If Oil Boils Again

The turmoil in Iraq has the potential to upset all plans that are being drawn up by the Narendra Modi government to revive the Indian economy. Global prices of crude oil have already risen and could go up further. If that happens, the Indian economy will be impacted badly simply because the country currently imports around 80 per cent of its total requirements of oil. With domestic prices of petroleum products creeping up and with a deficient monsoon, the government will not be able to contain strong inflationary pressures.

The civil war in Iraq many not end quickly. International oil prices had already touched US$ 115 a barrel in the third week of June, the highest in nine months, before declining. At the time of writing in early-July, the pessimistic picture was that prices could go up by another $10-15 a barrel. If the conflict between the Sunni Arab-led Islamic State of Iraq and al-Shams (ISIS) and the beleaguered government in Baghdad led by Nouri al-Maliki does not conclude expeditiously -- despite the intervention of America, Russia and Iran -- the chances of Iraq imploding into three parts cannot be ruled out in a worst-case scenario.

When the unrest in Syria escalated two years ago, oil prices went up only marginally before stabilizing. This was because Syria is not a player in the oil market. The situation is now completely different with ISIS, now simply called the Islamic State, seeking to carve out a chunk of the geographical territory of Syria with sections of the northern and western parts of Iraq as an independent nation-state. Sunni militants have already declared the formation of an Islamic Caliphate which could have a strong emotional appeal across different parts of the Arab world. The unstable political situation in West Asia does not forebode well for India.

In the recent past, international oil prices have been extremely volatile. During 2008, crude oil prices jumped from $ 40 a barrel to $ 147 a barrel before collapsing again to $ 40 a barrel. Through 2009 and 2010, prices rose steadily to around $ 90 a barrel before spiking to a 30-month high of $ 120 a barrel in February 2011, after the so-called Arab Spring began with the ouster of the Zine El Abidine Ben Ali regime in Tunisia and the Hosni Mubarak government in Egypt. Thereafter, Muammar Gaddafi was ousted as head of the government of Libya -- the country's oil terminals remain crippled by rebels. Over the last few years, the short-term demand-supply imbalances were sought to be bridged and oil prices stabilised by Saudi Arabia, a Sunni-dominated monarchy which has been America's closest ally in the Arab world for decades.

Coming to India, oil imports account for approximately a third of total imports and around a third of the country's imported crude oil comes from countries located in and around the Persian Gulf region in West Asia. Whereas the government deregulated petrol prices in 2010, prices of diesel prices (as well as kerosene and liquefied petroleum gas) continued to be officially administered. India has been particularly fortunate that crude oil prices have been benign over the last few years. This enabled the government to not just decontrol prices of petrol but also allow the prices of diesel to go up gradually over recent months.

In mid-June, it appeared that if diesel prices went up by a rupee or two per litre over the next few months, domestic prices of this fuel -- the most-widely used among all petroleum products -- would become more or less on par with international prices. However, with crude prices going up, the government's plans of cutting the subsidy on diesel may not materialise soon. Diesel prices have gone up 17 times between January 2013 and June 2014 in small doses.

At the end of June, the total annual subsidy outgo on diesel and cooking gas -- euphemistically called "under recoveries" by oil companies to signify the difference between what is claimed to be the cost of production and the selling price -- was in excess of R1,00,000 crore. The "loss" per litre of kerosene sold was R33 while the corresponding figure for a cylinder of LPG was approximately R450. The government may choose not to increase kerosene or LPG prices very much as this would be a particularly unpopular move. However, diesel prices are expected to creep up and, perhaps, even decontrolled.

What would be the implications of decontrolling diesel prices? Diesel is the largest selling petroleum product in India in terms of tonnage as well as value, accounting for roughly 40 per cent of the total value and around 60 per cent of the total volume of all petroleum products sold. Importantly, diesel is the main fuel used for transportation. Higher diesel prices have a cascading impact on the prices of a very wide range of articles of mass consumption, especially food items.

Petrol, unlike diesel, is consumed primarily by the rich for personalized transport. But the same is not true for LPG which is used by the middle classes and kerosene which is supposed to be used by the poor for cooking and lighting but which is illegally diverted in large quantities (to adulterate petrol and diesel) and smuggled out of India. Targetting of subsidies is easier said than done. All sorts of measures have been unsuccessfully tried to curb diversion of kerosene - from colouring it blue to putting chemical markers in the liquid. But the incentive to adulterate continues because of the yawning gap between kerosene prices and those of diesel and petrol.

What the government does not publicize is that total taxes on petrol are more than half its selling price and over 30 per cent of the price paid by a consumer of diesel is in the form of taxes. Roughly 37 per cent of the selling price of petrol comprises excise and customs duties, which accrue to the Union government. Excise duties on petroleum products contribute over 40 per cent of the Indian government's total excise collections. Importantly, customs and excise duties on crude oil and petroleum products are ad valorem or a percentage of value, which implies that tax revenues go up as prices rise, which is good for the government but bad for the consumer.

As for controlling inflation, forget it.

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