Stability of oil prices under threat

Sushma Ramachandran

Senior Financial Journalist

THE geopolitical tensions witnessed in 2023 have spilled over into the New Year. Yemen-based Houthi militants are continuing their attacks on merchant ships in the Red Sea, and even the US Navy has shot down a few of their drones. The strife in the region could lead to a wider conflagration that may play havoc with the global economy. In turn, this could impact economic recovery in India, which has seemingly defied external headwinds over the past two years to emerge as the fastest-growing major economy in the world.

Indian-flagged ships or those carrying goods to or from the country remain vulnerable, as evident from the recent drone strikes.

In case tensions grow and the movement of international cargo through the Suez Canal continues to face disruptions, it would lead to higher costs for trade flows between Europe and Asia. Most shipping lines have already shifted to the longer and more expensive route via the Cape of Good Hope. This adds as much as 6,000 nautical miles to the distance between the two continents.

Around 42 per cent of all Europe-Asia trade passes through this canal. The Red Sea is the inlet that ships must traverse before reaching the canal, if they are coming from the Asian side. At the entrance to the Red Sea, however, they must pass through Bab el-Mandeb, a strait between Yemen and Eritrea. It is from here that the Houthis who control most of Yemen have been launching attacks, either by boats or drones. With the intent of supporting Hamas, the Houthis are ostensibly targeting all vessels linked in some way to Israel. Significantly, those linked to Russia or China are being spared. But Indian-flagged ships or those carrying goods to or from the country remain vulnerable, as evident from the recent drone strikes.

The US has cobbled together a coalition of countries called the Operation Prosperity Guardian, which is meant to protect merchant shipping lines moving through the Suez Canal route. Thanks to this initiative, a leading logistics firm, Denmark-based Maersk, resumed cargo movement via the Red Sea. But the latest attack has forced it to defer shipments through the route yet again as the Houthis are clearly undeterred by the multinational defence force.

If the situation spirals out of control, there could be a series of ripple effects on the global economy. The first and most immediate impact will be on oil prices. Currently, these are $75-80 per barrel for the benchmark Brent crude, far lower than the rate of over $90 in September last year. The cuts in production quotas announced by the Organisation of Petroleum Exporting Countries Plus (OPEC+) have had little impact owing to the slowing global demand. Economic recovery has not been as fast as expected in China, cutting consumption by the world’s biggest oil importer. Crude inventories are also reported to be high in the US, while recessionary trends are continuing in the Eurozone.

In this backdrop, the decision by OPEC+ to cut production by an additional one million barrels per day (bpd) in 2024 has not made much of an impact on the market. This is despite the fact that it brings the total output cuts to 2.2 million bpd.

A protracted Red Sea crisis could reverse the situation and lead to a spike in oil prices. This would raise red flags even in developed countries, which have borne the brunt of high energy prices since the onset of the Russia-Ukraine war.

The second negative outcome of a prolonged conflict in the region could be a fresh impetus to inflationary pressures around the world. This would be the result not just of higher oil prices but also the disruption to global supply chains due to avoidance of the Suez Canal route between Asia and Europe. Though last year’s runaway inflation has begun to moderate in the US and Europe, it could well spike and force central banks to push up interest rates yet again.

As for India, the threat to rice exports has already been voiced by industry and government spokespersons. But if the Red Sea crisis persists, a wide range of commodities will be affected by the soaring freight rates. Exports to key markets of the US and Europe will become more expensive if ships carrying goods keep going around Africa instead of through the shorter canal route.

Merchandise exports have already experienced a decline in the current fiscal (2023-24) compared to the previous one when they touched a record level of $455 billion. From April to November 2023, exports declined by 6.5 per cent compared to the corresponding period in 2022. Rising freight charges could make the country’s exports uncompetitive, while growing inflation in major markets could equally slow down demand.

Imports, especially of critical crude oil and natural gas, would also come at a higher price. Currently, projections for 2024 are that oil prices would continue to remain in the range of $70-80 per barrel. But the incessant attacks in the Red Sea could lead to ramifications far beyond the conflict zone. This would raise India’s oil import bill substantially, since over 85 per cent of the demand is met from abroad. The cost was contained in the last fiscal partly due to the availability of oil from Russia at discounted prices.

Thus, the situation in the Red Sea could become a drag on growth in critical economic sectors. It could lead to widening of the current account deficit, while supply chain disruptions might affect industrial output as well. For the time being, however, India can only wait and watch, even as the presence of the Navy in vulnerable areas is being enhanced to protect domestic shipping lines.

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