In the early stage of the Covid – 19 crisis and much before it had assumed monstrous dimensions, the international crude oil market was already oversupplied. Then, OPEC [Organization of Petroleum Exporting Countries] – a cartel of oil suppliers in the middle-east led by Saudi Arabia the lead exporter – and non-OPEC suppliers led by Russia sat together to hammer out an agreement to cut production with a view to bring about a semblance of demand-supply balance. But, the agreement eluded them as Russia refused to back even a moderate cut [it would have only served to help US shale-oil companies to run at full capacity – which it didn’t want].
In sync with the past happenings whenever OPEC didn’t agree to production cut, thereby creating a free for all scenario [1997, 2015] Saudi Arabia responded by pumping additional supplies aimed at capturing the shrinking market. In a tit-for-tat, Russia also increased supplies thereby aggravating the imbalance to result in plummeting price to less than US$ 30 per barrel – reduction of 50% over the level prevailing in the beginning of 2020.
Meanwhile, during the month till early April 2020, there was exponential growth in Corona cases forcing governments world-wide to impose lock-down involving stoppage of all flights [domestic and international] and most of other economic activities. This in turn, has led to destruction of oil demand. According to Research firm Rystad Energy, during the April month, there is excess supply of 27.4 million barrels per day.
This unprecedented situation forced all key suppliers [including those who had turned adversaries] to go into brainstorming session yet again. On April 10, 2020, the OPEC and non-OPEC countries including Russia agreed to an orchestrated production cut plan spanning 25 months till April, 2021.
The plan is to take off supplies by 10 million barrels per day until July, 2020, 8 million barrels per day through the end of the year to December 2020 and 6 million barrels a day for 16 months beginning January 2021 to April 2022.
With some more countries expected to join viz. Norway, Canada, Indonesia and others that hadn’t been part of the so-called OPEC plus talks on production cut plan, likely withdrawal from the market could reach 15 million barrels a day. This would still be nearly 50% of the demand destruction caused by Covid – 19.
The global storage is already close to being filled to the brim [on an average, about 80% of the capacity is already full] with around 7.4 billion barrels of crude and products in storage, including 1.3 billion currently on board tankers at sea [according to S&P Global Platts] with a high probability of all available storage likely to get exhausted by May, 2020. The situation has reached such a pass that in USA, pumps are willing to offer money to anyone who lifts fuel.
It is therefore, not surprising that an unprecedented cut in production has failed to make an impact on the price which has since increased marginally by about 2%. While, it is bound to remain low with possibility of touching a low of US$ 20 per barrel if crisis continues, even after it ends, the supply-demand mismatch will remain. This is because while, the demand may see some revival, production too is likely to increase. The Saudi – Russia rivalry too may come in to play which will aggravate the mis-match.
During the next couple of years, therefore, the price of crude will not only continue to remain ‘low’ but also ‘stable’. This will be good for India which depends on imports for close to 85% of its oil requirements. India can use this opportunity to address some of the ‘structural weaknesses’ especially in sectors such as fertilizers, power, fuel, food etc which have been persisting for long. The genesis of weakness in all these areas has to do with two overarching hard facts which work at cross-purpose with each other.
First, all 4 items are used preponderantly by the poor viz. fertilizers by majority of the poor small and marginal farmers [those with land holding between 1-2 hectare and < 1 hectare respectively]; power by farmers for running agricultural pump-sets and poor households for domestic consumption; fuel primarily LPG for cooking and food for consumption by poor households. This underscores the need for making the items available at price they can afford. What is an affordable price?
The governments have perceived the lowest possible price as being synonymous with an affordable price. Thus, the maximum retail price [MRP] of urea – the most widely used fertilizer being the source of nitrogen – is currently Rs 5360 per ton. It is at the same level as it was 20 years ago. The price of wheat and rice on supplies under National Food Security Act [NFSA] is Rs 2 per kg and Rs 3 per kg and has not changed since the Act came in force 2013. The electricity supply to farmers is charged at 50 paise per unit and even free. Look at the second fact.
The process producing these items is energy or fuel intensive. About 90% urea production in India is based on natural gas [remaining 10% is on naphtha – a comparatively less efficient fuel than gas]. Nearly 2/3rd of gas supply to urea plants is indigenous whereas the balance 1/3rd is from import as liquefied natural gas [LNG]. The price of domestic gas is bench-marked to its price at 4 international locations [as per October 2014 guidelines]. The global price of gas in turn, is linked to the price of crude.
The price of LPG besides petrol and diesel [though, technically these two are deregulated, de facto their price continues to be controlled as about 90% of sale is by public sector undertakings (PSUs) which are majority owned and controlled by the government and hence calls the shots] is linked to their respective international price. In turn, these prices follow the movement in the price of crude oil.
Nearly 25,000 megawatts [MW] of power generation capacity in India [or 7% of total installed capacity] is based on gas most of it is imported as LNG. The pricing of LNG is based on a complex formula [it varies depending on the specific contract for purchase] but fundamentally, it involves linkage with crude.
The production and supply of food up to the last mile too is a highly energy intensive operation starting from crop cultivation involving use of agricultural inputs such as fertilizers, seed, power, irrigation etc to handling and transportation which is also fuel intensive [diesel traction accounts for 36% of rail freight] even as all of the movement by road involves consumption of diesel.
All this makes for cost of supply to be higher that selling price with the former moving in tandem with increase in price of crude oil. The difference is reimbursed as subsidy to their manufacturers. With increasing gap between the cost and price, the subsidy has been ballooning leading to higher fiscal deficit. This also makes the political brass scary of implementing reforms viz. price de-regulation and direct benefit transfer [DBT] of subsidy to the beneficiaries as then, the price will suddenly shoot up.
The big drop in the price of crude has changed the scenario. It has led to corresponding reduction in price of fuels viz. natural gas, naphtha, diesel, LPG etc. and in turn, cost of supplying fertilizers, electricity, food etc. For instance, the price of imported gas has dropped by about US$9 per million British thermal units [mBtu] while price of domestic gas by US$3 per mBtu. The effective drop works out to US$5 per mBtu [9×0.33+3×0.67] which will reduce production cost of urea by about Rs 9000/- per ton [5×24 (mBtu required to produce a ton)x75 (current exchange rate)].
The cost of running irrigation pumps and transportation will also go down significantly if only the government does not mop up the benefit of reduction in international price by increasing central excise duty [CED] or cess as it did during 2015 [then also crude plummeted to as low as US$ 26 per barrel].
Considering that the lower crude price scenario is expected to continue for couple of years, the government can use this buffer for deregulating these sectors. With this, even under deregulated/market-based environment, the price of these items won’t spike even as the poor are given relief through DBT. Besides, the sectors will reap the full benefits of competition in terms of across the board improvement in efficiency and reduced cost which will eventually be passed on to the consumers by way lowering of price.
Will Modi crack the whip say, after the crisis ends?