Why the crude oil price frenzy might not continue
The effectiveness of crude oil as an indicator of economic growth was again demonstrated during the pandemic. Last March, when the scale of the pandemic was first revealed, Brent oil futures plunged to $ 22. But with the significant rollout of stimulus measures and the gradual resumption of growth, prices also rose to $ 55.
The price of crude oil has been on the boil in recent weeks, however, with Brent futures hitting a high of $ 75 on July 6, posting a 36% gain year-to-date. Indian consumers have also been in the heat with the retail price of gasoline hitting 100 on all subways this month.
Speculators and investors seem to have contributed to this frenzy. This is evident in the extremely optimistic projections of the brokerage houses.
Goldman Sachs expects Brent prices to average above $ 80 in the third quarter of this calendar year with peaks above that price; JP Morgan expects crude to exceed $ 80 in the last quarter of 2021, and Bank of America expects Brent prices to hit $ 100 by next summer.
With the huge impact of rising oil prices on the economy and consumer budgets, the moot question is whether the recovery in crude oil will hold up and what the price range is likely to be over the medium term? The answer lies in the supply-demand equation for crude oil.
Global demand for oil has increased from 99.7 million barrels per day (mb / d) in 2019 to 91 mb / d in 2020 as the Covid-19 pandemic has taken a heavy toll. Travel and mobility were among the most affected by the closures, limiting oil consumption. With the fall in crude oil prices, supplies were reduced in the second quarter by both OPEC and non-OPEC producers.
The sharp rise in oil prices in 2021 is due to two main factors. First, the virus appears to have been contained quite effectively since the start of this year, especially in OECD countries which account for around 47% of demand. The rapid pace of vaccination has helped revive economic activity in these countries, suggesting good demand for petroleum products. The IEA, in its June report, expects global oil demand to return to pre-pandemic levels by the end of 2022, increasing by 5.4 mb / d in 2021 and by 3 , 1 mb / d more in 2022.
Second, while demand is expected to pick up, supply is causing concern due to the current standoff between the UAE and OPEC countries. According to the IEA, the oil production of non-OPEC countries is expected to increase by 710 mb / d in 2021. Given the projected demand of 96.4 mb / d in 2021, there could be a gap of production this year, unless the OPEC countries come to an agreement on increasing production.
The quarrel within OPEC
In 2020, OPEC plus countries agreed to reduce their production by 10 mb / d from May 2020 to the end of April 2022, in order to contain the fall in prices caused by the drop in demand. Now, with the revival of global demand, Saudi Arabia has proposed that OPEC increase production by 2 mb / d between August 2021 and December 2021, but extend the rest of the cuts until the end of 2022. But the United Arab Emirates want production cuts to continue until the end. 2022 only if the baseline for production is revised. The productions of OPEC members are linked to the benchmark and this was to be revised at the end of the current production reduction agreement, which was in April 2022. Extend the cuts until the end of next year would prevent the UAE from pumping more oil. , thus leading to an under-utilization of its production capacity.
The good news is that the UAE has said it is ready to pump as much oil as needed to meet global demand, if the condition is met. OPEC Plus members have a reserve capacity of 6.9 mb / d, even after the increase in production, so far this year. Increasing the oil supply is therefore only a deal. Saudi Arabia fears flooding the market with oversupply, pushing prices down. Once common ground is found, the production of OPEC Plus is likely to increase.
The other wild card in the equation is Iran. While the new leader has created uncertainty over the timing of the lifting of sanctions, an additional 1.4 mb / d could enter the market from Iran once the sanctions are lifted. Among non-OPEC countries, the United States is expected to add 900 mb / d by 2022, with Canada, Brazil and Norway also contributing to the increase next year.
While the supply situation is not unrecoverable, demand projections may require a downward revision if the third wave or new variants of the virus further disrupt the global recovery. In addition, the recovery is limited to advanced economies, as most developing and underdeveloped countries have yet to make material progress in immunization. Global travel cannot resume under these conditions.
Given the uncertainty in demand caused by the ongoing pandemic and the ability of producers to increase production, there is unlikely to be a galloping rally towards $ 100 again. That said, oil-producing countries will be careful enough to keep production in balance so that prices do not collapse either.
This should keep prices in the $ 50 to $ 80 range over the medium term. The other comfort is that there is no major geopolitical crisis brewing right now. If we look at the evolution of crude prices since the 1950s (see chart attached), the sharp price increases were mainly accompanied by geopolitical tensions or other factors leading to a shortage of supply. This time around, given that there is no shortage of supply, a sustained rally may be unlikely.
Impact on India
The Indian economy has been able to cope with crude oil prices hovering between $ 50 and $ 70 since 2014. It is only when prices significantly exceed $ 70 that some negative ramifications are observed. The biggest impact is on the trade deficit. India is a net importer of crude oil, which depends on imported oil to meet more than 77 percent of domestic demand. The share of petroleum products in Indian imports exceeds 25 percent in normal times.
As a result, soaring crude oil prices tend to inflate the import bill, widening the trade deficit. This tends to have an impact on the movement of the rupee. As the attached chart shows, the rupee has depreciated against the dollar during a period of soaring oil prices. The same trend has manifested itself over the past year as rising oil prices weaken the rupee. With fuel and lighting weighing heavily in the CPI basket, soaring crude oil prices also tend to push up the CPI. This has been seen in recent months.
However, once the global supply of crude oil increases, the rupee and CPI could be relieved.