Crude oil holds the key

The single variable most strongly associated with India's macro-economic trends is the price of crude oil. The correlation is negative. When crude prices are high, GDP growth suffers and there are rising trade deficits and rising fiscal deficits. 

Energy is, by far, the single largest item in the import basket. India imports over 80 per cent of its crude. It also imports about 50 per cent of its gas.  The mitigating factor is that India is a net exporter of products like diesel and petrol. Even so, imports far exceed exports, leading to higher trade deficits if crude prices rise.  

The government also faces a policy problem when crude runs high. When crude runs low, it can impose higher taxes and generate revenues. If crude runs high, it has to cut tax imposts, leading to higher fiscal deficits or else, risk retail prices spiking to unacceptable levels. High retail prices cause high inflation and public dissatisfaction. When crude prices are very high, governments have forced oil-marketing companies it owns to sell below the cost of production. Then, the subsidies had led to even higher fiscal deficits.  

Starting September 2014, the Modi government received a windfall. Crude prices dropped from over $100/ barrel to lows of below $30. Prices stayed low for the next three years. This allowed decontrol of retail prices and the imposition of higher taxes.  Fertiliser production costs also dropped, leading to savings on fertiliser subsidies.  

There were two major reasons for low prices. First, the global economy was growing slowly, leading to low energy demand. Second, better technology helped develop shale deposits in the US. If crude prices rose above a certain level, shale production ramped up, leading to a price-ceiling. 

In desperation, the OPEC (Organisation of Petroleum Exporting Countries) members cut production, to try and change the supply-demand equation. The production cuts are still in force and global economic growth has also improved. Hence, crude prices have risen appreciably through the past year. 

In 2015-16 and 2016-17, India paid $46.17 and $47.56 respectively for crude. It imported around 214 Million Tonnes (MT) of crude (there are about 7 barrels per metric tonne) in 2016-17 (about 194 MT for domestic consumption while the rest was used to produce exports).  

India will import about 219 MT in 2017-18 (about 200 MT for domestic consumption). In 2017-18, India paid an average of $55.74 barrel (April 2017 -February 2018). The March 2018 price is likely to be around $65. 

The import bill will rise by about 22 per cent in 2017-18. If crude prices stay at current levels, imports in 2018-19 will be at least 15 per cent higher. A price change of $1/barrel leads to a change of $ 130 million in the import bill.  A change in the exchange rate of Rs 1/dollar also leads to a similar change of $130 million in imports. Those variables are moving the wrong way, with crude up and the rupee down. This is an election year, which means super-sensitivity to public unhappiness about inflation. As a result, the government may decide to cut tax imposts on fuels. If crude jumps to beyond say $80, it may even control prices.  That could mean a reworking of tax revenue numbers and the fiscal deficit. 

Investors in the PSU oil-marketing companies enjoyed a bull run as BPCL, HPCL, IOC saw outperformance while they were allowed to charge profitable retail prices.  These stocks are now suffering sell offs. ONGC and Oil India (primary producers) could receive a counter-balancing boost. But producers might be forced to subsidise the oil marketing companies (OMCs).

There is another unusual negative for investors to consider. Reliance Industries (RIL) own Reliance Jio Infocomm (RJIL) and it's already invested over Rs 2 trillion in the telecom business. So long as refining margins are up, RIL can afford to pump money into RJIL. But refining margins fall when crude prices rise. This could retard RIL's drive to dominate telecom. 

If crude oil stays high, speculation on the commodity front with long positions in petroleum futures is possible. Speculative long dollar positions could also work since the rupee is likely to weaken more. These are risky, of course. If crude prices mitigate, OMCs will become investment-worthy again.

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