"Declining Oil Price : Implications for Indian Economy and the World" [Type the document subtitle]

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1 "Declining Oil Price : Implications for Indian Economy and the World" [Type the document subtitle] Submitted to : Urvanki Shah By Abhigyan 2/4/2015

2 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 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. 1

3 Contents FALL IN OIL PRICES: WHY??... 3 IMPACT OF THE FALLING PRICES... 4 INDIA: IMPACT AND OPPURTUNITIES... 6 HOW FAR WILL IT FALL??

4 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 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. 3

5 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 4

6 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 5

7 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 much- 6

8 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 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 7

9 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. 8