Why Modi government doesn't need to worry about oil prices for now

While wishing everyone a happy Dussehra, Dharmendra Pradhan, India's minister of petroleum and natural gas tweeted: "We are blessed with a record low international crude price of recent times at $91.77/barrel (sic)".

Indeed, the Modi-led government and India in general has a lot to feel thankful about. Many key economic indicators have shown improvement in the past few months, which places the new government in a good position to build its economic legacy on.

Apart from falling crude oil prices, the first quarter GDP growth in fiscal year 2014-15 improved to 5.7 per cent, up from 4.7 per cent for the entire 2013-14. Note that two of the three months of this quarter fell under the regime of the previous government.

Apart from this, due to a host of extraneous factors (which I will tackle in a later article), wholesale and consumer price inflation in August 2014 have fallen to 3.7 per cent and 7.8 per cent respectively, down from an average of 6.6 per cent and 9.9 per cent in the two fiscal years preceding those of 2012-13 and 2013-14.

However, none of these has had a more direct impact on the new government's policies than a fall in the international crude oil prices recently. Owing to this, the government has managed to cut petrol and diesel prices. (For the unacquainted: crude oil is refined to make petroleum products such as petrol and diesel. International crude oil prices are linked to international demand and supply, and therefore vary significantly over time).

On the other hand, in India, until recently, petrol and diesel prices were artificially fixed to low levels by the government, leading to under-recoveries which were financed by petroleum subsidies. These subsidies were also eventually paid by the people indirectly, in the form of taxes. In order to reduce subsidies, the government first increased petrol and diesel prices to thereby reduce under-recoveries, and has now let the domestic prices move with international crude prices.

The BJP's election ads on radio in Haryana even take credit for the fall in petrol and diesel prices. However, with the expectation being created of further cuts in domestic petrol and diesel prices, the question then arises: how sustainable is the fall in domestic petrol and diesel prices? In order to understand this, we must first understand why international crude prices are moving the way they are, and why India chose to decontrol the fuel prices in the first place.

Petrol price deregulation in India began in 2010 (and diesel in 2013) as oil subsidies had hit Rs 38 thousand crore in 2010-11 and shot up to Rs 68 thousand crore in 2011-12, up from only around Rs 2.7 thousand crores between 2005-06 and 2008-09.

Fuel subsidies in India were peaking because international crude oil prices were shooting up. Brent crude oil prices went from hovering around $40 per barrel in the early 2000s, to shooting up to $140 in early 2008.

Petrol and diesel prices in India did not move at the same pace, leading to under-recoveries and therefore the subsidy. Fuel subsidies peaked in 2012-13 at Rs 96 thousand crores, which severely constrained the government's ability to spend on infrastructure creation and social schemes impacting economic growth. The fuel price deregulation which was necessitated by the gargantuan fuel subsidies led to the rise in petrol prices and later even diesel prices in the past few years.

The new government, with its eyes set firmly on GDP growth will therefore, resist taking on a fuel price subsidy burden. If the deregulated nature of the prices remain moving ahead, increases in international crude oil prices will lead to the rise of petrol and diesel prices in India (going with the assumption that taxes on fuel will remain the same).

So why are crude oil prices falling in the first place, even as political turmoil continues to rise in Iraq, Syria and Libya? These three nations contribute to approximately five per cent of the total global supply.

BP reports that the percentage fall in 2013 in oil production in Syria and Libya has been 67 and 34 per cent respectively. Additionally, the last few years have seen sanctions on Iran, which contributes to 4.8 per cent of the global supply.

Normally, such instability in the Middle East (or as an economist friend likes to call it, the "Middle West"), coupled with a falling or stagnant production in Saudi Arabia, Russia and other key producing states, would have led to skyrocketing prices.

As a consequence, the world would have seen screaming headlines and heated TV debates (imagine the sheer horror of that) on how oil price hikes have crippled our economies and how we need to move away from fossil fuels once and for all.

However, none of this happened. The unlikely saviour from high oil prices (and the "nation wants to know" debates) has been the United States of America. The United States (which now contributes close to 11 per cent of global supply) ramped up production by a whopping 13.5 per cent in 2013: far more than any major supplier in the world. The United State's rise in production compensated for global fall in the supply of oil. There was a one-for-one increase in US oil production for the fall in output elsewhere, which led to stable global supplies, and therefore stable oil prices.

The rise in US oil production has been enabled by a boom of tight oil (crude oil which is extracted from an unconventional source) production which kicked off in 2008, enabled by high crude oil prices. Such unconventional oil production would not have been viable at low oil prices.

Moving forward, stable but high prices are expected to keep feeding the unconventional oil boom in the USA, which in turn will work to keep oil prices steady over time. Institutions such as IMF, World Bank, Economist Intelligence Unit, all predict Brent crude oil prices to be in or around the $90 per barrel, falling marginally over time for the next few years.

Of course, such projections do not (and cannot) account for "black swan" events, so an unexpected revolution here or an environmental catastrophe there can drastically change the course.

To make things more interesting, Saudi Arabia has signalled that it will defend its market share instead of targeting prices, effectively implying that the international oil cartel, OPEC will not be able to influence crude oil prices as it once did.

In sum, the Modi government is rallying towards being rid of the petroleum subsidy burden off its back. It has one less thing to worry about (at least in the near future) when it comes to the economy.

Petrol and diesel prices may well remain steady over time, so discontent (at least from this avenue) will be curtailed. Further, the Rs. 63 thousand crores budgeted this year for the fuel subsidy is already looking like an overestimate, since it was calculated using higher crude oil prices. That's a big change from the recent past, when budgeted fuel subsidies were gross underestimates and the government had to make cuts into its spending towards the end of the financial years.

CommentThe new government will not have to bother about this (at least in the current fiscal year) and so, has a major advantage going into the next few years. It's a starting advantage any new prime minister would have wished for.