By Hari Shankar

Edited by Anandita Malhotra, Senior Editor, The Indian Economist

Oil prices have been falling for a while now. The price of the Indian basket of crude oil as on December 10, 2014, stood at $63.16 per barrel. At the beginning of this financial year, as on April 1, 2014, the price had stood at $104.56 per barrel. Hence, prices have fallen by close to 40% since then.

This comes after nearly five years of stability. At a meeting in Vienna on November 27th the Organisation of Petroleum Exporting Countries, which controls nearly 40% of the world market, failed to reach agreement on production curbs, sending the price tumbling. Also hard hit are oil-exporting countries such as Russia (where the rouble has hit record lows), Nigeria, Iran and Venezuela.

 Four things are now affecting the picture. Demand is low because of weak economic activity, increased efficiency, and a growing switch away from oil to other fuels. Second, turmoil in Iraq and Libya—two big oil producers with nearly 4m barrels a day combined—has not affected their output. The market is more sanguine about geopolitical risk. Thirdly, America has become the world’s largest oil producer. Though it does not export crude oil, it now imports much less, creating a lot of spare supply. Finally, the Saudis and their Gulf allies have decided not to sacrifice their own market share to restore the price. They could curb production sharply, but the main benefits would go to countries they detest such as Iran and Russia. Saudi Arabia can tolerate lower oil prices quite easily. It has $900 billion in reserves. Its own oil costs very little (around $5-6 per barrel) to get out of the ground.

The conventional thinking is that a fall in oil prices will benefit India tremendously. A major reason for the same is that India imports nearly four fifths of the oil that it consumes. Hence, a fall in oil prices will mean that there will be lower oil imports and this will mean a lower trade deficit.

Further, low oil prices will also mean lower inflation and a lower fiscal deficit for the government.

But here’s why the fall in oil prices may not be so important for the Indian economy at the current juncture:

India’s growth is still weak. The index of industrial production (IIP) growth for October showed its sharpest fall in three years. A decline in crude oil prices is certainly a plus in this scenario, as it lowers costs not just for consumers but for companies as well.

 But if industry faces uncertain consumer sentiment not just in India, but globally, the fall in costs may simply improve their bottomline while adding little to the top line. There will be little incentive for companies to invest in expanding capacity.

Global growth is weak as well. The uncertainty in the rest of the global economy, including the Euro area and China, coupled with a strong US economy, is one of the factors driving a strong dollar. Another index of global growth — metal prices, which are vital inputs into industry — is also showing weakness.

Now let’s look at the trade deficit or the difference between imports and exports. Oil imports in the month of October 2014 fell by 19% to $15.2 billion in comparison to the same period last year. Despite this, the overall trade deficit for the month rose to $13.3 billion from $10.6 billion a year ago.

Inflation. Petrol and diesel together make up for around 2% of the consumer price index. Over and above this, the government has raised the excise duty on petrol and diesel twice in the recent past. This has reduced the “passthrough to consumer prices”. Hence, consumers haven’t benefited as much as they should have.

Professor NR Bhanumurthy, professor at the National Institute of Public Finance and Policy (NIPFP), says: “The fall in the forward price of oil tends to be a leading indicator as far as the health of the global economy is concerned,” he says. “It can reflect expectations of the health of the global economy going forward.” In an environment of such uncertainty, expectations among investors or firms will be crucial for the health of the global — and by extension — the Indian economy.

To conclude, what these points clearly tell us is that a fall in oil prices will not benefit India as much as it is being made out to be.

Posted by The Indian Economist | For the Curious Mind