The price of crude has swung madly through October and November. The benchmark Brent contract hit $86 a barrel before declining to below $70. Similarly, West Texas Intermediate, the United States benchmark grade of crude, swung from a peak of $76 to a low of $58.
The proximate cause is American sanctions against Iran, which came into effect on November 5. Initial fears that Iran’s production would be removed at one shot have been allayed with the United States giving conditional waivers to eight countries, including India, Japan and China (all big oil importers), to continue Iranian oil imports for a limited time. These countries have to commit to cutting down on Iranian imports, however, within a short timeframe. Anyhow, fears of instant supply disruption receded and the market settled down.
There are guesstimates that energy demand may ease next year. Most fund managers are bearish about global growth prospects in 2019. The International Monetary Fund maintains global growth will stay at a reasonable 3.7%, the same as 2018, but it also says “downside risks to global growth have risen in the past six months and the potential for upside surprises has receded”.
That was another reason for crude prices dropping lower. In an attempt to rebalance the demand-supply equation, Saudi Arabia says it will cut production by 500,000 barrels a day. It is trying to get other members of the Organisation of the Petroleum Exporting Countries (and Russia, which is not a member) to also make production cuts. A key December 6 meeting with all the member countries in Vienna, (which is where the cartel is headquartered even though Austria is not a member of the organisation) might give us a sense of direction when it comes to next year’s oil production.
We could see a delicate balancing act by price-setters, or countries with high crude (and natural gas) production. If Brent prices stay above $60 a barrel or so (West Texas Intermediate is priced quite a bit lower), the United States will remain the biggest oil producer in the world. If prices fall below $55, (in which case West Texas Intermediate will probably fall below $45), US production will drop to third place, with Russia and Saudi Arabia overtaking it. If oil prices stay above $80, the United States will hit an unpleasant patch of inflation, since it is also the biggest oil consumer in the world.
Goldilocks price range
The United States has a lot of oil and it has fantastic engineering skills when it comes to extracting oil from unlikely places, such as shale rock deposits and “tight” pockets. But a lot of that oil is very expensive to extract. Some of it is in very inaccessible places too. Half of America’s current oil production costs more than $46 a barrel to extract. In contrast, Saudi Arabia, Russia, Iran, Iraq and Libya, among others, have much lower costs of production, below $20 a barrel in some places.
Much of the United States’ shale production is also based on short-term operations. It takes years to start production from a conventional crude deposit, by conventional means. Production from a shale operation can start within about four months and a shale operation can shut down equally quickly. So, many American shale oil producers gamble on getting into production whenever they see a profitable window of, say, six months to a year.
The United States oil lobby is firmly in the Republican camp because the Republicans are far more willing to overlook extensive environmental damage from drilling in fragile regions (remember the “Drill baby drill” slogan?), and the inherent damage caused by shale operations (shale extraction is hugely water-intensive and pollutes groundwater). The oil industry also employs a lot of people in the “red states” (the Republican colour) of Texas, North Dakota, Alaska, Oklahoma and Wyoming, which consistently vote Republican.
So, it would be to President Donald Trump’s advantage to keep the oil industry buzzing. However, if prices rise above a certain level, it would force inflation up, which would also be bad for his popularity ratings. Many key United States allies are also oil importers and would be unhappy about very high prices. So American policy should be geared to creating a “Goldilocks” price range that is not so low that it drives shale oil out of business and not so high that it causes inflation.
Can it manage this feat of price manipulation? It will require the cooperation of sundry oil producers, including Saudi Arabia and Russia. Note that there is a “Goldilocks range” for Saudi Arabia, Russia and other oil producers as well, but it may not be the same as that of the United States.
India’s oil imports
India, on the other hand, has a much simpler relationship with oil: the cheaper, the better. So long as the Iran sanctions last and India decides not to take on America by going against the sanctions, it will have to find alternate sources of supply. That will drive up the cost of the Indian crude basket for sure. But if the November trends are sustained, oil imports will not absolutely destroy the trade balance (the difference in the sum of a country’s exports and imports).
Softer oil prices have already helped the rupee regain a fair amount of lost ground. Fears of higher inflation driven by energy prices have receded to some extent. The government will heave a sigh of relief at the thought that it will not have to cut excise duties to soften retail prices.
However, in real terms, India will surely have a much larger oil import bill this year – though it may not be quite as large as feared. In 2017-2018, the Indian crude basket cost an average $56.4 a barrel and it is running at $74.6 this year (April-October). Every dollar increase in oil prices pushed up the import bill by about Rs 10,700 crore annually. So we can expect a larger trade deficit, a larger current account deficit and a larger fiscal deficit. Only, the numbers will not be as bad as the October estimates suggested.
Another upheaval will occur in the energy industry over the next year since global shipping will switch to more environmental-friendly, low-sulphur fuels by January 2020. That will drive up the demand for certain categories of crude and reduce the demand for others. A lot of refining capacity will need to be “rebooted” to cope with that switch. It is unclear how well-prepared India is for the changeover.
The crude equation could, therefore, get more complex, even though there has been some respite.