Price outlook: Oil on the boil

For India that imports more than 80 per cent of its crude oil requirement, the past year has not been a good one on energy pricing. Global oil price (Brent) and, along with it, the price of the Indian crude oil basket has rallied more than 70 per cent since mid-June last year — from about $45 a barrel to almost $80 now. This is a sharp reversal from the rout that saw oil prices crash from about $115 a barrel in mid-2014 to less than $30 in early 2016 before recovering to $45-$55 levels.

The rally in oil has adverse implications on several macro-indicators such as the country’s import bill, its current account deficit and the currency value, with these parameters feeding into each other.

Until last year, the popular wisdom was that crude oil, even if it rallies, was unlikely to go beyond the $65-$70 a barrel mark. This was based on the assumption that US shale oil — a game-changer that triggered the global oil rout — would make a strong comeback, and higher output would keep a cap on prices. But yet again, oil has proved that trying to forecast its movement is a mug’s game.

Reasons behind the rally

The sharp rally over the past year has been aided by a few factors. One, the output cut deal between the Saudi Arabia-led OPEC (Organisation of the Petroleum Exporting Countries) and some major non-OPEC players, including Russia, finally showed results and squeezed out much of the excess oil inventory in the market.

Two, the economic meltdown in Venezuela has resulted in a sharp cut (about 40 per cent) in the country’s oil production.

Three, with Donald Trump as US President, there was always the overhang of the US pulling out of the Obama-led nuclear deal with Iran — a risk that finally played out earlier this month. Now, with the US likely to re-impose economic sanctions on Iran, the latter’s oil exports that had picked up in 2016 and 2017 after the nuclear deal, will fall again; estimates of the cut vary between 5,00,000 and 1 million barrels per day. At the upper end, that’s about 1 per cent of the global consumption of about 100 million barrels a day.

Finally, the pick-up in the global economy resulted in smart demand increase for crude oil and aided its price ascent last year. The US shale oil industry has been responding to higher prices and has stepped up output, but that has not been enough to offset the perfect storm of factors that propelled oil higher.

Oil may have run its course

How far up can oil go? Can it again reach the three-digit mark? Nothing can be ruled out for a commodity that has swung from $115 to $26 to $80 a barrel in four years. That said, the rally may have run its course and oil could take a breather.

A few factors support this view. The OPEC and non-OPEC countries’ deal to cut oil output by about 1.8 million barrels a day is until December 2018. The chance of another extension seems unlikely — the objectives of the deal have largely been met. Also, Russia was reportedly reluctant on an extension last year to prevent giving the price advantage to US shale players.

Next, how successful the US move on Iran will be needs to be seen. Unlike the last time, the US seems isolated and does not have the support of the major European powers such as France and Germany. Also, major consumers China and India could well continue importing oil from Iran; this could mean lower-than-expected supply disruption in the market. Also, there are indications that the OPEC will step in to make up the shortfall from the Iran squeeze. Finally, lucrative prices will incentivise US shale oil producers to speed up their output growth further. In short, higher oil supply than expected may be coming; this could keep prices under check despite demand growth.

Oil, economics and politics are often closely linked. But there are striking contradictions between the political alignments and the economic interests of some key players in the oil game now. While the US-Saudi Arabia-Israel troika wants to undermine Iran’s political and military influence in West Asia by re-imposing sanctions, US shale producers and Saudi Arabia are now primary competitors in the oil sphere. Also, Russia backs Iran on the political and military fronts but is part of the Saudi-led oil output cut deal. Unravelling of any of these contradictions could help increase global oil supply and cap the price rise.

On the other hand, there is also the risk of further rise in oil prices. Saudi Arabia is preparing for the multi-billion dollar public offering of its oil giant, Saudi Aramco, and would like high oil prices to aid the issue’s success. Besides, increased risk of armed conflicts in West Asia due to recent geo-political developments could cause a supply shock. Also, the pain in Venezuela could deepen with likely US sanctions after the elections there.

India, its consumers and oil companies would rather that oil takes a break now; they feel the pinch badly.

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Impact on oil sector

Oil-politics-economics hurts public sector oil companies

The crude oil spike can, in theory, help both refiners-cum-marketers and oil producers by bestowing inventory gains on the former and improving price realisations for the latter. That, in turn, should get a thumbs-up from the equity market. But that’s not how the script has played out for the major public sector oil company stocks. The PSU oil marketing companies (OMCs) — Indian Oil, HPCL and BPCL — have lost 20-30 per cent on the bourses since end-October 2017, even though crude oil prices have rallied about 30 per cent. The stocks of the PSU upstream companies — ONGC and Oil India — have lost 3-5 per cent during this period. The market seems worried about the fallout of the oil-politics-economics cocktail on the fortunes of the public sector oil companies, and justifiably so.

Tenuous freedom

A pattern is emerging of the PSU OMCs capitulating to the diktats of their major shareholder, the government, and losing their so-called pricing freedom on petrol and diesel in the poll season. It happened during the run-up to the Gujarat State elections last December and, more recently, repeated itself prior to the Karnataka State elections.

In November 2017, with a month to go for the Gujarat Assembly elections, oil prices had breached $60 a barrel and were on their way up. Global petrol and diesel prices, based on which the OMCs set fuel rates in India, were also going north. The price of petrol and diesel should have increased. Instead, Indian Oil’s petrol price in Delhi hovered around ₹69 a litre despite the ‘dynamic’ daily pricing mechanism since mid-June. Similarly, diesel prices were stuck around ₹58 a litre.

Indian Oil’s marketing margin took a knock — falling from ₹3 for a litre of petrol in end-October to just about ₹1 by end-November. This continued until the Gujarat elections in mid-December 2017, after which petrol prices started rising again and played catch-up. By end-March, it was up to ₹73.5 a litre and Indian Oil’s marketing margin increased to almost ₹3.5 a litre.

The go-slow on fuel prices before the Gujarat elections worsened to a complete freeze before the Karnataka polls on May 12. For 19 days, the petrol price remained unchanged; Indian Oil charged the same ₹74.63 a litre of petrol in Delhi every day from April 24 to May 13. It was only on May 14 that the daily dynamic pricing was again invoked. Reports suggest that the OMCs lost ₹400-500 crore in profit in these 19 days of prize freeze — with oil prices steadily increasing and the rupee rapidly losing ground. The marketing margin reportedly fell to about ₹0.5 a litre of petrol in this period.

Sure, once the polls are over, the oil firms have stepped on the price pedal again. But whether that will be possible in the coming months needs to be seen, with an intense election cycle on the cards. Elections in Rajasthan, Madhya Pradesh and Chhattisgarh are lined up towards the end of the year. And then, the big prize, the Lok Sabha election, is likely to be held around April 2019. The PSU oil marketers could again be told to shoulder the burden of costlier oil, with the government unlikely to reduce excise duties and unwilling to earn voter ire. The upshot: the OMC stocks could remain under pressure.

Under-recovery threat

The pricing decontrol of petrol in 2010 followed by that of diesel in 2014 saw the under-recoveries of both upstream and downstream PSU oil companies fall sharply over the years. For the past two years, these companies have been completely spared the under-recovery burden, with the government fully absorbing the loss from selling domestic LPG and PDS kerosene below cost. But this was possible primarily due to low oil prices that kept the burden well under control.

The spike in oil price though could rock this boat. Oil price now (about $80 a barrel) is well above the government’s estimate of about $60 a barrel for 2018-19 and the actual subsidy burden for the year could overshoot, by a large mark, the estimate of about ₹25,000 crore. The need to maintain fiscal prudence could see the government transfer the excess burden to the PSU oil companies. This risk is higher for the upstream companies ONGC and Oil India that would otherwise have benefited from higher oil prices. A return of the subsidy burden could put a cap on their price realisations, offsetting potential gains.

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Impact on consumer

Squeezed by rising fuel prices, high taxes and a weak rupee

Petrol prices in India (about ₹76 a litre in Delhi) have climbed to near peak levels while diesel is at its costliest ever (about ₹67 a litre). Oil on the boil has left consumers hot under the collar. Oil prices have been rising, people agree. But, they ask, when the price of the Indian crude oil basket now ($78 a barrel) is still far lower that in mid-2014 ($112 a barrel), why do petrol and diesel today cost more than in mid-2014 (about ₹71 and ₹57 a litre respectively?)

Taxes, the culprit

The answer lies primarily in the fact that when the crude oil rout was underway from mid-2014 to early 2016, the Governments at the Centre and many States chose to pocket most of the gains through regular hikes in excise duty and VAT (value added tax) on petrol and diesel. Between November 2014 and January 2016, excise duty on petrol and diesel was raised nine times. In all, the total increase in excise was as much as ₹11.77 a litre of petrol and ₹13.47 a litre of diesel.

To add to this, many states upped their VAT rates when the going was good. High VAT rates are why consumers in some States such as Maharashtra and cities such as Mumbai have it worse than others.

In effect, only a relatively small portion of the cost reduction benefit was passed on to consumers. The understanding was that, if and when oil prices rose sharply, taxes would be cut to cushion consumers. But when it came to crunch, consumers have not been given meaningful relief.

When petrol and diesel prices began rising rapidly from the middle of last year, there was a furore. There were insinuations that the too-little-to-be-observed price changes under the daily pricing mechanism from mid-June were being used as a cover to give effect to sharp hikes cumulatively. The Centre, under intense public pressure, cut excise duty on petrol and diesel by ₹2 a litre in October. Some States followed with a cut in the VAT on these fuels. But this was a case of little and late.

Oil that had risen from $45 a barrel in mid-June to $55 a barrel by October went from strength to strength and is now around $80 a barrel. To add to the pain, the rupee has also slipped considerably in recent months and added to the rupee cost of crude oil.

The Centre and the States are now reluctant to roll back the tax hikes due to huge revenue implications — excise and VAT receipts from petroleum and oil products have ballooned sharply over the past few years. Excise duty on petrol now is ₹19.48 a litre of petrol and ₹15.33 a litre of diesel. The petroleum sector is a cash cow — it contributed 64 per cent of the Centre’s excise duty receipts and 24 per cent of its revenue receipts in 2016-17. Also, 8 per cent of the revenue receipts of the States in 2016-17 were contributed by the petroleum sector.

Sharing the burden

The burden then falls on fuel customers and/or oil marketing companies. The daily pricing mechanism since mid-June 2017 has seen steady, creeping increases in fuel prices, which customers have had to bear, despite protest, for most of the last year.

But there have been brief spells of respite for them in the run-up to major elections, when the burden shifted to PSU oil companies that had to go slow on hikes or freeze fuel prices.

This pattern may continue over the coming year, with consumers bearing the burden and the tab shifting to oil companies during election time. That said, with several State elections and the Lok Sabha elections slated over the coming year, the Centre may not want to antagonise voters too much. This could mean fewer price hikes and more go-slows/prize freezes than has been the case so far.

That’s also because higher oil prices have a knock-on effect on general inflation through increase in freight and other costs. According to the Petroleum Planning and Analysis Cell, petroleum products have weight of nearly 8 per cent in the wholesale price index (WPI), and an increase of ₹1 per litre in the price of petrol and diesel increases inflation by 0.03 per cent and 0.08 per cent respectively.