Crude oil’s effectiveness as a gauge of economic growth was once again on display during the pandemic. Last March, as the scale of the pandemic was first revealed, Brent oil futures plunged to $22. But with the large stimulus roll-out and gradual recovery in growth, prices too moved higher to $55.
The price of crude oil has, however, been on the boil over the last few weeks, with Brent futures reaching a high of $75 on July 6, recording year-to-date gain of 36 per cent. Indian consumers have also been facing the heat with the retail selling price of petrol hitting ₹100 in all the metros this month.
Speculators and investors seem to have a hand in driving this frenzy. This is evident in the extremely rosy projections of brokerages.
Goldman Sachs expects Brent prices to average above $80 in the third quarter of this calendar year with spikes above that price; JP Morgan expects crude to break above $80 in the last quarter of 2021 and Bank of America projects Brent prices to hit $100 by next summer.
With far-reaching impact of rising oil prices on the economy and consumer budgets, the moot question is, will the rally in crude oil sustain and what is likely to be medium-term price range? The answer lies in the demand-supply equation of crude oil.
Global demand for oil declined from 99.7 million barrels per day (mb/d) in 2019 to 91 mb/d in 2020 as the Covid-19 pandemic dealt a sharp blow. Travel and mobility were among the worst affected by the lockdowns, constricting petroleum consumption. With crude oil prices crashing, supplies were reduced in the second quarter, by both OPEC and non-OPEC producers.
The sharp rally in petroleum price in 2021 is due to two primary factors. One, the virus seems to have been contained quite effectively since the beginning of this year, especially in the OECD countries which account for around 47 per cent of demand. The fast pace of vaccination has helped revive economic activity in these countries, leading to expectation of good demand for petroleum products. The IEA, in its June report, expects global oil demand to return to pre-pandemic levels by the end of 2022, rising 5.4 mb/d in 2021 and a further 3.1 mb/d in 2022.
Two, while demand is expected to revive, there are concerns over supply due to the ongoing stalemate between the UAE and the OPEC countries. According to the IEA, oil output from non-OPEC plus countries is set to rise by 710 kb/d in 2021. Given the projected demand of 96.4 mb/d in 2021, there could be an output gap this year, unless OPEC countries come to an agreement on increasing output.
The wrangle in the OPEC
In 2020, OPEC plus countries agreed to reduce output by 10 mb/d from May 2020 to end of April 2022, to contain the price decline caused by falling demand. Now, with global demand reviving, Saudi Arabia has proposed that OPEC increase production by 2 mb/d between August 2021 to December 2021, but extend rest of the cuts until the end of 2022. But the UAE wants the production cuts to extend until end of 2022 only if the baseline for output is revised. OPEC members’ productions are linked to the baseline and this was to be revised at the end of the current production cut agreement, which was April 2022. Extending the cuts until end of next year would result in the UAE not being able to pump more oil, thus leading to under-utilisation of its production capacity.
The positive is that the UAE has said that it is willing to pump as much oil as required to meet global demand, if it’s condition is met. The OPEC plus members have spare capacity of 6.9 mb/d, even after the increase in production, so far this year. So increasing the oil supply is just an agreement away. Saudi Arabia is concerned about flooding the market with excess supply, thus making prices crash. Once a middle-ground is found, output from OPEC plus is likely to increase.
The other wild card in the equation is Iran. While the new leader has created uncertainty on the time-line for lifting the sanctions, another 1.4 mb/d could enter the market from Iran, once sanctions are lifted. Of the non-OPEC countries, the US is expected to add 900 kb/d by 2022 with Canada, Brazil and Norway also contributing to the increase next year.
While the supply situation is not unsalvageable, demand projections may need downward revision if the third wave or new variants of the virus cause further disruptions in global recovery. Also, the recovery is limited to advanced economies with most developing and under-developed nations yet to progress materially in vaccination. Global travel cannot revive under these conditions.
Given the uncertainty in demand caused by the ongoing pandemic and the capability of producers to increase output, there is unlikely to be a runaway rally towards $100 as yet. That said, oil-producing countries will be careful enough to maintain the balance in output so that prices do not crash either.
This is likely to keep prices in the $50 to $80 range over medium term. The other solace is that there is no great geopolitical crisis brewing currently. If we see the movement of crude prices since 1950s (see accompanying chart), sharp spikes in prices were mostly accompanied by geopolitical tensions or other factors leading to shortage in supply. This time around, since there is no dearth in supply, sustained rally may be unlikely.
Impact on India
The Indian economy has been able to cope with crude oil prices moving in the $50 to $70 range since 2014. It’s only when prices spike materially beyond $70 that some negative ramifications are seen. The larger impact is on trade deficit. India is a net crude oil importer, depending on imported oil to meet over 77 per cent of domestic demand. The share of petroleum products in India’s imports is over 25 per cent in normal times.
Therefore, the surge in crude oil price tends to inflate the import bill, widening the trade deficit. This tends to impact the rupee’s movement. As the accompanying chart shows, the rupee has depreciated against the dollar in periods of oil price surge. The same trend is playing out over the past year as increasing oil prices is making the rupee weak. With fuel and light having a significant weight in the CPI basket, the surge in crude oil prices tends to make the CPI spike higher as well. This is being witnessed in recent months.
However, once global crude oil supply is ramped up, both rupee and the CPI could get some relief.