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A Grim Fairy Tale?

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For the third time in the past few months, estimates of global oil demand have been revised upwards. Added to the impact of a severe winter, crude oil prices are now being projected at $100 a barrel (it is already too high at $90). Oil producing countries — represented by the OPEC cartel — are comfortable at these prices; OPEC ministers have said that they are not thinking about upping production because there are adequate inventories.

Which is not very surprising. Even during past episodes of demand increases, oil producers from the Persian Gulf, which together account for 40 per cent of global supply, haven't upped production to expected levels. In the oil price run-up during 2004-08, the increase in production from the Persian Gulf was a mere 1 million barrels a day.

Some analysts believe that keeping production low contributed to the price increases in no small measure. Looking back 35 years, today's production from the Persian Gulf (at roughly 22 million barrels a day) is the same as it was in 1974. What has happened since the 1980s is that most of the countries from this region have been increasing the estimates of their oil reserves. Oddly, though, not many seem to be worried that oil may touch $100 soon: many see it as a brief spike stemming from winter conditions in Europe and the US, and liquidity from QE2 (the second round of quantitative easing by the US Federal Reserve).

Global growth is going to be slower, reducing demand. More significant, China is expected to slow down, which could lead to lower oil prices. But others believe that the price increase is more structural, and that oil at $100 a barrel — or at least $90 — is here to stay.

But this much is clear: oil at such high prices is not good for the Indian economy. At the macroeconomic level, a higher oil import bill would widen the current account deficit further. This week, the government postponed action on diesel price deregulation. Chances are that reform of pricing policy for liquefied natural gas and kerosene will be subject to a similar fate. The consequences for the country's fiscal health are detrimental.

At the microeconomic level, input costs for most manufacturing industries would have an adverse impact on bottom lines. Prices of naphtha and bitumen — by products in petroleum refining — will also go up, as will fertiliser prices, perhaps electricity prices as well. The prices of other commodities like metals also rise when oil rises. Manufacturing inflation, which was originally expected to moderate, may instead stay stubborn. Food price inflation, already a big worry, could get higher. Two states — West Bengal and Tamil Nadu — go to the polls soon, and incumbent governments will feel the angst of consumers. 

From a policy standpoint, the worries for the Reserve Bank of India will intensify before its January-end policy review. Already, most analysts and observers anticipate a policy rate hike of a quarter of a percentage point. Now, they worry about the risks of a bigger hike necessitated by inflation.

Tighter monetary conditions could be ameliorated by higher capital inflows, but a strengthening dollar — stemming from an increase in oil prices — could dent those expectations. Taken together, all these effects could result in one thing no one wants: India's economic growth, which most project at nearly 9 per cent in 2011-12, could end up at slightly less than 8 per cent. High oil prices could throw sand into the wheels of India's growth story.

(This story was published in Businessworld Issue Dated 10-01-2011)

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