At an average price from $71.7 per barrel, the import bill of crude oil during the first three quarters of this financial year (April-December 2018) has risen by about 65%, compared with the same period a year ago.
By V Shunmugam & Tulsi Lingareddy
India’s substantial dependence on crude oil imports to meet the growing domestic energy demand is making the economy vulnerable to volatilities in international crude oil prices. The steep increase in crude oil prices during the first half of the current financial year has not only drove the trade and current account deficits (CAD) significantly wide, but also turned on the rupee highly volatile. Indian basket crude oil prices have witnessed a steep 25% increase between April 2018 and October 2018. Consequently, the rupee depreciated by 13% from about 65 levels in March 2018 to a high of 74 per dollar in October 2018. The depreciating rupee makes the imports more costly, pushing the CAD into a ‘spiralling effect’.
At an average price from $71.7 per barrel, the import bill of crude oil during the first three quarters of this financial year (April-December 2018) has risen by about 65%, compared with the same period a year ago. At the same time, the crude oil imports in quantity terms have increased only by about 4%. With crude oil being the single largest commodity import bill, it had resulted into a significant increase in the CAD to 2.7% of GDP during the first half FY19, from about 1.8% a year ago.
In addition to the currency effect, the steep rise in crude oil prices is likely to have a considerable impact on the fiscal deficit through increase in petroleum subsidy for LPG and kerosene, which is budgeted at 0.14% of GDP for FY19. The rise in crude oil prices can increase this subsidy burden and hence impact the fiscal discipline as well. The central bank publication, Mint Street Memo #17 of December 2018, estimates that for a $10 per barrel increase in crude oil prices, it will increase the fiscal deficit by 0.43%.
Apart from the direct impact, the rise in crude oil prices also has an indirect impact on a number of sectors of the economy through increase in input costs, as petroleum products are major raw materials for all the stakeholders of the economy, including agriculture. Further, as the prices of petroleum products such as diesel, petrol and aviation turbine fuel (ATF)—a major cost to the transportation sector—are passed on a daily/monthly basis, it will add to inflation. Petroleum products such as naphtha and petcoke, which are important feedstocks for fertiliser and cement industries, add to the cost increase and hence indirectly nudging inflation.
With the pass-on of more than 75% of the product burden, in terms of daily petrol, diesel, ATF, fuel oil, etc, oil marketing companies (OMC) do not run the risk with the global market volatility. There are two ways we can think of insulating us from the global crude market volatility; one way is through OMCs stabilising their import costs and pass on those benefits to the economy by way of stable and low prices in a rising market. The other way is to make daily price benchmarking—as is done by OMCs currently—as transparent and tenable as possible so that derivative products on it can be launched to help customers manage their risks in those products.
For the risks to be mopped off the economy, markets with crude distillate derivatives should have foreign portfolio investors as well. As the domestic derivatives markets develop and discover the product prices in advance, it will provide purchasing price indications to OMCs, thereby strengthening the market linkages between consumer expectations and raw material pricing, which otherwise literally does not exist in the current markets. While China had attempted to provide a derivatives market to manage its import price risks with foreign investors being allowed, a better way in a large importing economy such as India would be to have thriving derivatives markets for most widely used crude distillates, and as these markets develop, an India crude basket derivative could also be examined. The major advantage of rupee-denominated contract in Indian commodity exchanges is that it discovers pricing including exchange rate expectations of the market participants as well.
It is worth noting here that a number of other countries have also been indulging in hedging to safeguard against crude oil volatility, but a lot of them are crude oil exporting countries. With more than two-thirds of price pass-on happening except for LPG and kerosene, sovereign or OMCs may hedge only for the purpose of stabilising their purchases to pass on the benefits. Under such a scenario, a suitable way, as discussed above, would be to protect against the crude market volatility through active hedging by consumers using suitable derivatives instruments such as futures and options on petroleum products, to which they have exposure, rather than OMCs or sovereign to hedge and pass on the benefits.
In this regard, there is an urgent need to develop a derivatives market for petroleum products, and in order to do so, the underlying physical market would have to move towards daily transparent pricing, if not to an ideal requirement of these products traded in an organised/regulated spot exchange platform. While these markets develop as and when they are allowed and benchmark spot prices for crude products emerge out of them, exchange traded of futures and options contracts on petroleum products such as diesel, petrol and ATF may provide an opportunity for consumers to effectively hedge and protect themselves against the risk arising out of adverse volatility in international crude oil prices. It’s an effective way out for the economic stakeholders to protect themselves against volatility that arrives on the shore along with the imported crude.
(Shunmugam is head, Research, Lingareddy is senior research analyst, MCX. Views are personal.)