Oil prices: the biggest tail-risk for Pakistan’s economy

A tail-risk is an event that has an extremely low probability of occurring but when it does, the loss is severe and more than what would be anticipated by anyone. For instance, a financial crisis is always a tail-risk for the global economic system. Things can go wrong, just as they did during the financial crisis of 2008.

As energy prices continue to increase and central banks around the world embark on a net tightening policy – (there were more than 60 increases in the last three months) – and there seems to be no end in sight to the war in Ukraine (affecting global food prices to which emerging markets and developing countries are most vulnerable too), Pakistan as a country faces a tail risk that no one is taking seriously.

Given the country’s dependence on oil imports, a complete ban on Russian oil by the European Union (EU) can result in oil prices breaking through their highs of 2008 and touch $170 - $200. This will be a tide that our rickety economic boat would not survive.

The EU is considering banning Russian oil as a result of its invasion of Ukraine. This is happening while the whole world is facing an unprecedented rise in global commodities, especially energy prices.

Not only that, the global oil supply is also under pressure as OPEC+ has curtailed production under a self-imposed quota.

OPEC+ supplies around 50 percent of the global oil supply. Spare capacity, defined as the amount of crude that can hit the markets within 30 days and sustained for 90, is also very low. Global oil refinery's output has also drastically reduced especially post-pandemic. According to calculations, world oil inventories have shrunk by 600 million barrels in the past year and a half — the fastest drop on record.

Inventories of distillate and diesel are also nearing historic lows. All in all, the world is looking towards a looming supply crunch as sanctions on Russia threaten to remove 3 million barrels of oil per day from the markets.

For Emerging Markets and Developing Economies (EMDEs) this is bad news. Such developments will further cement the ongoing commodity super-cycle.

It is worse for countries like Pakistan that import almost a third of its energy and 25 percent of its oil usage. Recently, due to a rise in global oil prices, our oil import bill has increased by a concerning 96 percent (almost double) from $7.55 billion to $14.81 billion in the last 9 months.

Similarly, due to rising commodity prices, palm oil imports registered an uptick of 60 percent. On the other hand, our reserves took a beating in March where in just one month they fell by $5 billion and now stand at $16 billion whereas the State Bank of Pakistan (SBP) reserves are close to breaking the psychological barrier of $10 billion. Help is expected - ($3 billion from Saudi Arabia, $2.5 billion from China, and $900 million from IMF) - but ‘ifs’ remain.

As of today, (June 1, 2022), the EU has agreed to ban 90 percent of Russian oil imports. But the ban, for now, will only be implemented on oil coming from the sea and not pipelines. Oil prices are already heading north and will hit $130 (Brent) soon.

For the incumbent government, this can prove to be an existential challenge as subsidies on oil are already poking a big hole in the national exchequer and remain a hindrance in our successful negotiations with the IMF. Rising interest rates by the Federal Reserve continue to strengthen the dollar which makes debt servicing expensive for us and also puts immense pressure on our import bill (the increases mentioned above are a case-in-point).

Expect petrol prices to touch at least Rs220 in the coming weeks. They can rise even further. The upcoming budget will be extremely tough for ordinary citizens as it offers little to no respite in terms of inflation and relief.

The future of Pakistan’s economy (and politics) has never been so intricately and intimately linked with European politics.

There is an urgent need for Pakistan to start building oil storage facilities so that during times of low prices (such as in 2020) we can save crude for later use. There is also a dire need for us to strike a deal with Russia to buy oil at steep discount as India has done (at 20 percent or $35 less than the standard price).

If diplomatic caveats hinder our ability to do so, we should turn to China as the country has recently increased its oil imports from Russia. China’s Strategic Petroleum Reserves are also very high. One option would be to form an agreement where oil goes to China and is then delivered to Pakistan.

Policy-makers should brace for a $170/barrel crude oil and act proactively and preemptively in order to avoid a full blown economic catastrophe that might be in the making for developing countries in general and Pakistan in particular.

The article does not necessarily reflect the opinion of Business Recorder or its owners