During the past month or so, oil prices have charted their own course upwards, in clear contrast to the prices of most other commodities. As on 13 May, The Economist magazine’s metals index has fallen 3.6% compared with a month ago and its food index was down 1.7%. The probable reason: a rebound in the value of the US dollar. The US dollar index, which measures its value relative to other currencies after adjusting for differences in inflation, is at 80.5711 this month compared with a low of 78.9937 in March, its lowest value since July 1995. But while commodity prices have dipped a bit as a result of the strengthening of the dollar, nothing of the sort has happened to crude oil prices. As on 13 May, they were up 10.6% over one month. This is strange, as the received wisdom is that crude prices, like that of other commodities, are dependent on the dollar.
Have oil prices delinked from the dollar?
A recent Citigroup research report points to data from the International Energy Agency, which show that while oil demand in March was lower by 2.8% y-o-y in the developed countries, with demand in the US down 3.3%, demand from the non-OECD countries continued to be strong. Chinese oil demand was higher by 11% in March, while in India growth in demand was 7%. Isn’t this another indication of the de-linking of these economies from the West?
That’s because both these countries subsidize fuel prices, buoying consumption. For instance, the report says that the ex-refinery price of petrol and diesel in China are 21% and 45% below the free market price for these products in Singapore. Also, because taxes on these products are very low in China, their retail prices are much lower than in countries where they are heavily taxed (see table). In India, the report says that retail petrol/diesel prices are 30-35% lower than international prices. The point is that a policy of subsidizing fuel prices, while having an obvious negative impact on oil companies and on the fisc, also has the effect of keeping demand artificially high. It’s one reason why economies such as India and China can stay decoupled to an extent from a global growth slowdown. Moreover, with China accounting for 35% of the growth in oil demand in the past five years and India accounting for 5% of the growth, fuel subsidies in these countries help keep global oil prices high.
However, there’s one big flaw in that line of reasoning. Consider how low the retail price of petrol is in the US—among the countries in our table, it ranks the second lowest, just above Beijing. That’s because taxes on fuel are much lower in the US than in many other countries. The consequence: on a per capita basis, the Americans use three times as more oil then the Europeans. In the circumstances, pointing to emerging countries as the reason for the higher oil prices is rather hypocritical.
For all these reasons, the upward pressure on crude prices certainly looks like it’s here to stay. That should support gold as a hedge against inflation.
Rising oil will hurt India most
It has taken more than two decades for crude oil prices to climb above the real or inflation-adjusted level that prevailed during the second oil shock of the late 1970s/early 1980s. (The first shock occurred in 1973, at the time of the Arab-Israeli war). During the second shock, triggered by the revolution in Iran and the Iran-Iraq war, oil prices soared to $105 (Rs4,473) a barrel (in current dollars). We’re quite a bit above that level now.
What was the impact of the second oil price shock? US GDP growth fell from 5.6% in 1978 to -0.2% in 1980 and to -1.9% in 1982. In India, GDP growth fell from 5.5% in 1978-79 to -5.2% in 1979-80 before rebounding to 7.2% in 1980-81. Inflation measured by the wholesale price index skyrocketed to 17.1% in 1979-80 and 18.2% the following year before coming down to a still painful 9.3% in 1981-82.
Sure, this is not 1979, but unlike countries in the West that have moved away from heavy oil dependence, it’s big oil importers such as India that will be hurt the most this time. Citigroup economist Rohini Malkani writes that assuming oil at $115 a barrel, our current account deficit would rise to 3.3% of GDP.
In the stock market, it’s hardly surprising that, with losses of Rs450 crore a day by the three state-run retailers on petrol, diesel, LPG and kerosene, the BSE oil and gas index is underperforming the market. It’s unlikely that the government will raise domestic fuel prices with inflation so high and with elections near. While the government may issue oil bonds to help oil companies, their issue is delayed and monetizing the bonds also takes time, hurting cash flow.
Indian investors have long placed their bets on oil and gas services instead. It’s no surprise that companies such as Shiv-Vani Oil and Gas Exploration Services Ltd and Aban Offshore Ltd have been outperformers.
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