Price, Income and Cross-elasticity of Crude Oil Demand: A VECM approach to Indian Economy

Abstract

The paper attempts to establish short-run as well as long-run relationship among crude oil consumption, international crude oil prices, GDP, domestic crude oil production, coal production and exchange rate in India. The study employs vector error correction model over the time span from 2001 to 2017. To inspect changes caused due to endogenous variables in the system, impulse response function and variance decomposition are applied. The results show that both short-run and long-run price and income elasticities are inelastic. Only GDP and oil production have significant effect on the crude oil demand in short-run indicating that increase in economic growth and domestic production leads to rise in crude oil demand irrespective of price, coal production and exchange rate. However, in the long-run, crude oil demand is significantly influenced by all the variables (inelastic). GDP and exchange rate influence crude oil demand in India more than any other variable considered in the study as growth in economy leads to higher demand for crude oil and favourable exchange rate fluctuations positively influences oil imports consequentially, oil demand. The outcome of the study concludes that India must take measures to combat oil price shocks. India has a strong renewable energy potential in terms of solar and wind energy which can contribute to India’s energy security and reduce crude oil import demand in India. Moreover, India must improve strategic oil reserves as it can hold 90 days’ oil reserves as instructed by the International Energy Agency but currently it has only oil reserves of 13 days.