After protracted battle within the bloc [as also with countries outside], members of the Organization for Petroleum Exporting Countries [OPEC] – a conglomeration of oil exporting nations from the middle east – have agreed to reduce their combined output by about 1.2 million barrels a day. Likewise, 11 non-OPEC countries led by Russia have decided to knock off over 500,000 barrels from their supplies. The agreement is effective from January 1, 2017.
The agreement has to be viewed in the backdrop of a steep decline in the international price of crude oil from the peak of US$ 117 per barrel in June 2014 to a low of US$ 27 per barrel in February, 2016. During the current calendar, even though it picked up, by November [end], it had barely touched US$ 40 per barrel.
The low price realization from sale of oil had led to substantial erosion in profits/surpluses of exporting countries devastating a number of economies viz., Venezuela, Nigeria [overwhelmingly dependent on earnings from oil export] and destabilizing state budgets of even most prosperous countries such as Saudi Arabia. These countries were desperate to reverse this trend.
The price is primarily a function of global demand-supply balance. If, it is easy, the price will decline; this is what happened during last 30 months. On the other hand, if, the balance is tight, then, the price will increase. This is precisely what OPEC countries are trying to achieve by their concerted action to cut supplies. Already, the price has surged to US$ 54 per barrel currently and will increase sharply after the agreements take effect from January 1, 2017.
While, putting more money in the pocket of exporting countries, the hike will have serious ramifications for countries which depend heavily on import for their energy requirements. India without doubt falls in that category as it imports 80% of its oil requirements. It also imports a substantial portion of its gas consumption the price which follows the trend in the price of crude oil.
Since mid 2014, when crude price started falling, India has saved huge sums on import of oil and oil products. This helped in substantial reduction in prices to consumers, increase in tax revenue [both to center and states] and lower subsidy payments. In turn, these enabled reining in fiscal deficit within set target and reducing current account deficit [CAD] and thus achieve macro-economic stability.
With crude price commencing its north-ward journey, all of above gains will disappear [the pace of disappearance depends on the speed at which oil price will increase]. To prevent increase in price to consumers especially LPG and kerosene which continue to be subsidized, the government will be under pressure to reduce taxes; alternatively, it will have to shell out more towards subsidy. Either way, there will be a risk of fiscal deficit slipping out of control.
During 2016-17, government got a bonanza due to re-writing of long-term agreement for supply of gas from RasGas of Qatar [India imports 30 million standard cubic meter per day from there] in the wake of reduction in international price of gas. This helped reduce cost of power generation by gas-based plants and cost of fertilizers [mainly urea] by manufacturing units using imported gas. On fertilizers, it was able to rein in subsidy as selling price is controlled at low level.
Considering that price of imported gas is invariably linked to prevailing international price of crude [including supplies under the contract with RasGas], the former will also move up in tandem. This will increase cost of power leading in turn, to higher tariff. In case of fertilizers, the subsidy on domestic urea will increase thereby exerting further destabilizing effect on the budget.
In short, reduced tax collection, higher subsidy on fertilizers, LPG and kerosene and even on power [as normally states do not let higher generation cost to be transmitted to farmers/households forcing center to come out with bail-out package] will make a big hole in the government budget. Hence, there is an urgent need for it to create adequate buffers to nullify the effect of oil price hike.
During 2017-18, the government may have adequate cushion, courtesy demonetization announced on November 8, 2016. According to KV Kamath, chairman, New Development Bank [NDB] of BRICS countries, this would yield a tax bonanza of Rs 250,000 crores. But, a lot will depend on expenses Modi will commit under Pradhan Mantri Garib Kalyan Yojna [PMGKY]. The finances can come under stress if it decides to spend the whole of tax bonanza on welfare programs for the poor.
The government was also pinning hope on introduction of GST from April 1, 2017. By bringing in billions of transactions within the purview of tax, this has the potential of substantially increasing tax revenue. But, in view of tough posturing by opposition parties who are unhappy with demonetization [or its implementation], it seems unlikely that this would be kicked off before September, 2017. So, the intended buoyancy may not accrue during the next fiscal.
Even so, this may not be the best way of cushioning the effect of impending oil price hike. This is not a sustainable option either. The problem needs to be tackled right at the source. This is best done by implementing long pending reforms in affected sectors. Thus, there is no point in continuing with subsidy on LPG to majority of the better-off/rich who continue to enjoy it. Likewise, kerosene subsidy can be instantly dispensed as it is not going to poor. Major reforms are needed in oil retailing too.
The fertilizer sector has been crying for reforms for much too long. The present government has proclaimed its commitment to remove price control and introduce direct benefit transfer [DBT] of subsidy for better targeting. This can drastically reduce subsidy and will make subsidy payments less vulnerable to increase in price of oil and gas. But, when DBT will actually be implemented is hanging in the air.
Likewise, reforms in the power sector viz., removal of controls, competitive tariff setting, freedom to choose supplier, curbing leakages and power theft have been held hostage to populism and political expediency. Until, these are implemented, the sector will remain devoid of the much needed resilience to absorb external shocks like increase in oil and gas price.
Team Modi has done little to tackle these subsidy monsters head on. Thus far, they were tamed, courtesy low oil price. But, with latter set to increase sharply, they will grow in size and ferocity posing a serious threat to fiscal consolidation, macro-economic stability and people’s welfare. It is time to act now.