OiL FUTURES: You may feel heat of oil flares soon

Though crude oil has begun to hit new highs with unfailing regularity over the past two months, the rise has not begun to upset our monthly budget thanks largely to government subsidies. This state of bliss may not last for too long.

Considering the pace of price rise in crude oil, its impact is likely to be felt soon. Crude oil prices, which have already breached a level of $110 per barrel are up by nearly 10% since December end, compared to 15-25% fall in major stock indices during the period.

The rising oil prices are building up an underlying inflationary pressure. Though petroleum products' prices are administered in India and there is an incomplete pass-through of the burden to the final consumers. Nearly a fifth of the incremental change in inflation was accounted for by fuel price index for the week ended March 3.

The burden of in most visible in case of aviation turbine fuel (ATF), naphtha and bitumen, which are traded at market-determined prices. There price are up by 27-39% year-on-year for the week-ended March 3. This will impact air travel, power and polymers (plastic products and synthetic material) directly. We need to prepare to pay more for most manufactured products in the future.

A strong demand growth and high profit margins have given India Inc the leeway to absorb a part of input cost hikes in the past. But, as corporate earnings have slowed and economic growth is likely to soften, companies are running out of headroom to absorb further increases in crude oil prices. Most manufacturers are expected to take a price hike and some have done so in last few month. More increases in crude prices or a hike in domestic fuel prices will build up more pressure.

Retail prices of petrol and diesel are unlikely to go up, considering the forthcoming general elections and higher food prices. The government may compensate oil-marketing companies by issuing more oil bonds and this will increase future subsidy burden. This will create more liabilities for the future government and raise fiscal deficit few years down the road. Oil bonds will only delay the pain and will come back to haunt tax-payers in future.

Another fallout of rising oil prices is the depreciation in rupee against dollar. A stronger rupee helps cool domestic inflation by lowering the price of imports, which include crude oil food and many industrial raw material.

However, a weaker rupee adds fuel to the inflationary pressure in the domestic economy. Rupee has depreciated by 2.4% during the month ending March 18. The net import bill (underlying assumption is that domestic consumption will grow at a three-year CAGR of 3.75%) is likely to touch a level of Rs 2,47,580 crore by March 2009 (almost $62 billion at current exchange rate), recording a growth around 19%. Such heavy import bill will account almost 5.5% of GDP further weakening rupee.

In short, rising oil prices weigh heavily on Indian economy. The demand growth is showing signs of moderation especially in interest rate sensitive sectors such as construction, consumer durables and automobiles sector. In order to stimulate the growth, interest rate cut is expected. However, rising oil prices have put RBI in a dilemma.

So far, RBI has fought inflation by cooling off investment lead economic growth and is likely to continue with this policy. But what if GDP growth slips below 7%. It will amount to a severe slowdown in economy coupled with oil induced inflation and may began to hurt all and sundry.

Source: India Economic Times

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