Many years ago, I was in conversation with the late Maloy Krishna Dhar, retired Intelligence Bureau officer and best-selling author. While on the subject of geopolitics, he said, “You know, the real problem starts with dependency on oil. If it wasn’t for that, there wouldn’t be all this jhamela.”

It was a narrow-focus opinion. But within its own parameters, it was correct. There are many reasons for the United States to hate Iran, and vice-versa. There are many reasons for the Saudis and Iranians to want to cut each other’s throats. There are many reasons why Russia’s relationship with the European Union is not as lovey-dovey as it could be. But if it were not for Russia, Iran and Saudi Arabia possessing lots of oil, the geopolitics would be a lot easier to negotiate.

Oil, or more broadly energy, is the classic example of a necessary good. Demand is driven by economic activity and does not vary too much with price. You and I, and billions of others, need to travel every day. Ships have containers to deliver. Farmers run tractors.

If the price of oil goes up, demand falls very slowly relative to price change. Consumers cut back discretionary expenditures – they smoke fewer cigarettes, and postpone buying new phones. If price drops, demand does not rise too much. People splurge on other things.

Supply is the crucial element for necessary goods. If supply shrinks to even slightly less than demand, prices spike, since everyone needs their fix. Conversely, if there is a small supply surplus, prices nosedive because nobody wants the extra oil.

The politics driving oil prices

Global consumption has risen from around 93 million barrels per day in 2012 to around 99 million barrels per day now. Global production is at around 98-99 million barrels per day, which just about matches demand. In 2017, primary energy consumption grew 2.2% and that led to the price of oil (Brent, which is a benchmark grade) averaging $54 a barrel, up 25% from an average of $44 in 2016.

The tighter supply-demand equation has meant rising prices through 2018. From January to October, Brent has risen from $69 to $81. Supply has tightened due to two factors. One is that the Organisation of the Petroleum Exporting Countries decided to impose a production cap in November 2016, and agreed to extend the cap in November 2017, for at least another year. Note: oil exporters do not lose by producing less. Since the price rises sharply if supply falls, they actually make more money selling less.

The second factor that has led to high prices is fears of supply disruption as American sanctions kick in against Iran in November. Iran used to export about 2.7 million barrels per day and cut that voluntarily to about 2.4 million in April. In September, Iranian exports fell to 1.6 million barrels per day and may fall further if the United States can make its threats stick. Fears of shortages have led to higher prices, as importers stockpile.

Donald Trump's decision to re-impose sanctions on Iran has led to fears of a disruption in oil supply and consequently higher prices.

The United States used to be an oil importer. But its knowhow in exploiting “tight oil” (found in impermeable shale and limestone rock deposits) and shale assets, and the Donald Trump administration’s willingness to destroy the ecological balance of fragile environments, has led to the country becoming energy-surplus. As more production has come online, the Trump administration has also removed long-standing bans on United States oil exports. Note: US oil is expensive. Many fracking (a technique to recover oil and gas from shale rock) operations are unprofitable at less than $50 a barrel. So, the Trump administration may actively seek policies that cause geopolitical tensions and higher crude prices.

One possibility of filling the gap is persuading Saudi Arabia and other members of the Organisation of the Petroleum Exporting Countries to ramp up production and thus, compensate for the dip in Iran’s share. That looks unlikely. The members of the organisation, including Iran, have benefited from the voluntary production cap. Most of them do not have a great deal of capacity to spare. The two “swing” producers with substantial excess capacity – Saudi Arabia and Russia – may be perfectly happy to keep prices high. (Among major exporters, Russia is not a member of the Organisation of the Petroleum Exporting Countries, neither is the United States or Norway.)

If energy importers like the European Union take a principled stand on the alleged murder of dissident Saudi journalist Jamal Khashoggi inside Saudi Arabia’s consulate in Istanbul, the Saudis may retaliate by cutting production to force up prices. Similarly, Russia may respond to European Union strictures over the Crimea annexation, or the poisoning of a former double agent and his daughter in London, by forcing prices up. Or, if the Saudis want to hurt the United States, it could flood the market and drive American producers out of business by forcing prices down.

The ifs and buts of geopolitics are, therefore, very hard to assess. But most industry experts seem to believe the energy supply-demand equation will stay tight through 2019. Global gross domestic product growth is reasonably strong, though estimates have been cut. That means more demand.

India and oil shocks

India is, and has always been, among the most vulnerable where oil shocks are concerned, since it imports over 80% of crude and about 30% of its gas. India also has zero diplomatic leverage with the Organisation of the Petroleum Exporting Countries, and very little, if any, with Russia and the United States. India may get into a confrontation with the United States if it buys Iranian oil anyway, using the new Chinese initiative of paying via yuan instead of the dollar.

I recall the day in November 1973 when petrol prices were increased from Rs 0.65 a litre to Rs 1.60 a litre. That was the first oil shock. Members of the Organisation of the Petroleum Exporting Countries were unhappy with the diplomatic fallout of the Yom Kippur War and exported their unhappiness to every oil-deficient nation by raising prices. That sparked a multi-year global recession and contributed to misery in India.

The next oil shock was in 1979 when the Iran monarchy collapsed. Another big, though short-lived oil shock occurred when Iraq invaded Kuwait in January 1991. That triggered a near-collapse in the Indian economy, but proved a blessing in disguise as it led to reforms. A fourth oil shock in 2013 nearly led to a run on the rupee and pushed India’s balance of payments in the red again.

Every oil shock has led to rupee depreciation, domestic inflation, and slowed gross domestic product growth. When fuel prices rise, so does India’s import bill. In addition, the cost of petro-related imports, such as plastics and feedstock for fertilisers, also rises. Exports cannot keep pace, leading to a drain on reserves, as the trade deficit (the gap between imports and exports) and the current account deficit (the difference between inflow and outflow of foreign exchange) expand.

The rupee then falls, leading to all imports becoming more expensive. Since India’s imports amount to about 24% of its gross domestic product, the impact is considerable. In addition, transportation costs rise. That means all-round inflation. The next follow-on effect is household consumption getting hit, since people tighten their belts when they are faced with inflation.

When it comes to understanding what is happening, none of this is rocket science. But it is not easy for policy-makers to deal with. We are currently seeing the negative effects kick in. The rupee has fallen 15% since January. The current account deficit could rise to 3% of gross domestic product in 2018-2019.

An oil shock leads to rupee depreciation. The rupee has fallen 15% since January. (Credit: Indranil Mukherjee / AFP)

The last time this happened was in 2012-2014, when policy-makers struggled. The situation was actually much worse then. Crude prices hit $100-plus a barrel and stayed that way for two years. This time around, crude prices are nowhere near the same levels, yet. But in the meantime, the government (and various state governments) have increased excise rates on petroproducts considerably and the rupee has fallen too. Hence, retail prices have hit record levels.

In 2013, a combination of measures was taken to handle the situation. The Reserve Bank of India, under governor Raghuram Rajan, targeted inflation by raising interest rates and protected the rupee by raising $34 billion in foreign exchange deposits from non-resident Indians via a swap deal with banks. That was expensive. But it provided a cushion (technically, those deposits did not count as reserves but they could be tapped at need). The central bank has spent $20 billion since April trying to stop the rupee’s free fall.

In 2013, the government also tried a combination of retail price subsidies for petrol, diesel, kerosene, compressed natural gas or CNG and fertilisers, while gradually raising prices. Gross domestic product growth nosedived that year and the current account deficit rose to 4% of gross domestic product. This time could also see a similar situation.

Domestic growth is likely to be affected soon, if prices stay high. Household consumption is already falling, going by the fact that the Society of Indian Automobile Manufacturers has cut estimates for 2018-2019, meaning people will buy fewer vehicles. Higher import tariffs (a very bad idea) have already made white goods and mobile phones more expensive. The only reason inflation has not gone through the roof yet is because food inflation has stayed low. But that is a subject for another day.