Lower volatility in oil prices

Napoleon once said about a general: “I know he’s good but is he lucky?” It is a remark that applies as well to India’s finance ministers. Their track record depends to a large extent on two factors which are outside their control.

 

One is the monsoon and the other is crude oil prices. India’s agriculture is alarmingly dependent on rainfall, and India’s population depends to a large extent on agriculture. This is despite the fact that agriculture generates only 15 per cent of the gross domestic product (GDP). Over 50 per cent of households derive some proportion of income from agriculture. At another level, assuming the Consumer Price Index (CPI) faithfully reflects actual consumption, nearly 45 per cent of household consumption is geared to food.

 

Last year, the monsoon was on the better side and rescued the economy. This year monsoon projections are positive. This is one area where the finance minister has been lucky. However, there were sub-optimal monsoons in 2014 and 2015 so two good monsoons just balance off prior bad luck.

 

The other factor — global crude oil prices — has gone very much in India’s favour. Around 80 per cent of crude oil and 30 per cent of gas is imported. Given India’s massive dependency on imports, global prices are crucial. There is room for negotiation and long-term contracts where gas is concerned. But, crude oil prices are market-driven. India’s crude basket is calculated as the weighted average of Oman-Dubai sour (high-sulphur) grades, with the standard Brent contract in a ratio of approximately 70:30. In April 2014, when the last Lok Sabha election took place, the basket was trading at around $105 a barrel. The basket averaged out at $105.5 a barrel for 2013-14. Crude oil prices had been above $100 from February 2011 onwards. In September 2014, prices fell below the triple-digit for the first time in 44 months. Prices continued to trend down through 2014-15, and the cost of the Indian crude basket averaged $84 a barrel in that financial year. In 2015-16, the basket dropped to an average $46.2 a barrel, which sharply reduced import costs. In 2016-17, the basket averaged marginally more, at $47.56 a barrel. In April and May 2017, the basket has moved between $49 and $52. Lower crude prices lead to a reduced trade deficit. The government had leeway to free diesel prices and reduced the subsidy on kerosene and gas. This means a reduced fiscal deficit. In addition, duties on fuels helped recover higher revenues and the Government of India has also started to build a strategic oil reserve.

 

Refiners could generate higher profits as margins improved on falling crude prices. Strong profits were available for private sector refiners who export. Public sector units (PSUs) that control retail marketing and refining also made profits instead of suffering “underrecoveries”. The “luck” has been driven by several factors.  The cartel of Opec (Organisation of the Petroleum Exporting Countries) has been unable to coordinate any scheme to cut global production, though it has tried.  

 

The second factor is better mining technology. Led by the US, engineers have developed more effective techniques for extracting oil from shale or ‘tight-oil’ deposits. ‘Frakking’ operations have serious environmental consequences and are relatively more expensive. But, many shale mining operations are profitable at the $45 a barrel mark and higher prices. Frakking takes three-four months to start production and needs to generate another three-four months of production to break-even. Despite those constraints, shale imposes a ceiling on prices. Every time prices surge above, say, $55 and show signs of remaining above that level, new shale production hits the market. Moreover, speculators bought super-tanker cargoes at low prices. So, some inventory is liquidated every time oil prices rise.

 

Moderately priced crude oil seems the likely medium-term prognosis, given these factors. That means healthier government finances. It’s good for refiners, marketers, and exporters of petroleum-products. The proposal to revise daily retail prices could reduce price volatility at the pump. Instead of large hikes/cuts every fortnight, there will be small changes on a daily basis. The PSU marketers use a formula based on the moving average of the previous 15 days product price, with a two-day lag. Marketers will benefit from the flexibility of one-day change, if they can reduce throughput times and transportation times.


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