Is Modi’s luck on oil running out?

In mid April earlier this year, the finance minister Arun Jaitley spoke at the Peterson Institute, a Washington based think tank.
In his speech, Jaitley said that in late 2013, India was “teetering” and was “on the edge of a macro-economic crisis”. “Inflation was at double-digits, the current account deficit at 4 percent of GDP, growth was decelerating sharply, investor confidence was evaporating, capital was fleeing the country, the rupee was plunging; fiscal deficits were high; and India was reeking with the odour of corruption scandals and weak governance,” Jaitley went on to add.
After the Narendra Modi government came to power, most of these economic problems have been corrected, Jaitley said during the course of his speech. Jaitley further said that: “A budget…which reinivigorates growth by emphasizing public investment while maintaining fiscal discipline and protecting the vulnerable,” was passed.
What Jaitley, like a good politician, missed out on saying was that a lot of economic factors improved simply because the oil prices crashed. On May 26, 2014, when the Narendra Modi government took oath of office, the price of the Indian basket of crude oil was at $108.05 per barrel. It fell by around 60% to $43.36 per barrel by January 14, 2015.
This rapid fall in the price of oil helped set many economic factors right. India imports close to 80% of its oil requirements. As the oil price fell, oil imports came down in dollar terms bringing down the current account deficit. In technical terms, the current account deficit is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances. Or to put it in simpler terms, it is the difference between outflow (through imports) and inflow (through imports and foreign remittances) of foreign exchange.
Further, oil is bought and sold in dollars. When Indian companies buy oil, they need to pay in dollars. This pushes up the demand for dollars and leads to the value of the rupee falling against the dollar. When oil prices rise, Indian companies need more dollars to buy oil. And this in turn puts a greater amount of pressure on the value of the rupee against the dollar. With oil prices falling dramatically, the total amount of dollars needed to buy oil also fell. This, to some extent, stabilized the value of the rupee against the dollar.
Falling oil prices even had an impact on the fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. When the oil prices were rising the Congress led UPA government did not allow the oil marketing companies (Indian Oil, Bharat Petroleum and Hindustan Petroleum) which sell oil products, to sell them at a price at which it was financially viable for them to do so.
In the process they incurred under-recoveries. The government along with oil production companies like ONGC and Oil India Ltd, compensated the oil marketing companies for these under-recoveries. This led to the government expenditure going up and in the process the fiscal deficit also went up. A higher fiscal deficit leads to the government borrowing more, in the process pushing up interest rates, as the amount of money that others can borrow comes down.
Falling oil prices also had some impact on taming rampant double digit inflation.
In his Washington speech Jaitley took credit for all of the above economic factors improving because of the change in government. Nevertheless, falling oil prices had a huge role to play in the improvement on the economic front, Jaitley’s speech notwithstanding.
Oil prices have been rising in the recent past. On March 31, 2015, the last day of the financial year 2014-2015, the price of the Indian basket for crude oil was at $53.64 per barrel. On May 8, 2015 (the most recent data point available), the price of the Indian basket of crude oil was at $64.05 per barrel. Hence, the oil price has risen by close to 50% from mid January 2015 onwards.
What does not help is the fact that one dollar is now worth close to Rs 64. This means that the Indian companies buying oil will have to pay more. As long as they are able to pass this on to the end consumers of oil products like diesel and petrol, it does not really matter. But what if they are not?
In October 2014, the government had deregulated the price of diesel, allowing the oil companies to set the price of diesel depending on the prevailing international price of oil. Interestingly, the government used the fall in oil prices as an opportunity to shore up its revenues from oil by increasing the excise duty on petrol and diesel multiple times.
At close to $64 per barrel, the price of oil is still around 41% lower than where it was on May 26, 2014, when the Modi government took oath of office. Nevertheless, the price of petrol in Mumbai is at Rs 70.84 per litre, only 11.5% lower from the time when the Modi government came to power. The price of diesel is 12.8% lower.
The real test of deregulation will come if the price of oil keeps going up and the price of petrol and diesel cross the levels they were at when Narendra Modi came to power. In fact, the oil minister
Dharmendra Pradhan recently said: “The subsidy-sharing formula…can be extended…if the current market situation prevails.” He was referring to the compensation paid by the oil production companies like ONGC and OIL to the oil marketing companies. The compensation has come down because of the fall in the price of oil. The oil production companies still continue to compensate the oil marketing companies for the under-recoveries suffered on selling cooking gas etc.
But what Pradhan did not say is what happens if the current market situation does not prevail and the oil prices continue to go up? Will the compensation provided by the oil production companies go up? This would mean that the government would force the oil marketing companies to sell oil products like diesel and petrol at an unviable price.
It would also mean that the government would have to share the compensation provided to the oil marketing companies for their under-recoveries, with the oil production companies. It would lead to a higher fiscal deficit. Rising oil prices will also put pressure on the current account deficit as well as the value of the rupee against the dollar. Inflation will also go up to some extent depending on how much increase in the price of oil is allowed to be passed on to the end consumer. A higher inflation will mean that the Reserve Bank of India will not cut interest rates.
To conclude, the Modi government was very lucky with the price of oil falling by 60% between May 2014 and January 2015. That luck might now have started to run out, as it completes its first year in office.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on DailyO on May 11, 2015

Fiscal deficit is not for our grandchildren to repay: Here’s why I agree with Arun Jaitley

Vivek Kaul

In my past columns I have been critical of finance minister Arun Jaitley for saying things that he has. Take the case of people not buying as many homes as they were in the past. Like the real estate industry in India, the finance minister seems to believe that Indians are not buying homes simply because interest rates and EMIs are on the high side. “If you bring down the rates, people will start borrowing from banks to pay for their flats and houses. The EMIs will go down,” Jaitley had said in December 2014.
This as I have explained more than a few times in the past is the wrong argument to make. The EMIs simply don’t matter any more when it comes to buying homes—Indians are not buying homes because homes prices are way beyond what they can afford given their income levels. Figuring this out isn’t exactly rocket science and given this, the finance minister of the country shouldn’t have been making such statements.
Nevertheless, for once I agree with Jaitley. He recently told an industrial gathering: “The whole concept of spending beyond your means and leaving the next generation in debt to repay what we are overspending today is never prudent fiscal policy.”
As Mihir S. Sharma writes in his new book
Restart—The Last Chance for the Indian Economy: “Economics has very few real laws. In fact, it only has one, but that one is of iron: you cannot spend more than you earn forever.”
Typically governments spend more than they earn and thus run a fiscal deficit. This deficit is financed through borrowing. When the borrowing keeps piling up, it needs to be repaid by taxes paid by future generations(our children and their children). And that can never be a prudent policy. The fact that Jaitley understands this (or at least says so in the public domain) is a good thing. It will work well for him during the process of formulation of the next budget which is scheduled to be presented on the last day of this month.
It has been suggested that the finance minister should not bother much about the fiscal deficit while presenting the next financial year’s budget. He should unleash a public investment programme in order to ensure that the Indian economy grows at a much faster rate in the years to come, than it currently is.
Leading the increase in public investment charge is
 Arvind Subramanian, the Chief Economic Adviser to the ministry of finance. In the Mid Year Economic Analysis released in December 2014, Subramanian wrote: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.”
This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing. In order to get around this problem Subramanian suggested that: “it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.”
A major reason being offered in favour of the government increasing public investment is the fact that oil prices have crashed. As on February 6, 2015, the Indian basket of crude oil was priced at $$55.62 per barrel. On May 26, 2014, the day the Narendra Modi government took oath of office, the oil price was at $108.05 per barrel. Hence, the price of Indian basket of crude oil has fallen by 48.5% since then.
This fall has ensured that the amount of money that the government would have had to pay out as subsidy to oil marketing companies has come down. Oil companies suffer from under-recoveries while selling kerosene and cooking gas. The government compensates them for a part of this loss. Further, it is being assumed by analysts and economists that oil prices will continue to remain low and this will help the government limit the oil subsidy payout in the next financial year.
With the oil subsidy payout being limited the government can spend more money on public investment is a theory that has been put forward.
As analysts Neelkanth Mishra, Ravi Shankar and Prateek Singh of Credit Suisse write in a research report titled
FY16 Budget: From famine to feast and dated January 27, 2015: We believe that the government can raise capex[capital expenditure] by at least 1.2% of GDP in FY16E. It is pocketing a large part of the gains from the oil price decline, and can spend to generate growth.”
This is a reasonable assumption to make if the current state of affairs continues. But as I have often pointed out in the past forecasting oil prices is a risky business. There are too many variables at play, especially politics. And once politics enters the equation, normal demand-supply analysis goes out of the window.
As Eric Jensen writes in writes in 
The Absolute Return Letter for January 2015 titled Pie in the Sky: “ “It is now a highly political chess game and, as I have learned over the years, when politics enter the frame, logic goes out the window.” The Saudi Arabia and the OPEC, the United States, Russia and many other countries are players in this political game.
Also, it is worth remembering that budgets of countries that produce oil are not balanced at the current level of oil prices. As Eric Jensen writes in The Absolute Return Letter for February 2015 titled
The End Game:The one additional dynamic to consider is the large fiscal deficits in most oil producing countries which is only made worse the further the price of oil drops. Clearly the biggest risk factor in this context is Russia which needs an oil price of around $105 to balance its budget this year.”
Countries typically borrow money when their expenditure is more than their earnings. But as Jensen puts it: “It is a fact that virtually none of the world’s leading oil producing countries have as easy access to bond markets as we are used to in this part of the world.” Hence, low oil prices are hurting oil producing countries the most.
Given this, it is in their interest to ensure that oil prices start rising again in the days to come. In fact, oil prices have been rising from mid January onwards. The price of the Indian basket of crude oil as on January 14, 2015, was at $43.36 per barrel. Since then it has risen by 28.3% to $55.62 per barrel.
Hence, it is important that Arun Jaitley and his team while making the budget make a conservative estimate for the oil price and not get carried away by the recent low levels.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on on Feb 10, 2015 

Lesson from the rouble crash: Don’t put all your eggs in one basket


Vivek Kaul

The Russian rouble has been crashing over the last few days. On December 10, 2014, one dollar was worth 55 roubles. After this, the rouble started crashing against the dollar and it even touched 73 to a dollar on December 16, 2014. This happened despite the Russian central bank raising interest rates to 17%.
Interestingly, as I write this in the late evening on December 17, the rouble has recovered to 62 to a dollar, after the Russian central bank promised to sell close to $7 billion to buy roubles, in a bid to push up the value of the currency.
The Russian government is totally dependent on revenue from oil. With the price of Brent Crude Oil falling below $60 per barrel, the Russian economy is expected to contract majorly next year. This has led to foreign investors exiting Russia.
When foreign investors exit Russia they sell the roubles they have and buy dollars. This leads to an excess supply of roubles in the market and a demand for dollars. This led to the rouble crashing against the dollar. The Russian central bank is now selling dollars and buying roubles being sold and in the process has managed to stop the crash for the time being.
But that’s the simple bit. The first question that arises here is how did the Russian economy become so heavily dependent on money coming in from selling oil. Currently, nearly 50% of government’s income comes from oil. Oil also makes up for two-thirds of Russian exports.
The answer to this question is provided by Yegor Gaidar in an excellent research paper titled
The Soviet Collapse: Grain and Oil. Between 1991 and 1994, Gaidar was acting prime minister of Russia, minister of economy and the first deputy prime minister.
The story starts with Joseph Stalin who was the leader of the Soviet Union from 1922 till his death in 1952. Stalin essentially forced collectivization and expropriation of agriculture. “The result of the disastrous agriculture policy implemented between the late 1920s and the early 1950s was the sharpest fall of productivity experienced by a major country in the twentieth century,” writes Gaidar.
In the 1960s, this “state production of grain stabilized” and remained fixed at around 65 million tonnes per year, until the late 1980s. The trouble was that the urban population was increasing and more grain was needed. This led to Russia becoming a major importer of food grains.
As Gaidar points out: “The cities, however, continued to grow. What policy could succeed if a country had no increase in grain production and an 80 million–person increase in its urban population? The picture was bleak. Russia, which before World War I was the biggest grain exporter—significantly larger than the United States and Canada—started to be the biggest world importer of grain, more so than Japan and China combined.”
So, the harebrained agricultural policies of Stalin turned the world’s biggest exporter of grains into the world’s biggest importer, in a matter of a few decades. The trouble was that the imports had to be paid for in hard currency (largely dollars). Nations like Japan were also importing food grains, but then they also were exporting a lot of goods using “their machine-building and processing industries” as well. This helped Japan earn the foreign exchange it needed to pay for its imports.
The Soviet Union did not have this ability simply because it had followed a policy of “socialist industrialization” which had resulted in “in the Soviet industry being unable to sell any processed (value-added) products”.
Since no one would buy machine products manufactured in the Soviet Union, it became a big exporter of raw materials which included oil and gas. As Gaidar writes: “The Soviet economy thus hinged on its ability to produce and export raw commodities—namely, oil and gas. The Soviet leadership was extremely fortunate: at almost exactly the time when serious problems with the import of grain emerged, rich oil fields were discovered in the Tyumen region of Western Siberia.”
So, oil and gas helped the Soviet Union earn enough dollars to pay for the food grains that it needed to feed its citizens. The country was totally dependent on the revenue from oil and gas.
In fact, its leaders had to get the Tyumenneftegaz (the  production association of the oil and gas industry in the Tyumen region) to produce more than what had been initially planned for. “The Soviet premier, Aleksey Kosygin, used to call the chief of the Tyumenneftegaz, Viktor Muravlenko, and explain the desperation of the situation: “
Dai tri milliona ton sverkh plana. S khlebushkom sovsem plokho” [Please give three million tons above the planning level. The situation with the bread is awful],” writes Gaidar.
After the breakup of the Soviet Union in 1991, this model has been followed by Russia as well. The trouble is that over the years Russia started to assume that high oil prices would stay forever. As Gaidar puts it: “ the idea that “high oil revenues are forever” has gained an even wider acceptance.”
The Financial Times reports that around two weeks back, the current Russian president Vladmir Putin, “ signed the federal budget for 2015-17 — which is still based on forecasts of 2.5 per cent annual gross domestic product growth, 5.5 per cent inflation and oil at $96 a barrel.” As I write this Brent Crude Oil is selling at around $59.3 per barrel, inflation is about to cross 10% and the economy is expected to contract in 2015. Hence, the assumptions are going all wrong.
The Russian government’s budget becomes balanced at a price of close to $100 per barrel, which is nearly 66% higher than the current price of oil. Interestingly, Russia is not the only country which has worked out its government finances assuming a high price of oil.
As Ambrose Evans-Prtichard
recently wrote in The Daily Telegraph: “ The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup.”
This applies to the Organization of Petroleum Exporting Countries as well.
As Javed Mian writes in an investment letter titled Stray Reflections and dated November 2014: “Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment.”
Moral of the story: Countries cannot be dependent on revenue from just one major source like oil sales. It is like the old investment wisdom which the financial planners never get tired repeating: “Don’t put all your eggs in one basket”.
What applies to long-term investing applies to countries as well. The basic lesson is the same.

Postscript: Yesterday I had written about why the government should not be bailing out SpiceJet. But what has happened is exactly the opposite. In fact, the ministry of civil aviation said in a statement: “Indian banks may be requested to give some working capital loan based on the assurances of the promoter. Banks or financial institutions to lend up to Rs 600 crore backed by a personal guarantee of the chairman, SpiceJet.”
The question is if the promoters of SpiceJet are not willing to sink in any more money into the airline why are banks being
“requested” to lend? This in a scenario where the stressed assets of public sector banks is already greater than 10% of their total advances. Beats me totally.

The article originally appeared on The Daily Reckoning, on Dec 18, 2014 


Foreign investors exit Russia lock, stock and barrel: Rouble crisis has lessons for India

Pmr-money-rouble-10-obvVivek Kaul

The Russian rouble has been in trouble of late. The value of the currency crashed from 55 roubles to a dollar as on December 11, 2014, to nearly 73 roubles to a dollar as on December 16, 2014. Since then the currency has recovered a little and as I write this around 67 roubles are worth a dollar.
What caused this? A major reason for this has been the fall in the price of oil by 50% in the last six months. As I write this the Brent Crude Oil quotes at slightly less than $60 to a barrel. The Brent Crude price dropped below $60 per barrel only this week.
The Russian government is majorly dependant on revenues from oil to meet its expenditure. The money that comes in from oil contributes around half of the revenues of the government and makes up for two-thirds of the exports.
As The Economist points out: “The state owns big stakes in many energy firms, as well as indirect links via the state-supported banks that fund them.” Given this excessive dependence on oil, Russia needs the price of oil to be in excess of $100 per barrel, for the government expenditure and income to be balanced.
As Javed Mian writes in the
Stray Reflections newsletter dated November 2014: “Today, Russia needs an oil price in excess of $100 a barrel to support the state and preserve its national security.” The Citigroup in a report puts the break-even cost of the Russian government budget at an oil price of $105 per barrel. The oil price, as we know, is nowhere near that level.
The rouble lost 10% against the dollar on December 15 and another 11% on December 16. Why did this happen? Foreign investors are exiting Russia lock, stock and barrel. The Russian central bank recently estimated that capital flight
could touch $130 billion this year.
The foreign investors are selling their investments in roubles and buying dollars, leading to an increase in demand for dollars vis a vis roubles. This has led to the value of the rouble crashing against the dollar.
The Russian central bank has tried to stem this flow by buying the “excess” roubles being dumped on to the foreign exchange market and selling dollars. It is estimated that on December 15, 2014, it sold around $2 billion to buy roubles.
But even this did not help prevent the worse rouble crash since 1998. This forced the Russian central bank to raise the interest rate by 650 basis points (one basis point is one hundredth of a percentage) to 17%. Despite this overnight manoeuvre, the rouble continued to crash against the dollar and fell by 11% on December 16.
The Russian central bank has spent more than $80 billion in trying to defend the rouble against the dollar this year and is now left with reserves of around $416 billion. The question is will these reserves turn out to be enough?
Russian companies and banks have an external debt of close to $700 billion. Of this around $30 billion is due this month and
another $100 billion over the course of next year, writes Ambrose Evans-Pritchard in The Telegraph.
He also quotes Lubomir Mitov, from the Institute of International Finance, as saying that any fall in reserves below $330bn could prove dangerous, given the scale of foreign debt and a confluence of pressures. “It is a perfect storm. Each $10 fall in the price of oil reduces export revenues by some 2 percent of GDP. A decline of this magnitude could shift the current account to a 3.5 deficit,” Mitov told Evans-Pritchard.
This has implications for Russia on multiple fronts. With oil revenues falling, the Russian economy will contract in 2015. Before raising the interest rates to 17%, the Russian central bank had said that the economy could contract by 4.7% because of oil prices falling to $60 per barrel.
Also, inflation which before this week’s currency crisis was at 9.1%, could go up further. As The Economist points out: “Russian shopkeepers have started to re-price their goods daily. Less than two weeks ago one dollar could be bought with 52 roubles; on December 16th between 70 and 80 were needed. Shops defending their dollar income need a price rise of 50% to offset this.”
Further, so much money leaving Russia in such quick time, the country may also have to think of implementing capital controls.
The revenue projections of the Russian government have gone totally out of whack.
The Financial Times reports that two weeks back, the Russian president Vladmir Putin, “ signed the federal budget for 2015-17 — which is still based on forecasts of 2.5 per cent annual gross domestic product growth, 5.5 per cent inflation and oil at $96 a barrel.” These assumptions will have to junked.
Putin might also might have to go slow on the aggressive military strategy that he has been following for a while now As Mian points out: “Russia is the world’s 8th-largest economy, but its military spending trails only the US and China. Putin increased the military budget 31% from 2008 to 2013, overtaking UK and Saudi Arabia, as reported by the International Institute of Strategic Studies.”
Whether this happens remains to be seen. Nevertheless, the Russian crisis has led to financial markets falling in large parts of the world. As I write this the BSE Sensex is quoting at around 26,700 points having fallen by around 1800 points over the last two weeks.
So, what are the lessons in this for India? The first and foremost is that foreign investors can exit an economy at any point of time, once they finally start feeling that the economy is in trouble. They may not exit the equity market all at once but they can exit the debt market very quickly.
This is something that India needs to keep in mind. From December 2013 up to December 15, 2014, the foreign institutional investors have invested Rs 1,63,523.08 crore (around $25.7 billion assuming$1=Rs63.6) in the Indian debt market. This is Rs 44,443 crore more than what they have invested in the stock market.
Even if a part of the money invested the debt market starts to leave the country, the rupee will crash against the dollar. This is precisely what happened between June and November 2013 when foreign institutional investors sold debt worth Rs 78,382.2 crore.
When they converted these rupees into dollars, the demand for dollars went up, leading to the rupee crashing and touching almost 70 to a dollar. It was at this point of time that Raghuram Rajan in various capacities, first as officer on special duty at the Reserve Bank of India (RBI) and later as RBI governor, helped stop the crash.
This is a point that the finance minister Arun Jaitley needs to keep in mind and drop the habit of asking Rajan to cut interest rates, almost every time that he speaks in public. Rajan knows his job and its best to allow him and the RBI to do things as they deems fit. Further, Rajan and RBI are more cued into what is happening internationally than perhaps any of the politicians can ever be.
Also, one reason that foreign institutional investors have invested so much money in the Indian debt market is because the returns on government debt are on the higher side vis a vis other countries. If the RBI were to cut the repo rate (or the rate at which it lends to banks) these returns will come down and this could possibly lead to the exit of some money invested by foreign investors in India’s debt market. And that would not be good news on the rupee front.

The article originally appeared on on Dec 17, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Oil prices at a 4-year low: Decoding why Saudi Arabia won’t mind low prices for some time


Vivek Kaul 

Oil prices have fallen to a four year low. As I write this the price of Brent crude oil stands at $82.82 per barrel, down 30% from June 2014.
The latest drop in price has come after Saudi Arabia, the biggest producer of oil within the Organisation of Petroleum Exporting Countries(OPEC), the global oil cartel, decided to
cut the price at which it sold oil to the United States by roughly 45 cents to a barrel. At the same time it increased the price to customers in Europe and Asia, for the first time in five months.
The theory going around for sometime has been that Saudi Arabia needs the price of oil to be at least at $83-84 per barrel to balance its budget. Hence, it won’t allow the price of oil to fall below that level. But that as we have seen hasn’t turned out to be the case with the price of Brent crude now less than $83 per barrel.
So, the question is why is Saudi Arabia allowing the price of oil to fall and taking a hit on its income? On many past occasions, the country has cut production when the price of oil is falling. This has helped the country prevent a fall in the price of oil.
As analysts at Merrill Lynch write in a recent report titled
Does Saudi Want $85 oil Our analysis suggests that since 2008, on average, a 10% drop in oil prices has historically led to a 1.5% reduction in Saudi production 3 months later, rising to 2% after 6 months.” Nevertheless, it doesn’t seem to be doing that this time around.
So what has changed? In 2013, United States
became the largest producer of oil in the world, displacing Saudi Arabia. The shale oil fields of the United States are producing a lot of oil, and this has helped the country to become the largest producer of oil in the world. This has led to American imports of oil from Saudi Arabia coming down. Data from the US Energy Information Administration tells us that the imports from Saudi Arabia comprised of around 4.6% of total US oil consumption in August 2014. This is down from 7% in August 2013.
In fact, over the last two months, American imports of oil from Saudi Arabia
have fallen under one million barrels per day, against 1.4 million barrels earlier. If one looks at the data over a longer period the situation looks even more grim. Over a period of last six years, the production of oil in the United States has increased by 70%. This has led to the reduction of oil imports from OPEC by half. Saudi Arabia is the biggest producer of oil within OPEC.
Saudi Arabia is trying to set this situation right. Shale oil is expensive to produce. Given this, it is viable for companies to produce oil, only if the price of oil remains at a certain level. As the Merrill Lynch analysts point out “
With production costs ranging from $50 to $75/bbl at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment.”
Hence, Saudi Arabia is trying to make the production of shale oil unviable for companies which produce shale oil, by driving down the price of oil. The question is how long can the Saudis keep driving the price of oil?
Loren Steffy writing for points out that “The Saudis appear willing to use the abundance of U.S. production to allow prices to keep sliding, enabling the kingdom, which can profit from oil at as little as $30 a barrel, to grab a larger share of the global market.”
While the cost of production of oil in Saudi Arabia maybe low, there are other costs that need to be taken into account.
David Strahan in his book The Last Oil Shock explains that that over the years in Saudi Arabia is that as oil prices have gone up, the rulers have been able to run one of the most lavish welfare systems in the world. This has helped them buy political legitimacy and the support of its citizens. For a very long time, the citizens of Saudi Arabia paid no tax, yet had access to free healthcare and education. At the same time, housing, electricity, food and fuel were subsidized. All this was possible because of all the money that was being earned by selling oil. And that is why for Saudi Arabia to balance its budget (i.e. the expenditure of the government is equal to its income), it needs to sell oil at a price of $83-84 per barrel.
Given this, will the Saudis start cutting production and pushing the price of oil up? “
Much has been written recently about the marginal costs of production of crude oil, and how much which nation will “hurt” if West Texas Intermediate oil prices fell below the US$ 80 mark,” says Vijay L Bhambwani, CEO of West Texas Intermediate is the American oil benchmark and is currently at $77.2 per barrel.
Nevertheless, as long as long as Ghawar, Safania, Shayba, Abqaiq, Berri, Manifa, Abu Safah, Faroozan oil fields are viable, Saudis can sustain even lower prices, feels Bhambwani. At the same time, the fact that Aramco (officially known as Saudi Arabian Oil Company) has deep pockets is a point worth remembering. “Saudis can produce low cost arab light sweet crude very cost efficiently and only the recent state welfare schemes implemented after the arab spring, have raised the marginal costs. Even a slight rollback / delayed released of the additional welfare payments (US $ 36 billion) can add sizeable cash flow into the Saudi national balance sheet and give it additional staying power,” adds Bhambwani.
Also, it is worth remembering that the Saudi central bank has reserves worth $734.7 billion. Further, as Edward Chow a senior fellow at the Center for Strategic & International Studies in Washington,
recently told Bloomberg “The Saudis ran deficits from the mid-1980s until the late 1990s and may be prepared to do so again.”
What this tells us is that the Saudis can easily sustain low oil prices in the short-term, if they are looking to break the backs of the shale oil companies. At the same time low oil prices will hurt Iran, much to the delight of the Saudins.
To conclude, any fall in price of oil, will benefit India, and help the government further control its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. So, India should hope that Saudi Arabia continues with its current strategy of driving down the price of oil.

The column appeared on on Nov 6, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)