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The West Asian Crisis and Oil Price Expectations

Shebonti Ray Dadwal is Consultant at the Institute for Defence Studies and Analyses, New Delhi. Click here for detailed profile
Dr. G. Balachandran was a Consulting Fellow at the Institute for Defence Studies and Analyses, New Delhi. Click here for detailed profile
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  • July 04, 2019

    Once again, the West Asia – or the Middle East – is on the boil as Washington and Tehran ratchet up the aggression. If President Donald Trump is to be believed, the American forces came close to attacking Iran after Tehran brought down an American drone; but backed off at the last minute, ostensibly to prevent killing 150 Iranians! A couple of vessels have also come under attack in the Gulf of Oman by unnamed attackers. The United States (US) and its Arab allies have pointed the finger at Iran. Meanwhile, on July 01, 2019, Iran’s semi-official Fars News Agency, quoting Foreign Minister Javad Zarif, reportedly confirmed that Iran’s enriched uranium stockpile has passed the 300-kilogram limit set under the July 2015 nuclear deal1 – formally, the Joint Comprehensive Plan of Action (JCPOA). On July 03, President Hassan Rouhani even declared that Iran will begin, as early as July 07, enriching uranium “in any amount that we want” and would exceed the levels specified under the 2015 nuclear deal.2

    After the recent JCPOA Joint Commission meeting held on June 28, while the European Union (EU) confirmed that the planned barter trading mechanism -the Instrument in Support of Trade Exchanges (INSTEX) – was now “operational”, the Iranian Deputy Foreign Minister Abbas Araqchi observed that this may not be sufficient to change Iran’s decision to breach its JCPOA commitments, and that it would not abide by the deal until Iran was allowed to sell some of its oil.3 Therefore, the uncertainty around re-imposition of the earlier United Nations (UN) sanctions on Iran still remains and will only add to the volatility of oil prices in the near future.

    Iran has also periodically been threatening to disrupt shipping through the vital Strait of Hormuz through which a majority of the region’s oil transits for (mainly) Asian consumers. Several nations, including India, have responded by sending naval escorts to protect their vessels traversing through these waters. As concerns over a potential (though unlikely) conflict in the region grow, the pressing issue of what a conflict would mean for the price of international crude oil also needs to be addressed urgently. In the aftermath of the recent US-Iran stand-off, both spot and future prices of crude oil witnessed a five per cent hike. Although there is no supply shortage as such, the price at which it is bought will impact on consumers.

    As the third largest consumer of oil, with its current import dependency at more than 83 per cent, India’s economy is bound to feel the pinch of higher oil prices. With domestic production continuing to stagnate and the transport sector expected to register a compound annual growth rate (CAGR) of 9.5 per cent during the 2019-2024 period4, India’s thirst for oil is unlikely to abate in the near future. In fact, India is seen as potentially the largest market for oil over the next decade. This has a huge impact not only on India’s overall import bill, of which oil – and gas – imports make up the bulk, but also on the economy as a whole. With every US$ 10 per barrel hike in crude oil prices, India’s current account deficit (CAD) goes up by 0.4 per cent of GDP; every 10 per cent increase in prices can push up the inflation rate by 20 basis points.5 According to Petroleum Planning and Analysis Cell (PPAC) of the Ministry of Petroleum and Natural Gas, India spent $111.9 billion on oil imports in 2018-19, up from $87.8 billion in the previous fiscal year.6

    Organisations like the International Energy Agency (IEA) have been cutting their estimates for oil demand growth through 2019, citing the impact of trade issues between the US and China on the global economy, as well as growing concerns over the impact of hydrocarbons, particularly oil and coal, on climate change, which it says have led to a fall in the demand for oil.

    In fact, till the recent attacks on the ships, prices were seen as being bearish. Several reasons have been cited for this phenomenon, the most prominent being the surge in the US shale oil production by 1.6 million barrels a day (mbd), compared to a year earlier, as well as an increase in the US inventories. Also, due to the ongoing US-China ‘trade war’, concerns regarding a slowing global economy have impacted on growth and therefore on the demand for oil, preventing a rise in prices. As per the latest estimates of the Organisation of the Petroleum Exporting Countries (OPEC), the world oil demand will rise by 1.14 mbd in 2019, which is 70,000 barrels per day less than previously expected.7

    While all this may be good news for the new Indian Government which took office in May 2019, the question is how can this bearish trend in prices be sustained?

    First, while most global oil majors and analysts agree that by the late 2020s demand for liquid transport fuels will stop growing, the demand for oil for petrochemicals, particularly olefins and aromatics, will continue.

    Second, with global upstream capital expenditure having fallen by almost 45 per cent between 2014 and 2016, due to the price collapse, it will have an impact on the new production. According to the IEA World Energy Outlook-2017, an additional 2.5 mbd of new production will be required for conventional oil production to remain flat, given that it takes about three to six years from project sanctioning to coming onstream.

    Third, despite data from the US Energy Information Administration’s (EIA) June 2019 drilling productivity report suggesting that the oil output from major shale formations is rising, it has also lowered its total oil production growth forecast. This is based on the rig count, an early indicator of future output, which has been declining over the past six months, due mainly to independent exploration and production (E&P) companies cutting their spending. Also, although advanced technology has arrested declines, the lateral lengths of the wells have increased substantially, as have the volume of water used in drilling.8

    Fourth, Russia and the OPEC have agreed to roll over the production cuts for another few months, possibly till the end of the year, which saw prices go up slightly. As the US shale output starts declining, further cutbacks from the group will see excess supply disappearing. Without timely supplies entering into the market, prices will start ascending eventually.

    Under these circumstances, what can India do to reduce the impact on its economy? Apart from strategic oil reserves, which can be accessed in the event of a supply disruption, there are financial instruments that can hedge price increases. These include hedging and options contracts that allow oil companies to lock in the price of the oil they contract to import in the future, which can soften the risk of sudden spikes in oil prices.

    While private oil companies, including Indian, as well as several small countries systematically hedge against price increases, the Indian state-owned companies – a far larger importer of crude oil - continue to hesitate in employing such mechanisms, despite the Reserve Bank of India (RBI) recommendations that they should go for hedging, particularly for long futures contracts, fearing a backlash if prices drop.

    However, if prices do drop, a mechanism can be adopted whereby the loss is spread over time, similar to the mechanism that is in place for spreading the impact of higher oil prices over time. What is important is that the market should put existing mechanisms that could hedge against price spikes, which India is likely to see soon. Given that India will remain dependent on the international market for the foreseeable future, it is time that strategies and mechanisms are employed to minimise such risks.

    Views expressed are of the author and do not necessarily reflect the views of the IDSA or of the Government of India.

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