As we write, the price of Brent Crude has fallen below the $30/bbl and threatens to go closer to the $20 mark as was predicted by large investment houses like Citi and Goldman. The reasons are not far to seek. The OPEC has refused to cut supply of oil even as Russia, Nigeria, Iran and the US are still producing oil at peak capacities. On a daily basis, there is an excess supply of nearly 2-3 million barrels of oil. This excess supply for a sustained period of time has resulted in an oil stockpile of over 3 billion barrels, which is also preventing the price of oil from rising. Lastly, there is the issue of weak demand from China which is experiencing a distinct slowdown. This sharp fall in price of oil was last seen at the peak of the 2008 crisis but then oil managed to bounce back fairly quickly. But this time it seems to be different. Apart from excess supply, record stockpiles and weak demand there is the distinct danger of the world running out of oil storage capacity. If that happens then there may be a further glut of oil in the markets depressing prices further.
What do weak oil prices mean for the US…?
Over the last 5-7 years, the US extractors have invested billions of dollars in finding new shale wells. With prices at such low levels, over half of shale wells are currently idling. But then innovation has made the difference. The Americans have perfected the art of extracting more oil from their shale deposits and have managed to maintain supply. Any rise in oil prices will help the US shale producers to become viable again and that is something the OPEC would want to avoid. Additionally, the US has lifted its 40 year ban on oil exports, which was first imposed in the light of the Arab Oil Embargo in 1973. That will only mean more supply and further pressure on prices. Of course, the US shale wells are largely funded by junk bonds. That remains a major risk for US financial markets.
What does weak oil prices mean for the OPEC?
Broadly, there are two categories of countries in the OPEC. There are the Middle East nations like Saudi Arabia, UAE and Qatar who have amassed massive forex reserves and can fall back upon them to subsidise oil prices for much longer. However, other countries like Libya, Nigeria, Iran or Iraq may not have that luxury. In fact, OPEC members like Venezuela are already teetering on the brink of an economic crisis. For them a prolonged lull in oil prices will only make matters worse. Even the GCC countries are not exactly in a comfortable situation. For example, Saudi Arabia has already run down its forex chest by $110 billion in the last 14 months. IMF estimates that at this rate, Saudi Arabia may run out of funds in 4 years. Saudi Arabia is already running a budget deficit of 20% and has started cutting expenses on social security, infrastructure and housing. Others like UAE, Qatar and Bahrain are likely to be worse off.
Russia could be a principal player in oil…
Each time the price of oil dips by $1/bbl, Russia stands to lose $2 billion. That is how big and important oil exports is to Russia. Like Saudi Arabia, Russia has also drawn down its reserves heavily in the last one year trying to protect the value of the rouble against a rampaging dollar. The weak rouble has helped them to push oil exports but Russia is already in a recession for the first time since 2009. Russia has another important role to play in global oil economics. Today the US is the largest oil producer and pumps around 14 million barrels of oil per day. Russia and Saudi Arabia pump around 11-12 million barrels of oil per day. Currently, Russia is not part of the OPEC but if OPEC wants to push up prices by regulating supply, then Saudi Arabia will be heavily counting on the support of Russia to back them. Without the support of non-OPEC countries like Russia and Mexico, the OPEC will not be in a position to influence oil prices.
How will falling oil prices influence China and Japan…?
These are two very important countries in the global oil economics. Japan depends entirely on oil imports for its fuel needs. That means Japan is really getting the dividends of cheap oil playing in their favour. They are one of the biggest beneficiaries, although the worry is that as long as oil prices are low, Shinzo Abe will not able to achieve his inflation targets. China is a slightly different ball game. Apart from being the largest importer of oil in the world, China is also critical barometer of oil demand. One of the key reasons for the fall in oil prices was weak demand from China. Therefore weak oil prices have almost become symbolic of a slowdown in China. We need to remember that the first reliable lead indicator of the problems in China was oil prices. Hence as long as oil is low, it will be interpreted as a sign of weakness in China. That will lead to a weak Yuan with concomitant negative consequences across emerging markets.
What do falling oil prices mean for India…?
Like Japan, India has been a major beneficiary of weak oil prices as it imports 75% of its oil needs. Both at a macro level and in terms of government finances, cheap oil has been substantially helpful. In terms of corporate performance, it has been mixed, although the smaller and mid cap companies seem to have benefited more than the large cap companies. Here are a few key ways in which India has been impacted by falling oil…
- Falling oil prices has helped bring India’s fiscal deficit substantially under control. The government has been able to maintain fiscal deficit at 3.9% and hopes to reduce to 3.5% largely on the back of weak oil prices.
- At a macro level, the current account deficit has also benefited. From a peak of 4.6% of GDP in 2012, the CAD has come down to nearly 1% of GDP currently. This is likely to go down further if oil prices stay low. Surely it has helped India’s BOP substantially.
- In terms of import cover, the economy has benefited greatly. The RBI forex chest has been at around $350 billion for the last 6 months. But due to a sharp fall in imports due to lower oil prices, India’s forex cover has improved form 7.5 months of imports to 10.5 months of imports. These three factors have largely helped India maintain its ratings despite a global slowdown and negative impact on emerging market currencies.
- Cheap oil has also helped the government substantially on the revenues front. Since the fall in oil prices started, the government has managed to raise the excise duty on petrol and diesel 7 times. In fact, the excise on petrol has risen two-fold and the excise on diesel has increased three-fold. Despite that the pressure is not felt by the people due to weak oil prices. This also helped the government substantially in compensating loss of revenues. During the current fiscal, the government is likely to fall short of target on direct taxes by Rs.40,000 crore and on disinvestment by Rs.45,000 crore. These will be largely compensated by the higher excise on petrol and diesel.
- At a corporate level, most large caps have been susceptible either to low commodity prices or to a weakness in China. The real benefit has actually accrued to the mid cap and small cap businesses that are not so much into commodity businesses. That is also evident in the performance in the last year. While the Sensex was down by -5% in 2015, the mid cap index was up by 6%.
In conclusion, cheap oil surely has some key advantages as far as India’s macros are concerned. India has reasons to thank cheap oil for taking care of a plethora of its macro problems. However, historically, global growth and economic robustness has never been known to happen when oil prices are at such lows. It is a larger signal of a slowdown in demand globally. That is going to hit all emerging markets and India is unlikely to be spared. That is food for thought.