Why Petrol Price is Rising in India?

By Raman deep Kaur

India is the worlds fourth largest consumer of energy but with low per capita energy consumption. With
the ever increasing number of private vehicles, an overall domestic consumption of petrol and petroleum
product is on rise in India. There was a registered growth of 5% of the same in the year 2011-12 and to
meet the increasing demand, government has to import more and more petrol. If spending of the country
as a whole is considered then 80-90% is done to pay the import bills on petroleum products, which is
accounted as countrys expenditure. Hence more demand of petrol than supply is a leading factor of its
rising price in India.

But rise in petrol price in turn has a rippling effect. As all the commodities are transported across India on
vehicles that run on petrol or diesel, so increase in petrol price results in price rise of these commodities
as well. The greatest sufferer of all this is a common man. He is already bearing the pressure of inflation
and any increase in petrol price will further reduce his actual household income. Today every Indian
spends almost half of his income on food items. If the petrol price in India keeps on increasing then every
food item will get costlier. It will result in less of savings and more of expenditure. This in turn will affect
the real estate, banking and other sectors in India. Eventually, more and more people will be pushed
towards poverty line.

Why India needs to import oil? India does not have enough of oil to meet the growing demand of oil. Near
about 1.4 million barrels of diesels are used per day in India especially by farmers, trucks and industry.
So to meet the growing demand, most of the oil is imported from other countries resulting more
expenditure. It has been seen that petrol price has increased about 10 times within the period of three
years and still rising. Ultimate result of price hike of petrol is inflation.

Not only this but the condition of Indian currency is also not favorable at present. India is going through
currency crisis where value of Indian Rupee is falling to US Dollar. That is why Oil Marketing Companies
(OMCs) like Indian Oil Corporation (IOCL), Bharat Petroleum (BPCL) are paying more for the same
quantity of crude oil. Due to this, OMCs have lost near about 4,300 crores in the past six months for
selling petrol at low cost.

The price of petrol used to be stable in India but with the deregulation of petrol in 2010, Oil Marketing
Companies can increase the petrol price if large variation in cost is observed by these companies. Oil
marketing companies do so by linking the domestic price of petrol to international market rates.

Why petrol price is rising in India?

Depreciating rupee is one of the major reasons of the increase in petrol price in India. So we must
understand that why rupee is depreciating like a free fall. Economists believe that current euro crisis is
one of the fundamental reasons of depreciating rupee. But if this is the main reason then why other
currencies like Pound, Brazilian Real, etc are not getting affected to that extent. In fact Yen has moved up
against dollar.

So there must be some other reasons as well. Ever increasing fiscal deficit (difference between revenue
and expenditure) is one of the factors leading to currency crisis in India. We spend more than what we
earn. For the year 2011-2012, fiscal deficit was Rs 5,21,980 and for the year 2012-2013 target was to
have it at Rs 5,13,590 crores. Major reasons leading to this fiscal deficit is the financial funding or subsidy
offered on petroleum, food and fertilizer. Cost of subsidy on oil for the year 2012-2013 is estimated to be
Rs 43,580 crores and when the loss suffered by OMCs is also added to it, the total amount stands at Rs
1,14,000 crores.

Present earning of government is less than its expenditure which means that fiscal deficit of government
is increasing. Moreover, fiscal deficit is linked with trade deficit which means more import than export.
Major portion of Indias import is oil. Since import of oil is always paid in dollars, so importers need to buy
dollar by paying rupees. Present currency crisis means more rupees have to be given for the same
dollars leading to more rupees in the market. Applying demand and supply theory, rupee is continuously
losing value and OMCs have to pay more for the same amount of oil imports.

If the price of oil products is not increased, India will keep on facing this deficit. Price increase will
decrease the demand which in turn need fewer dollars for oil import. Trade deficit will also be lowered
down leading to lesser pressure on rupee-dollar rate. Not only petrol price but the price of diesel, LPG
and kerosene will also be increased to have more prominent impact. This will improve the fiscal deficit of
the government and lead to economic growth.

On the other hand, price rise of petrol can be controlled if the government reduces its revenue from the
taxes on petroleum. 35% of governments income is generated through petroleum taxes and as there is
no other substitute to this so probably this wont be done by the government. Hence petrol price for sure
will increase. But indeed Government has to take strong decision as increasing prices will solve one
problem but leads to many other such as poverty, inflating, high cost of living, frustration etc.

How the petrol price is calculated?

Petrol price is calculated on the basis of worldwide supply and demand factors. Foreign suppliers sell
crude oil to Oil Marketing Companies (OMCs) in India at benchmark prices. Delivery price at the refinery
and Brent crudes daily price are considered to calculate actual cost of petrol in India.

One barrel of crude oil contains about 160 litres of oil priced in US dollars. To calculate price, US dollars
are converted to Indian rupee and then divided by 160.

After buying, crude oil is transported to refineries in India. India at present has about 20 refineries. Crude
oil is then separated into various products like petrol, diesel, coal tar, etc in distillation towers of these
refineries. Cost of distillation and refining is added to the price of petrol. Also crude custom levy and
charges from ports to the refinery is added.

Separated petrol is now ready to be stored in the storage tanks of the oil companies. Oil companies now
pay to the refineries and to this added the cost of transporting petrol from refinery to OMCs tanks. So the
actual price of petrol that a consumer pays includes all the above mentioned cost plus commission of a
dealer, VAT, excise duty, total duties and taxes.

Thus petrol price is the cost price that includes procuring, refining and marketing plus taxes that include
central and state taxes.

Affect Of Rising Price Of Crude Oil On Stock Market

For the last few years it has been seen time and again that increase in the price of the crude oil had a
direct impact on the stock market. Though it is hard to imagine buy it is fact that a rise in the oil
price has negative effect on the stock prices at the stock exchanges all over the world.
The main reason behind this is the fear of the investors that the profit margin of the companies will
decrease because of the increase in the oil price. As an increase in the oil price directly increases the
operational cost, fuel cost, transportation cost of the companies, it is quite natural that the profit
margin of these companies will decrease. This is the reason that the buyers become susceptible about
the future of the companies that are hugely dependent on oil. This uncertainty restricts the buyers to
invest in these companies and as a result the price of the stocks falls that ultimately has a negative

effect on the overall market scenario. But this phase is temporary as the companies adjust in the price
level to make up for the increased price in the oil and maintain the profit margin.
All said and done this fear for the fall in the profit margin is not practical according to the theory. In
practice the effect of the price increase in the profit margin of the companies takes time. Before that
could actually happen the companies take adequate measure to avoid the loss.

What are the possible causes and consequences of

higher oil prices on the overall economy?
November 2007

What a daunting question! With oil prices increasing rapidly in the recent past, it
is hard not to wonder what has caused it and just what effect it might have on
the rest of the economy. Let me begin by discussing the evolution of oil prices
over time.
How have oil prices behaved in recent decades?
Figure 1 shows the history of the price of oil since the early 1950s. The price
shown is the monthly average spot price of a barrel of West Texas intermediate
crude oil, measured in U.S. dollars. The gray bars in this and all the following
figures represent recessions, as defined by the National Bureau of Economic
Research.

Figure 1. Spot Oil Price ($ Barrel)

As you can see from Figure 1, a long period of oil price stability was interrupted
in 1973. In fact, the 1970s show two distinct jumps in oil prices: one was
triggered by the Yom Kippur War in 1973, and one was prompted by the Iranian
Revolution of 1979. Since then, oil prices have regularly displayed volatility
relative to the 50s and 60s.
Figure 2 shows the real oil price, calculated by dividing the price of oil by the
GDP deflator. 1 This removes the effect of inflation and thus gives a more
accurate sense of what is happening to the price of the commodity itself. In
essence, the real measure allows you to compare oil prices over time in a way
that you cant when inflation is also part of the change in price. You can see
that real oil prices have varied a lot over time, and large fluctuations tend to be
concentrated over somewhat short periods. You can also see that by the spring
of 2008, as this posting was prepared, the real price of oil has easily exceeded
that of the late 1970s.

Figure 2. Real Oil Price

Why are oil prices rising?

It is likely that both increases in demand and fears of supply disruptions have
exerted upward pressure on oil prices.2 Global demand for oil has been
increasing, outpacing any gains in oil production and excess capacity. A large
reason is that developing nations, especially China and India, have been
growing rapidly. These economies have become increasingly industrialized and
urbanized, which has contributed to an increase in the world demand for oil. In
addition, in recent years fears of supply disruptions have been spurred by
turmoil in oil-producing countries such as Nigeria, Venezuela, Iraq, and Iran
(Brown 2006).
The breathtakingly sharp increase in the price of oil in the last half of 2007 and
first half of 2008 has led many to argue that increased speculation in
commodity markets has played a role, and indeed there is evidence of increased
activity in these markets. However, whether speculation is playing a role in
high oil prices is open to debate (Krugman 2008). It is also useful to remember
that both the demand for and the supply of oil react sluggishly to changes in
prices in the short run, so very large changes in prices can be required to
restore equilibrium if demand should move even modestly out of line with
supply.
As far as the implications of higher oil prices, there are both microeconomic and

macroeconomic answers to that question. I will address both of these aspects in

turn.
How do high oil prices affect the economy on a micro level?
As a consumer, you may already understand the microeconomic implications of
higher oil prices. When observing higher oil prices, most of us are likely to think
about the price of gasoline as well, since gasoline purchases are necessary for
most households. When gasoline prices increase, a larger share of households
budgets is likely to be spent on it, which leaves less to spend on other goods
and services. The same goes for businesses whose goods must be shipped from
place to place or that use fuel as a major input (such as the airline industry).
Higher oil prices tend to make production more expensive for businesses, just
as they make it more expensive for households to do the things they normally
do.
It turns out that oil and gasoline prices are indeed very closely related. Figure 3
plots average monthly oil prices from 1990 through early 2008, using the spot
oil price for West Texas intermediate (right scale, thin blue line, measured in
dollars per barrel) and the U.S. retail gasoline price (left scale, thick red line,
measured in cents per gallon). The two series track each other very closely over
time: increases in oil prices are accompanied by increases in gasoline prices. As
shown in the graph, the correlation coefficient (denoted r) for the two series is
0.98. Moreover, the monthly changes in oil prices and gasoline prices (not
shown) also are very highly and positively correlated.

Figure 3. U.S. Gasoline and Oil Prices

So, when oil prices spike, you can expect gasoline prices to spike as well, and
that affects the costs faced by the vast majority of households and businesses.
What effects do oil prices have on the macro economy?
Ive just explained how oil prices affect households and businesses; it is not a
far leap to understand how oil prices affect the macroeconomy. Oil price
increases are generally thought to increase inflation and reduce economic
growth. In terms of inflation, oil prices directly affect the prices of goods made
with petroleum products. As mentioned above, oil prices indirectly affect costs
such as transportation, manufacturing, and heating. The increase in these costs
can in turn affect the prices of a variety of goods and services, as producers
may pass production costs on to consumers. The extent to which oil price
increases lead to consumption price increases depends on how important oil is
for the production of a given type of good or service.
Oil price increases can also stifle the growth of the economy through their effect
on the supply and demand for goods other than oil. Increases in oil prices can
depress the supply of other goods because they increase the costs of producing
them. In economics terminology, high oil prices can shift up the supply curve
for the goods and services for which oil is an input.

High oil prices also can reduce demand for other goods because they reduce
wealth, as well as induce uncertainty about the future (Sill 2007). One way to
analyze the effects of higher oil prices is to think about the higher prices as a
tax on consumers (Fernald and Trehan 2005). The simplest example occurs in
the case of imported oil. The extra payment that U.S. consumers make to
foreign oil producers can now no longer be spent on other kinds of consumption
goods.3
Despite these effects on supply and demand, the correlation between oil price
increases and economic downturns in the U.S. is not perfect. Not every sizeable
oil price increase has been followed by a recession. However, five of the last
seven U.S. recessions were preceded by considerable increases in oil prices (Sill
2007).4
Is the relationship between oil prices and the economy always the
same?
The two aforementioned large oil shocks of the 1970s were characterized by low
growth, high unemployment, and high inflation (also often referred to as
periods of stagflation). It is no wonder that changes in oil prices have been
viewed as an important source of economic fluctuations.
However, in the past decade research has challenged this conventional wisdom
about the relationship between oil prices and the economy. As Blanchard and
Gali (2007) note, the late 1990s and early 2000s were periods of large oil price
fluctuations, which were comparable in magnitude to the oil shocks of the
1970s. However, these later oil shocks did not cause considerable fluctuations in
inflation (Figure 4), real GDP growth (Figure 5), or the unemployment rate.

Figure 4. Oil Prices and CPI Inflation

Figure 5. Oil Prices and Real GDP Growth

A caveat is in order, however, because simply observing the movements of

inflation and growth around oil shocks may be misleading. Keep in mind that oil
shocks have often coincided with other economic shocks. In the 1970s, there

were large increases in commodity prices, which intensified the effects on

inflation and growth. On the other hand, the early 2000s were a period of high
productivity growth, which offset the effect of oil prices on inflation and
growth. Therefore, to determine whether the relationship between oil prices and
other variables has truly changed over time, one must go beyond casual
observations and appeal to econometric analysis (which allows researchers to
control for other developments in the economy when studying the link between
oil prices and key macroeconomic variables).
Formal studies find evidence that the link between oil prices and the
macroeconomy has indeed deteriorated over time. For example, Hooker (2002)
suggests that the structural break in the relationship between inflation and oil
prices occurred at the end of 1980s. Blanchard and Gali (2007) look at the
responses of prices, wage inflation, output, and employment to oil shocks. They
too find that the responses of all these variables to oil shocks have become
muted since the mid-1980s.
Why might the relationship between oil prices and key macroeconomic
variables have weakened?
Economists have offered some potential explanations behind the weakening link
between oil prices and inflation. Gregory Mankiw (2007) suggests increases in
energy efficiency as one explanation. Indeed, as shown in Figure 6, energy
consumption per dollar of GDP has gone down steadily over time. This means
that energy prices matter less today than they did in the past. Blanchard and
Gali (2007) suggest additional explanations. They find that increased flexibility
in labor markets, monetary policy improvements, and a bit of good luck
(meaning the lack of concurrent adverse shocks) have also contributed to the
decline of the impact of oil shocks on the economy.
Finally, how monetary policymakers treated the economic shocks caused by
rising oil prices also may have played a role in the impact of the shocks on
economic growth and the inflation rate. Specifically, some have argued
policymakers tended to worry more about output than inflation during the oil
shocks of 1970s and did not adequately take into account the inflationary
aspect of the oil shocks when fashioning a policy response to them (see, for
example, Clarida, Gali, and Gertler 2000). In the case of the U.S., since
households and firms sensed that the Fed was not going to pay a lot of
attention to inflation, they probably realized that the oil shocks would lead to

substantially higher future inflation and adjusted their expectations accordingly.

By contrast, the Fed in the 2000s is more committed to fighting inflation, the
public knows it, and the result has been that, even though headline inflation has
risen noticeably because of the direct effects of oil and commodity shocks, core
inflation and inflation expectations remain contained.
The lack of major output effects of oil price shocks since the 1970s calls into
question what role they played during the two recessions of that period. In
other words, one possible reason why oil shocks seem to have noticeably
smaller effects on output now than they did in the 1970s is that the world has
changed. Another is that the effects of oil shocks were never as large as
conventional wisdom hold, and that the slow growth of that decade had to do
with other factors.
Figure 6. U.S. Energy Consumption

Endnotes