The Prime Minister Narendra Modi-led BJP government, which completes four years in office on Saturday, is staring at a 'crude' problem at the moment. Oil prices have been in an upswing over the past few months, hitting a high of USD 80 a barrel.
Oil is now coming off a supply glut engineered by international oil cartel OPEC (Oil Producing and Exporting Countries) and its partners, which had kept prices subdued for a couple of years. In fact, oil prices touched record lows a couple of years ago and as a result, the sitting government had an easier time dealing with its import bill.
However, a surge from $27 in January 2016 to $80 a barrel significantly impacts the economy and, by extension, capital markets. This, along with the upcoming assembly elections in various states and the general election next year, is likely to keep the government on its feet in the near future.
Impact on economy
For instance, from an economy point of view, rising crude prices are an assertive risk for any country and its investors. Oil prices directly impact the real income and spending of all the sectors operating in an economy.
A surge in oil prices dents growth, increases wholesale inflation and widens the country's current account deficit. For a country like India, it also spells a hefty a bill for its exchequer, as most of its oil needs is met through imports.
If surging oil prices push inflation up, the country's central bank, in this case the Reserve Bank of India, may be forced to raise interest rates in order to keep prices in check.
"As per the past economic survey by market agencies, it was estimated that every $10 increase in the oil price dents the economic growth by around 0.2-0.3 percentage points. Similarly, higher oil prices increases the WPI by 1.7 percentage points along distorting the current account of country with billions of dollars. The higher oil prices will result in higher WPI which would lead to a tighter monetary regime with higher interest rates reducing the real returns," Arpit Chandna, Fundamental Analyst at Karvy Comtrade, told Moneycontrol.
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Higher oil prices also happen to adversely impact the nation's finances and fiscal targets.
"Weakening of rupee against dollar although in smaller fraction, along with rising crude price is likely to put pressure on government’s fiscal target," said Dinesh Rohira, Founder and CEO of 5nance.com.
Experts at Arihant Capital feel that rising crude prices may also result in active steps by the government to maintain its financials. Subdued crude prices over the last 2-3 years have genuinely helped our economy and left the government enough room to concentrate on other reforms.
"In terms of price movements, we have very less control over it as they are determined by many global forces. Therefore, when prices move up, government has to start actively working on maintaining fiscal & Current Account Deficit," Anita Gandhi, Wholetime Director, Arihant Capital Markets, told Moneycontrol.
Impact on sentiment due to elections
With the coming 12 months being full of scheduled elections, the government is likely to implement populist policies in a bid to shore up people's sentiment.
An example of that could be a decision to cut excise duty on retail sale of fuel, which could lead to a fall in prices of petrol and diesel. Prices of both these commonly-used fuels have shot up over the past few months. In fact, in Mumbai, petrol prices rose to as high as Rs 85 a litre, while diesel touched a high of around Rs 76 a litre, resulting in a lot of heartburn for vehicle owners.
Although fuel prices are not controlled by the government now, having been de-regulated, a cut in excise duty would mean that the amount of money coming into the government's coffers from sale of fuel will go down. This will in turn, take a toll on its finances and pose an economic challenge.
Impact on markets
A mixture of surging crude oil prices and its resultant impact on interest rates will negatively impact capital markets, as economic stability is one of the essentials for any rally. In the past four years, when crude prices were lower than they are now, the government's current account deficit and fiscal deficit were kept in check, which was received well by the market.
In 2017, the Sensex and Nifty both hit saw record highs, having gained over 30 percent. Midcaps too had a stellar run, gaining around 50 percent over the calendar year.
"The rising crude oil price is not a welcome news for the Indian market given the import figure of the economy. Since domestic economy is directly dependent on crude oil or through crude derivatives as inputs, the first to get impacted would be Oil Marketing Companies, Aviation, Paints, and Steel through increase in raw material cost, which will lead to contraction in margin," said 5nance.com's Rohira.
Outlook
Crude is certainly a key challenge for the government at the moment, even among the other challenges that it currently faces. Analysts that Moneycontrol spoke to suggested that although oil prices will certainly not reclaim their previously-hit record highs, they could trade around USD 71 a barrel.
"Surge in oil prices, along with an improvement in domestic consumption demand, will buoy import growth. CRISIL Research expects oil to average around USD 70 a barrel in 2018, compared to USD 64 a barrel in the previous year. This could raise the import bull by 26 percent year on year to Rs 6.5 lakh crore," CRISIL Research said in a note.
Market participants also believe that oil producers may choose to ease supply, which may lead to some kind of cooling effect on oil prices.
"There are reports of Russia and Saudi Arabia being concerned on crude consuming nations, and in turn, easing supplies. For WTI crude USD 76-77 is a good resistance and support is visible at USD 64 a barrel. Falling below this level could mean OPEC stepping in to cut production. On Brent crude, USD 86 a barrel is seen as an upside cap, while the lower cap is around USD 71-72 a barrel," Jigar Trivedi, Fundamental Analyst – Commodity at Anand Rathi Securities, told Moneycontrol.
In addition to this, geopolitical factors could also have a role to play in oil's current rally, albeit for a short period. For instance, relations between US and North Korea, as well as those between US and China, could be key. Recently, US President Donald Trump pulled out of a summit in Singapore, where he was set to meet North Korea's Kim Jong-un.
However, these are events that could result in knee-jerk reactions, which typically have a medium-term impact. "Such events will come and go, whether it is North Korea or the Middle East. In that case, you see a sharp shoot up in prices, but this will be a temporary phenomenon. One needs to look at fundamentals in the long term," Trivedi added.
Case File
A look at the price chart for crude oil over the past four years shows that, on an average, it has traded around $63-64 ($63.89, to be precise) a barrel.
Movements in the price of oil are predominantly a result of demand and supply between oil producers and buyers. In the event of a supply surplus, prices tend to take a hit.
However, it can clearly be seen that oil prices have come off their downward move and have risen steadily over the past year, touching a high of around $80 in the recent past.
"Oil prices were trading below $30 and that was not comfortable for members of OPEC. The break-even levels for Saudi Arabia, Iraq, and UAE is below $10, but for other allies such as Venezuela, it is close to $50-55. These nations, including Russia, had pushed the OPEC to cut production to shore up prices," said Trivedi of Anand Rathi Securities.
For the moment, the central government seems to be stuck between a rock and a hard place, with rising crude prices increasing the possibility of an interest rate hike and rubbing voters the wrong way.
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