Clear and present danger

Underestimating the long-term impact of political risk on the oil trade, in Iraq and beyond, has serious economic consequences for India.

Amid reports that Iraqi militants have attacked oilfields in Iraq, the Minister of Petroleum appeared unruffled, reassuring the country that these developments would not lead to a shortfall of petroleum products in India. While the honourable Minister is to be applauded for taking timely steps to contain speculation or panic, this particular claim merits closer inspection.

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There are three reasons to believe that India will be largely insulated from the effects of crisis in Iraq. First, India produces a considerably greater quantity of refined petroleum products than are consumed domestically. In 2012-13, for instance, production stood at 220 million tonnes, as against 158 million tonnes of consumption. While disruptions in crude oil supply may reduce our exports of petroleum products, production will remain adequate to service domestic demand.

Second, while Sunni militias and rebels are currently attacking the important Baiji refinery, they pose no threat to the oilfields or refineries south of Baghdad. Northern Iraq’s oilfields and refineries, protected by Kurdish peshmerga forces, also continue to operate; the Kurds have even started selling oil through Turkey. Third, Indian refineries have already received almost 50 percent of the planned imports from Iraq for 2014, considerably limiting the potential shortfall.

Despite these reassurances, we have reason for concern. The economics of the global oil trade matter even when physical supply is secured. Disruptions in Iraqi oil production have the potential to undermine India’s economic growth, through their impact on oil prices, exchange rates and balance of trade. Iraq is a textbook case of political risks carrying heavy economic consequences. The strategic, counterfactual and farsighted thinking needed to assess and mitigate such risks remains conspicuously absent from India’s state-dominated petroleum sector.

Maintaining domestic supplies by reducing exports will lead to a growing trade deficit. India relies on exports of refined petroleum products to offset the costs of importing crude. In 2012-13, exports of petroleum products worth Rs. 3.2 lakh crore underwrote imports of over Rs. 8.8 lakh crore worth of crude. Petroleum accounted for one-third of total import costs, and one-fifth of total export revenue. No other sector affects our balance of trade on the same scale; reduced exports of petroleum products directly compromise our ability to afford imported crude in the future.

The deficit will be compounded by the fact that, as Iraq is the second largest oil producer in OPEC, the risk of disruption of Iraqi supplies inevitably leads to an increase in the market price of crude.  In June 2014 alone, the benchmark Brent crude price has crossed $115 per barrel, an increase of almost 6.5 percent in three weeks. In turn, the price of India’s crude oil import basket rose to over $111 per barrel, against the Finance Ministry’s estimated price of $105 per barrel. Even imports under long-term supply contracts will become costlier, as those prices are renegotiated every 30 to 60 days. As the Indian Express reports, this price rise has already increased India’s import burden by Rs. 8000 crore per month.

The Iraqi government had only recently refused to sell crude to India at anything other than market price. In other words, while we may still get all the oil we planned to buy from Iraq, we will be paying more than we planned for it. In effect, we will buy dear to use more and sell less; if oil subsidies are maintained, costs will be under-recovered from domestic sales as well. Rising oil prices will also weaken the rupee against the dollar, making this a losing proposition for India from every angle.

Our hopes now rest on the rapid resolution of the conflict, returning oil production and prices to near government-estimated levels. We have learned little from being in a similar position, quite recently, in Sudan. The same naiveté characterised the failure to anticipate how partition-related violence and pricing disputes would stall production there, to the detriment of Indian investments in the region. As of date, insurrectionist chaos in Sudan and South Sudan shows few signs of abating, let alone reaching an enduring resolution.

The risks of disruption in Sudan arose from well-studied and widely-known structural factors; Iraq was no paragon of stability either. India’s heavy reliance on imports dictates cultivating every possible source of supply, but surely some foresight and preparation can mitigate the associated risks? The Ministry of Petroleum, with heroic myopia, wrote to state-run refineries only last week to prepare contingency plans for disruptions in Iraqi supply; with the contingency already manifest, once would have hoped plans to address it were already in effect. While India’s refineries are adroit at resolving technical challenges, the exchequer will pay the price for this belated realisation.

Risk management relies on hedging; a late response tends to limit leverage, but better late than never. Short-term, India needs to identify alternate suppliers on a priority basis. Oil is notoriously a seller’s market, all the more so in light of anticipated disruptions, so our political alliances will be the key factor in securing any preferential deals for Indian refineries. The Prime Minister’s upcoming visit to Brazil may be one opportunity to explore such prospects.

In the long term, such measures must be institutionalised to form a comprehensive sourcing strategy, which can account for political risk beyond the formalities of insurance, and prepare for contingencies before they materialise. Given the rapid pace of change in the Middle East, our traditional source of supply, only a nimble strategy informed by adequate forethought can hope to keep pace. It is indeed time to invest in contingency planning – not just for refineries, but for the entire petroleum sector.

Photo: Altuk Karakoc