Oil Prices and Fiscal Deficit: Intent Is Not Enough

Oil industry is once again seized by volatility in the market. International crude oil prices are currently hovering in the range of $75-80 per barrel. After hitting an all-time high of $147 per barrel in July 2008, it hit a low of $47.48 and a high of $81.98 per barrel in 2009, and is now facing resistance at the range of $75-80 per barrel.

Looking at the positive signals emanating from the US and the rest of the world about the overall revival of the economy, it is expected that the demand for oil in 2010 may increase by about 1.5 million barrels per day, which is a 1.7% rise over the total consumption of the world in 2009. The forecast of OPEC, of course, stands at a rise of 1% over 2009 consumption.

Obviously, this is likely to push crude oil prices in 2010 upward: in the first half of 2010, oil prices may touch $85 per barrel, and by second half it is feared that it may reach $90 per barrel. As the dollar weakens—which is currently in a secular bear market, but from a long-term forecast, all set to weaken—the dollar-denominated crude prices are likely to rally. And if the price crosses $90 per barrel mark, it will be a matter of concern for all concerned in India.

It is reported that currently the three public sector oil companies are selling petrol at a loss of Rs 3.06 per liter, diesel at Rs 1.56 per liter, kerosene at Rs 17.23 per liter and LPG at a discount of Rs 299.01 per cylinder. And, cumulatively, these three companies are estimated to lose Rs 44,300 cr during the current fiscal, for their rates are pegged to a crude price of Rs 66 per barrel.

Now, what is most disturbing under this whole episode is the government’s subsidy bill: at the current level of prices, the government is incurring a subsidy bill of Rs 20,000 cr per annum under kerosene alone, while it is Rs 10,000 cr per annum under subsidy for LPG. And who are the beneficiaries: under petrol, it is the rich and filthily rich; under LPG, it is mostly the non-poor; under diesel, it is the transport sector, which is known to transfer every price rise in its supply-side to the consumers with least time-lag, and under kerosene, it is said to be mostly the adulterators, for most of the kerosene under subsidy is reported to be diverted for fuel-adulteration.

Yet, reports indicate that the government has deferred a decision on freeing petrol prices. It has also not allowed the three public sector oil retailers to raise petrol, diesel, domestic LPG, and kerosene prices. This is an untenable proposition on more than one count.

First, at 10.3% of GDP, the combined fiscal deficit of the Center and States of India sounds alarming. Intriguingly, the Planning Commission Deputy Chairman recently observed that our fiscal deficit does not look egregious when compared to the US, and the UK. True, but unlike American deficit, which the whole world is eager to fund even under the ongoing global financial crisis, India’s deficit has to be totally financed domestically. Which means, crowding out credit for private investment, and this phenomenon will be felt more acutely, once demand for credit picks up as the global economy revives.

Secondly, but importantly, our deficit is mostly consumption-oriented—subsidies under food distribution, fertilizers, petroleum products, including financing revenue deficit, whereas their deficit is now mostly meant for stimulating ‘growth’ in the economy. It can, of course, be justified, if deficit is used to make investments in productive assets that can in turn generate resources to service the debt. Otherwise, such fiscal deficits tend to hit the poor—28% of our population reels under abject poverty—hard, should there arise any change in macroeconomic fundamentals.

Hence, there is a need to rein in fiscal profligacy at the earliest, and elimination of subsidies for the consumption of petroleum products must be the first step in this direction. With the general elections being four-and-a-half years away, it is the right time for the government to deregulate retail prices. Such a move is sure to build competition in the retail market that ensures prices make economic sense.

That aside, having voluntarily announced to cut green gas emissions by 20%, does it make sense to subsidize consumption of the same petroleum-products that are known to result in more emissions? Instead, would it not make better sense to free retail prices and make consumers pay economic prices for their consumption?

Here, it is also necessary to bear in mind that the proposed reduction in emissions would compromise our economic growth, for we are already suffering from energy shortage, and the current state of technology being what it is, it would be prohibitively costly to immediately tap energy from alternative sources. This in itself demands that we use scarce capital resources for productive purposes. The answer is therefore to phase out subsidies and rein in fiscal deficit within the acceptable level and quality. Simultaneously, we need to invest in the development of appropriate technologies that could make solar lamps available at affordable prices to those who are likely to be hit by the withdrawal of kerosene subsidy and also encourage investment in domestic distribution of gas through pipes for better energy utilization/management.

- GRK Murty