Petrol and diesel prices have lately skyrocketed and, in some cities, the price of petrol hit Rs 85 per litre. In fact, on per-litre prices of petrol, India has one of the world’s highest figures. Several macroeconomic indicators such as the national import bill (India imports more than 80% of its crude oil demand), the currency value and the current account deficit are adversely affected by oil price spikes, which also have a knock-on effect on inflation through increase in transport and other costs, and dampen economic growth.
In the wholesale price index, petroleum products have nearly 8% weight. According to the Petroleum Planning and Analysis Cell estimates, if the price of petrol and diesel increases by Rs 1 per litre, it shoots up inflation by 0.03% and 0.08%, respectively. This is something that politicians may be wary about in the short run when elections loom. Like any macroeconomic problem, sharp spikes in oil prices in India can be attributed to both national and global factors.
We begin with domestic factors.
Brent, the global benchmark oil price, has a history of sharp volatility. It was priced at $115 a barrel in mid-2014, less than $30 in early 2016, and $45 a barrel in mid-June 2017. By mid-May 2018, it has hit a price of $80 a barrel, touching the highest since November 2014.
Why have domestic oil prices shot up manifold then? When global crude prices were going down in the recent past, both excise duty and value-added tax (VAT) on petrol and diesel had seen regular gradual hikes as the Centre and state governments wanted to boost revenues. More than 25% of a per-litre price of petrol went to state sales tax or VAT in cities like Delhi, Kolkata and Bengaluru in mid-May 2018, whereas the same figure stands at more than 30% for cities like Mumbai, Chennai, Bhopal and Hyderabad during the same period.
Despite a global crude price drop, many states had increased their VAT rates, which meant that customers did not gain much from a cost decline. Gradually, the small staggered rises got cumulated to sharp hikes. Following a beleaguered Centre that slashed excise duty on petrol and diesel by Rs 2 per litre in October 2017, some states reduced the VAT, but this was too little done, too late. In addition, the slide in the rupee-dollar rate in the recent months has made matters worse, which raised the exchange rate cost of crude oil.
With the daily dynamic pricing mechanism witnessing gradual hikes in oil prices since mid-June 2017, both customers and public sector oil marketing companies (OMC) have been affected. Only during the time of state elections (Gujarat and Karnataka) consumers had a brief respite as OMCs had to bear the burden. The stocks of OMCs have been badly hit on the bourses despite rising crude prices and they may soon face a windfall tax to cushion retail prices.
The reluctant central and state governments may probably roll back some taxes in a perfunctory manner. It is understandable, as it would otherwise have huge implications for public revenues. For instance, in 2016-17, the petroleum sector totted up 8% of revenue receipts of the states and contributed 64% to the central government’s excise duty receipts and 24% to the Centre’s revenue receipts.
As several state elections and the general elections are approaching, the Centre and state governments may try to woo the electorate and, consequently, the incidence will shift to the public sector OMCs and consumers will see some temporary price drops. Once the election season is off, OMCs may bounce back with price hikes. Indian politicians are wily and, hence, this trend may continue in the coming times.
The argument that bringing oil pricing under the ambit of the goods and services tax (GST) may rationalise and simplify the way petrol and diesel are priced in the country has a lot of merit. However, state governments are reluctant to adopt GST for petroleum products and do not want to forego the asymmetric petrol revenue gains. Different states have different sales taxes or VAT for petrol and diesel, and this creates anomalous price dispersion of oil across states and cities.
GST would not only streamline the tax structure for oil, but also may bring down price levels. It would also alleviate the pressure on OMCs to tinker with petroleum prices. But the state governments are not listening. Now, let’s discuss the global factors behind the oil price spike, which, obviously, include a pick-up in crude demand in the world economy.
Disproportionate to its oil reserves, the US controls the global oil supply and pricing in various ways. Currently, Donald Trump regime’s foreign policies and the output growth of US shale oil firms are crucial factors that affect supply in the global oil market. Although the US shale oil output has lately increased, several countervailing factors (and primarily driven by the US) have caused global price hikes over the past year, which may well continue in the near future.
First, in its May 8 decision, the Trump regime has pulled out of the Iran nuclear deal and, consequently, it has raised the likelihood of a decline in the central Asian nation’s oil exports. There could be a supply shock, as recent geopolitical developments have increased the risk of armed conflicts in West Asia. Some analysts opine if the US sanctions materialise, about half of Iran’s current oil exports would not be supplied in the global market in the coming days—for the record, Iran’s oil exports had declined by half when it had faced sanctions in 2012.
Second, the economic meltdown and political unrest in Venezuela, an important oil producer, have led to a sharp drop of about 40% in the country’s oil production. The situation in Venezuela may worsen as the US might impose sanctions there as well, in light of a rigged election of President Nicolás Maduro. In addition to these two potential US foreign policy decisions, other things matter, too.
The agreement between the Organisation of the Petroleum Exporting Countries (OPEC) cartel and some important non-OPEC countries like Russia has reduced oil production. Saudi Arabia leads the OPEC cartel, but as its oil behemoth Saudi Aramco will have a grand initial public offering in some time, it hopes the oil price spike might boost the IPO. Although global crude price volatility is hard to predict, an equally plausible view posits that the oil price may come down in the near future. This view is bolstered by certain US-led possibilities.
First, US shale oil firms may boost their output in view of price hikes. Interestingly, they are competing with Saudi Arabia in the current global oil game, while the latter backs the US in its reimposing of sanctions on Iran and tries to reduce Iran’s strategic clout in West Asia. Second, the success of the probable US sanctions on Iran is uncertain, since in the changed geopolitics, the US lacks the support of key EU countries like Germany and France on one hand and Russia and China who are part of the 2016 Iran nuclear deal on the other.
Other factors may drive down prices, too. The fact that Iran may well continue exporting oil to its major petroleum consumers India and China in any case may greatly offset an adverse supply shock. Besides, the hitherto largely successful agreement of the OPEC and non-OPEC countries to cut oil output is valid until December this year, and may not be extended further.
Moreover, Russia is against an extension as it does not want to lose out in a price war with American shale oil firms. Thus, global petroleum supply and price levels are subject to geopolitical and strategic considerations, and the timing of their playing out.
The author is an Assistant professor of Economics at Indian Institute of Management Amritsar.
Views are personal