflation is expected to be significant. Though government estimates peg the impact at around 50 basis points, most other estimates put a higher number to the figure—around 90 to 100 basis points. A Crisil impact analysis gives a detailed break-up of the incremental impact (both direct and indirect) on inflation— the study estimates a 95 basis point increase in inflation. This could force the RBI to intervene to cool off inflation. Says Sonal Varma, economist, Lehman Brothers: “The risk of monetary tightening remains high. We believe that interest rates will go up by another 100 basis points this financial year.”

Other economists believe that the RBI may not use monetary instruments to tame inflation as that could take a severe toll on the economy, which is already showing signs of slowing down. Says Gokarn: “The central bank is more likely to resort to liquidity control measures like a cash reserve ratio (CRR) hike.” Given the emerging scenario then, economists feel growth rates will be impacted, though it may not be a substantial hit just yet.

Most believe that GDP growth could dip below 8 per cent due to the fuel price hike. Says Marut Sengupta, Head-Economic Policy, CII: “If inflation crosses 10 per cent, then it will squeeze demand in the economy and really hit growth hard. However, that appears to be unlikely right now.” Adds Pawan Goenka, President, Automotive sector, Mahindra & Mahindra: “There will be a short-term impact on demand on sectors like auto. But we don’t expect it to hurt sentiment over the long term unless there is another price revision going forward.” Others are even more optimistic.

Says V.N. Dhoot, Chairman, Videocon Group: “India’s economic growth is still more than 9 per cent and I expect it to grow at the same rate for the next 5-10 years. Oil price increase may not have much impact.”

Fisc in a funk

However, all this could change if crude prices continue to rise. Says Sudhir Nair, Head of Research, Crisil: “It would mean a fresh bailout package for OMCs and that would have serious repercussions on the government’s finances.”

The latest duty rejig alone has cost the central government Rs 22,660 crore (an addition of around 0.4 per cent of GDP to fisc) and that too in a year when growth itself is expected to moderate. High oil prices mean that there will be a larger hole in the fiscal balance sheet. The oil bonds, which will be issued to oil companies to compensate them for the losses that they make, amount to a whopping 1.8 per cent of GDP this fiscal.

Naturally then the fiscal deficit of the Centre (along with off-balance sheet items such as the oil, food and fertiliser subsidy) is likely to be up at around 6.6 per cent of GDP in 2008-09. Contrast this with the 2.5 per cent that was budgeted for the year. Several estimates also peg the total fiscal deficit of the Centre and states topping 10 per cent of GDP this financial year. The issuance of oil bonds and the expanding deficit will ultimately lead to hardening of interest rates.

The time then may well have come, experts feel, to take reforms forward and gradually decontrol fuel pricing. Says ICRIER’s Kumar: “Fuels should be gradually removed from the realm of administered pricing.” During the NDA regime, an attempt was made to dismantle the administered pricing regime for the oil sector. On April 1, 2002, the administered pricing for petrol and diesel was dismantled, though not in the case of kerosene and LPG.

It was also decided to wind up the Oil Pool Account and the Oil Coordination Committee. The objective of free pricing, though, couldn’t be met as pricing decisions continued to be made by the Cabinet. Under the UPA government, oil sector reforms were completely abandoned with the government taking over the right of OMCs to fix prices.

Says Gupta: “The government will do well to implement the recommendations of the Rangarajan Committee on fuel pricing.” A committee headed by C. Rangarajan on Pricing and Taxation of Petroleum Products, which submitted its report in February 2006, had recommended that subsidies should be minimal, targeted and restrained by a monetary ceiling.

Moreover, it wanted that the subsidies should be routed entirely and transparently through the national Budget and OMCs should be exempted from this burden. Says K.V. Kamath, President, CII and MD& CEO, ICICI Bank: “India cannot afford to compromise its growth process and needs to better target the subsidy outgo in order to protect its poorest consumers.” Adds ONGC’s Sharma: “There has to be some balancing. There should be a substantial price increase so that consumers feel the pinch. It will give fillip to oil conservation efforts, which is the need of the hour.”

That perhaps may be the only long-term solution to prevent the economy from getting severely dented by the spike in crude prices—reducing consumption of petroleum products in the country and exploring alternative sources of energy. Though in terms of energy efficiency India still does better than countries like Russia, China and the United States (in terms of energy consumption per unit of GDP) according to some studies, clearly a lot more needs to be done. Adds Kamath: “We really need to take a very close look at India’s energy efficiency measures. We need to promote oil conservation.” As the story that follows makes it evident, that is India’s best near-term bet.

Additional reporting by Shalini S. Dagar in New Delhi and Virendra Verma in Mumbai