The crude truth: Rise and rise in oil prices and its impact

Analysts and market participants expect oil prices to firm up further, with some even talking about the possibility of Brent hitting $100 a barrel, over concerns of a possible supply deficit during the high winter demand season and indications that major oil producers could consider deeper production cuts going ahead. High oil prices could add to inflationary pressures and spell bad news for the fragile global economy and numerous countries that have been grappling with high inflation. India’s economy, too, is sensitive to oil price volatility, given the country’s extremely high import dependency. Apart from inflationary pressures, high oil prices could have implications for India’s trade balance, foreign exchange reserves, the rupee, and the overall health of the economy.

The current spurt in crude oil prices

Oil prices have been volatile for some time now, but the general direction over the past couple of months has been upward. Brent has appreciated nearly 25 per cent since mid-June due to a combination of some inter-dependent factors, which include production cuts by major oil producing countries, signs of improved macroeconomic conditions and easing of inflation in major oil consumers like the US, and global oil demand touching record highs with expectations of further demand expansion.

“Deepening OPEC+ supply cuts have collided with improved macroeconomic sentiment and all-time high world oil demand,” Paris-based International Energy Agency had said in August. IEA estimates oil demand to grow to 102.2 million bpd for 2023, the highest-ever for a full year. While some of the economic signals from China — the world’s largest oil importer — have been rather weak, which could weigh on oil demand, the country’s current oil demand is strong on the back of increasing petrochemical production.

In June, Saudi Arabia announced that it would voluntarily cut its oil output by 1 million (bpd) starting July, over and above OPEC+ cuts totalling 3.66 million bpd, which shall be in place till the end of 2024. Then in July, Russia announced additional production cuts starting August. OPEC+ is a larger group of major oil producing nations and includes members of the Organization of the Petroleum Exporting Countries (OPEC), along with Russia and a few other producers. OPEC+ produces around 40 per cent of the world’s crude oil, with Saudi Arabia as the top producer and Russia in the second spot.

On Tuesday, in what appeared to be coordinated statements coming from Riyadh and Moscow, the two countries sprung a surprise by extending their additional voluntary production cuts — 1 million bpd by Saudi Arabia and 300,000 bpd by Russia — until the end of the year. The message is clear: major oil producers are willing to push the limits to support oil prices for as long as possible.

Future and limits

“With the production cut extended, we anticipate a market deficit of more than 1.5 mbpd (million bpd) in 4Q23 (October-December). So, with oil inventories set to fall further over the coming months, we expect Brent to rise to $95/bbl by year-end,” Zurich-based financial services major UBS said in a note. Some analysts have even expressed the possibility of Brent breaching the $100-per-barrel mark if the supply deficit is maintained amid high demand.

The IEA, however, expects oil demand to contract sharply in 2024 due to expectations of a subdued macroeconomic environment, post-pandemic economic recovery being largely completed, and increasing adoption of electric vehicles. OPEC, on the other hand, expects oil demand to only rise next year. In either scenario, the major oil producers believe they are in a position to influence and support prices through coordinated regulation of production.

There are, of course, limits to the extent major oil producers can go to in order to pump up prices by pumping less oil. High oil prices on a sustained basis could feed into inflation globally, jeopardise global economic recovery, and lead to destruction in oil demand from major consumers. High oil prices also incentivise faster transition to cleaner fuels, particularly in the mobility sector.

Also, for countries dependent on oil for revenues, keeping prices artificially high just to see demand crash will not be desirable. There have been instances of differences within OPEC and OPEC+ on production cuts. In 2021, there was a rather public disagreement between long-time allies and oil heavyweights Saudi Arabia and the United Arab Emirates over extending production cuts.

There is also speculation that major oil consumers could intensify efforts to bring oil from sanctioned suppliers like Iran and Venezuela back into the market. A few international media reports have suggested that the US has held back-channel talks with Iran, while Venezuela is reportedly in talks with China.

India and oil

India depends on imports to meet around 87 per cent of its requirement of crude oil, which means that high oil prices can cause a big headache for the economy. High oil prices negatively impact India’s trade balance and are a drain on the country’s valuable foreign exchange reserves, which also has a bearing on the value of the rupee. As with other major importers of oil, a surge in oil prices adds to inflationary pressures for India as well. High oil prices can also potentially hit profitability of key sectors with high energy costs. All of these implications could have a negative impact on economic growth, as high inflation and low profitability in various sectors would hit disposable incomes and discretionary spending.

If crude oil prices continue to remain elevated or rise even further, they could deliver a fresh blow to the hope of a return to market-linked pricing of transportation fuels petrol and diesel. Prices of the two fuels have not been revised by public sector oil marketing companies (OMCs) Indian Oil Corporation (IOC), Bharat Petroleum corporation (BPCL), and Hindustan Petroleum Corporation (HPCL) since early April of 2022.

To shield the consumers and sections of the economy from extreme price volatility in energy markets following Russia’s invasion of Ukraine, the three companies did not hike fuel prices and suffered heavy losses in the first half of 2022-23 (FY23). There were indications from the government and the OMCs that they could revert to daily price revisions soon as most of their last year’s accumulated losses had been recouped. Till a few weeks ago, there was anticipation that petrol and diesel prices could soon see a cut. However, with the current spurt in the price of crude, the raw material of petroleum fuels, a price cut may be financially unviable for the companies. Even if they do go ahead and slash petrol and diesel prices at the government’s behest, they could incur losses and even require financial support from the government.