From UPSC perspective, the following things are important :
Prelims level : Pricing mechanism of fuels in India.
Mains level : Paper 3- Implications of oil-price war for India.
A “pass-through effect” of low crude prices is improbable given the constrained fiscal space.
The backdrop to the oil price war
- Against the backdrop of the covid-19 pandemic and the economic slowdown, Saudi Arabia-led oil cartel OPEC (Organization of the Petroleum Exporting Countries) wanted to curtail oil production by 1.5 million barrels per day.
- However, as Russia has not agreed to this proposal, Saudi Arabia has declared a price war by reducing the Brent crude oil price from $65 per barrel in end-December 2019 to $33 now.
- The race to the bottom to this extent by Brent is the first time ever since the 1991 Gulf crisis.
Would it impact India by providing a fiscal dividend?
- A $20 reduction in Brent oil prices can reduce India’s current account deficit.
- However, the instability in oil prices is a short-run phenomenon, and India cannot anticipate a prolonged fiscal dividend.
- Quite contrary to the expectations about a “pass-through effect” of low crude oil prices on consumers, the Government of India (GoI) raised the excise duty on petrol and diesel by `3 per litre.
- The special excise duty on petrol was hiked by 2 to 8 per litre in the case of petrol and to 4 in the case of diesel.
Fuel price determination in India
- There has been no “pass-through effect” primarily because the price determination of petrol and diesel in India is not linked to crude oil prices in the international market.
- Price determination is done through dynamic pricing, termed as “trade parity pricing,” based on the international prices of petrol and diesel (finished products) prevailing in the international markets, and not on crude oil per se.
- An obvious question here is whether the crude oil prices and the petrol-diesel prices move in tandem in the international market. Not always.
- Globally, the market mechanism of ad hoc configurations of demand and supply of crude oil is different from the demand-supply dynamics of petrol and diesel, and, in turn, their pricing behaviour will also be distinctly different.
- The goi fixes the price of petrol and diesel based on dynamic pricing and trade parity pricing by converting the price from dollars to Indian rupees.
Factors affecting fuel prices in India
- The rupee-dollar exchange rate mechanism also affects the pricing of petrol and diesel.
- This can offset the benefits India can reap from comparatively lower prices of crude oil in the international market, quoted in dollars.
- The other components of this pricing formula are: 1.The cost of inland freight marketing costs. 2. Taxes levied by the centre and the state governments. 3. The margins (charged by the oil companies) and (the dealer) commissions.
- It is, therefore, obvious that low international prices per se do not translate into lower prices for petrol and diesel in India as long as the centre and states levy exorbitant taxes on these products.
- The interstate variation in the prices of petrol and diesel is also significantly explained by the differentials in taxes imposed.
- Yet another factor to be borne in our minds is that the effect of international prices on the in-house pricing of petrol and diesel in India is not instantaneous or spontaneous.
- There is a time lag involved in the pricing process.
- Even though the goi uses the daily pricing mechanism in the dynamic pricing formula of petrol and diesel, the international prices component enters into the pricing equation as an international “benchmark price” of petrol and diesel.
- Today’s price in India reflects the average international prices of petrol and diesel of the previous fortnight.
- However, the fuel prices will not come down in a fortnight’s time.
- This is because, in the price equation, the international price component is just one among many components, whereas the tax component constitutes a dominant part in the equation.
The Covid-19 factor
- The covid-19 outbreak has started striking the financial markets and the real sector, and especially investment in the energy sector.
- So, the lowering of the oil price by Brent cannot help the global economy from recession.
- Overall, the oil price war can negatively affect the investment decisions in the energy sector and can be a drag on global growth.
- Due to the covid-19 outbreak, there could be reduced oil-drilling activities in the energy sector, and there will be some cutbacks in demand and, in turn, in the capex energy infrastructure.
- Analysts have revealed that every $10 fall in oil prices transfers around 0.3% of the global gross domestic product from oil-producing nations to oil-consuming nations.
- The interest rate strategists are also concerned as the Russian 10-year bond yields reached a record low of 2.56%, and Saudi Arabian government bonds maturing in April 2030 are currently at 2.38%.
Microeconomic policy to tackle oil price war?
- The US Federal Reserve has lowered the federal funds’ interest rate by 50 basis points (one-half of a percentage point) to 1.25%.
- The Bank of Canada also reduced the bank rate by 50 basis points to the US level. The stock market indexes fell to the levels of 2008.
- The 1.25% federal funds rate now is below the 2.5% US inflation rate. However, monetary policy has failed to trigger the economy.
- As mentioned by the European Central Bank, “targeting” rather than generalised public policy needs to be done.
- The Reserve Bank of India policy tools may be ineffective now to tackle the slowdown, especially against the backdrop of the worsening of the economy from the effects of covid-19. The re-dominance of fiscal policy by the North Block is what is keenly awaited, for an economic turnaround.