Hormuz closure could hit half of India’s oil supply

A COUPLE of weeks before Israeli and American missiles began raining down on Iran, one of the Islamic nation's two naval wings, the Islamic Revolutionary Guard Corps Navy, shut down the Strait of Hormuz for several hours as it conducted an exercise to test its new defence doctrine, the 'Smart Control of the Strait of Hormuz.' The objective was to show to the world that Iran had the capability to block any seaborne trade through the strait.

More than 20 million barrels of crude oil pass through the Strait of Hormuz every day. That makes up 25% of the world's crude shipments and 20% of global crude consumption. For us, the importance of the strait is even larger: 50% of India's crude imports transit through it.

Any sustained blockade will increase our crude import costs dramatically, over and above the impact it will have on global crude prices.

Defence analysts are divided over whether Iran can actually implement the blockade for long. Some say that Iran has war-gamed this exact scenario for years and has built up maritime defence capabilities that rival the best in the world. Janes, the much-respected defence analysis group, once called Iran the "foremost… practitioner of small boat 'swarm' tactics", which is of crucial value in the Strait of Hormuz.

It also has over 5,000 naval mines, including Chinese-made EM-52 rising mines, that can lie dormant on the sea bed until they sense there is a high-value target above.

Iran also has the largest anti-ship missile arsenal in West Asia, including the short-range Noor and the mid- to long-range anti-ship ballistic missiles (ASBMs), Khalij Fars, Zolfaghar Basir and Qasem Basir.

Other defence experts say that the US and Israel have abundant firepower to take out this entire naval configuration within a few days and clear up the Strait of Hormuz within a week. Yet, even if this were true, they would not be able to rule out guerrilla strikes on ships, like the Houthi rebels have demonstrated in the Red Sea.

That means ships will need to pay very high insurance premia to transit through the strait. Already, the additional war risk premium (AWRP) charged on ships that travel through the region has risen from 0.05-0.1% to 0.5-1%. of the vessel's hull value.

That means a very large crude carrier (VLCC) with a hull value of $100 million will have to pay up to $1 million in insurance. In some cases, major maritime insurers have simply withdrawn insurance coverage for any ship going through the Strait of Hormuz.

This will have a deadly impact on the crude 'basket' we import, whose price is estimated using a combination of the price of heavy sour crude from Oman and Dubai and sweet Brent crude.

We will have to pay more for the crude coming from the Gulf and also increase our dependence on crude from North America, which will drive up our import price. Estimates suggest that if the disruption in Hormuz continues, India's crude basket might rise from the current $70 per barrel to $100 per barrel or even higher.

There are four major effects of any large rise in crude prices on our economy. The first is the impact on our oil import bill and the current account deficit (CAD). The second is the cost of refining crude. The third is the impact on the price of fuel that a common citizen pays at the local petrol pump. And the fourth is the effect on what the Centre and states earn from taxes on petrol and diesel.

Estimates suggest that for every $10 increase in the global price of a barrel of crude, our oil import bill will go up by $13-14 billion since we pay lower prices than the global average.

If global oil prices rise to $100 per barrel, our oil import bill will rise by $30-40 billion. Other things remaining the same, this will raise our CAD — the gap between our imports and exports — to 2.3% of the GDP.

If crude import prices rise, oil refineries will proportionately increase their refinery gate prices — the price at which they ship it to petrol pumps — to maintain their profit margins. If the Centre and state governments continue to tax at the same rate as they currently do, consumers will spend much more when they buy petrol and diesel.

At $100 per barrel, refineries will sell petrol at Rs 80 per litre and consumers will end up paying between Rs 115 and Rs 135, depending on which state they are in. That, in turn, will have a huge impact on the overall retail inflation.

It is estimated that for every $10 increase in the global price of crude, the consumer price index rises by one-third of a per cent. A $100 per barrel crude could add a full percentage point to retail inflation. That will force the RBI to reverse its stance on interest rates by raising them to curb inflation. In a situation where both investment and consumption are already strained, this would have a dampening effect on India's GDP growth.

One way to compensate for the inflationary impact of rising crude prices is for both the Centre and states to reduce the taxes levied on petrol and diesel. Currently, the Centre imposes Rs 13 per litre as central excise on petrol and Rs 10 on diesel. State VAT rates vary widely, ranging from 16% to 26%, depending on the fuel type.

If retail prices are to be kept where they are, the Centre could end up losing as much as Rs 1.5 lakh crore in tax revenue, which will push up the fiscal deficit to 4.6-4.7%.

The government will have to borrow more to fill the gap, increasing the supply of government bonds and pushing up yields. Corporates will also have to follow suit by offering higher returns on their bonds.

In short, whether the rise in crude prices is passed on to consumers or absorbed by the government, interest rates could rise and affect India's GDP growth in the coming financial year.