Global oil markets are jittery with US president George Bush refusing to ruleout a preemptive strike against Iran’s nuclear facilities. International crudeprices have surged to record levels of $72.64 a barrel and are expected toremain high and volatile in the near future. There are no prizes for guessingwhat all of this implies for fast-growing emerging economies like India thatimport 70 per cent of its requirements of oil. So far, however, the inflationaryconsequences of costlier oil have not been felt due to the limited "pass-through"of global oil prices to domestic oil prices, thanks to administered prices.
Thus while the average basket price of crude that India imports zoomed to $65.5a barrel by mid-April 2006, only 15 per cent of the world oil prices hike waspassed on to domestic consumers. Domestic wholesale prices thus have beenrunning at only a modest rate of 3.5 per cent from the start of April but arelikely to rise upwards if global crude prices go through the roof. "We areconfident about containing inflation.. (but) we are worried about global oilprices" stated RBI governor YV Reddy after recently unveiling the annualcredit policy statement for 2006-07.
The world, too, is worried about President Bush’s intentions regarding Iran asthis country continues to defy international pressure to halt its nuclearprogramme. The current price levels could even spike to $100 a barrel if the USindeed attacks Iran and causes supply disruption from the world’s fourthbiggest exporter of oil. Few economies in the world can survive such severe oilshocks. There is thus a clear and present danger that costlier oil will tip theworld economy into stagflation like the previous oil shocks did during the earlyand late 1970s.
Interestingly, the global oil price surge has little to do with demand-supplyimbalances – the stock in trade of textbook economics. Global demand for oilthis year is pegged at 85.2 million barrels per day while global supply isidentical at 85.3 million barrels per day according to the US Energy InformationAdministration. But this hasn’t prevented prices from rising by 81 per cent to$60.9 per barrel in end-March 2006 from $33.7 per barrel in end-March 2004. Thereasons include natural devastations like Hurricane Katrina, supply disruptionsin Nigeria, threat of strikes in Norway among others.
None of these factors can, however, "explain" the zooming oil prices.According to oil experts, a more important factor is the limited spare crude oilproduction capacity worldwide. The US refineries have also to fully recover fromthe Katrina effect. Thus while demand and supply are in balance, any threat ofsupply disruption from a major oil producer or rumours to that effect, canresult in prices spiking upwards dangerously. This is indeed what has beenhappening since The New Yorker magazine published a story this month thatthe US was contemplating a tactical nuclear weapon strike against Iran.
Such a prospect worries the RBI. Till now, however, the "pass-through" ofcostlier global oil into domestic prices has been contained due to politicalcompulsions to insulate the urban middle class from inflation. There is simplyno question of raising domestic oil prices while elections to five stateassembly elections are underway. But in the process, India’s oil marketingcompanies have been taking a big hit and are awash in red. "Oil pass-throughis yet to take place in our economy… it is increasingly clear that there hasto be a fuller pass-through of increases in international crude prices",stated Dr Reddy.
The upshot is that the UPA government has to put in place a more rational oilpricing mechanism as per the recommendations of the Rangarajan Committee.Allowing a greater degree of pass-through of international prices to domesticprices clearly is warranted at the moment. As the current international oilprices have a "large permanent component" -- in other words, they are likelyto stay high for a long time -- such a pass-through enables greater efficiencyin the usage of oil in the economy. Higher prices will trigger the need forgreater conservation in the utilization of oil.
Greater pass-through can also stanch the bleeding of India’s oil majors. Someof these are so-called navaratnas or PSU jewels whose continued existenceas state-owned entities forms part of the UPA government’s commitment underthe National Common Minimum Programme. Interestingly, while the Left exertstremendous pressure on the government to safeguard these navaratnas atall costs, there is no concern that continuing with administered prices canbankrupt them. The government, for its part, wants to insulate the middle classfrom inflation for political reasons.
With oil not well, there is no getting away from enhancing greaterself-sufficiency in oil production. Today, this is around 30 per cent and islikely to go down further to 15 per cent over the near term. With prices at $72a barrel and testing higher levels, the country’s oil import bill will widensubstantially. The need, therefore, is to curb import dependence through a moreaggressive plan to step up domestic oil production through deepwaterexploration. With a rational oil price mechanism, this is indeed the best way toinsulate the middle class from global oil prices without bleeding the domesticoil majors.
N. Chandra Mohan is a Delhi-based analyst of economic and business affairs
