How To Make Sense of The Indian Economy: Importance of Crude Oil

Crude Oil is one of the most economically mature global commodities. Despite reserves and production being skewed in favour of a few companies (belonging to even fewer nations) and wide distances between points of manufacturing and consumption; oil markets should still be looked at as a global pool. If a single player withholds or floods supply, the price impact will be felt uniformly through the pool.

 

Low shipping costs have a key role in ensuring this uniformity. Oil cargoes can move with relative ease across oceans where 80% of international Crude Oil moves. Traders can quickly redirect transactions towards markets with higher prices, minimizing opportunities for regional arbitrage.

How To Make Sense of The Indian Economy: Importance of Crude Oil

Major producer nations include US, Russia, the Middle East and parts of North Africa & South America (last two often represented by an intergovernmental organization or in real means a cartel known as OPEC), Canada etc. Biggest buyers include US, Japan, China, India, and parts of Asia.

 

Pricing is determined by a mix of supply factors, demand factors, and panic. The supply-demand dynamic is perhaps easier to explain i.e. when demand for oil is high e.g. during wintertime when heating oil demand spikes or during summers when people tend to drive more, Crude Oil prices go up. Geopolitical factors e.g. the Gulf war, re-imposition of sanctions on Iran (a major Crude Oil producer) by the US can cut supplies and increase prices. Such events also bring with them a certain degree of panic, which, by definition, is irrational e.g. the energy crisis of early 1970s. 

How To Make Sense of The Indian Economy: Importance of Crude Oil

How is Crude Oil Priced?

 

As explained earlier, the ‘fungible’ nature of oil i.e. the ease of re-direction of cargoes to the highest-priced buyers, means any price impact is felt uniformly across the world.

 

One must however remember that Crude Oil is still a heterogenous commodity, with regional differences in viscosity, extraction costs, sulfur content etc. Like any heterogenous commodity, their pricing can be understood by using some important global benchmarks. These benchmarks set a “marker” price which is used to track general price movements. All transactions in turn are priced based on the relevant marker price with additional adjustments incorporated for location and quality of oil. The most important oil price benchmarks in the world are:

 

  1. West Texas Intermediary (WTI): representative of US markets, valid for low viscosity (or “light”), low sulfur content (or “sweet”) oil
  2. Brent: blend of light sweet Crude Oil extracted from the North Sea. Comparable to WTI
  3. Fateh (or “Dubai Crude”): Crude Oil stream from Dubai. Denser and sourer than WTI and Brent. Used as a benchmark for Crude Oil shipments from the Middle East to Asia
  4. Bonny Light: Crude Oil stream from Nigeria. Light sweet oil comparable to WTI and Brent. Used as a benchmark for African Crude Oil
  5. Urals: Crude Oil stream from Russia. Denser and sourer than WTI and Brent. Serves as benchmark for oil exports from Russia

 

The idea is that any transaction in the International oil markets will be pegged as per one or more of the above benchmarks, with additional adjustments incorporated to account for location factors and the properties of underlying oil being transacted i.e. viscosity, sulfur content etc.

 

Moreover, each country will look at these benchmarks or their combinations to track and resolve domestic price issues as well as drive energy reforms. These selections will again be a factor of how the country gets its oil.

 

Indian government for example looks at a combination of Dubai (& Oman) and Brent oil (in a ratio of 72.38:27.62) refined in Indian refineries to determine its regional benchmark of price (named the “Indian Basket”). Such a combination ensures the price being tracked is representative of both “sour” and “sweet” oil being refined in the country. With USD being the sole global reserve currency of choice, most International Crude Oil trading is conducted in USD.

 

India sources 80%+ of its annual Crude Oil requirement externally, making us one of the largest oil importers in the world. Being a relatively price inelastic product, such an external dependence makes Crude Oil a key force driving our macroeconomic realities.

 

Next I will briefly explore How the Indian Economy gets affected when International Crude Oil prices go up.

 

This will be a recurring column published every Friday under the title: “How to Make Sense of the Indian Economy”.

 

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