Oil Prices: Always Slippery?

Oil prices have crossed the $125 per barrel mark. They have risen by almost 400% in the last five years. The reasons for such a phenomenal rise are many: one, the boom in the global economy that is being witnessed across the globe, that too, for a long time now; two, post-2003, almost 90% of the demand for oil essentially coming from developing economies such as China and India, which are considered less efficient in using oil vis-á-vis developed countries such as the US—where, according to Rosenfeld, simply by using more efficient fridges over the years Americans have saved more than 200 twh annually, said to be equivalent to the production of 80 power plants—adding additional demand for oil; three, the increased purchasing power among the middle-class of developing countries that has resulted in a substantial increase in  the demand for private transportation; and four, the fact of quoting oil prices in dollars—a currency that has depreciated by almost 25% in real effective terms since 2002— has only made oil sound cheaper in non-dollar regions leading to increased demand for oil from such zones.  That aside, a falling dollar has resulted in reduced returns from the dollar-denominated financial assets. This has obviously diverted investors’ attention to commodities—whose prices are always known to be impacted by supply-side glitches—as a class of investment assets. And, amidst such turmoil, it is no wonder that speculation has fueled the oil prices further, though the market considers its impact on current price rise as certainly not that big.

Now, the question is: What does oil price rise mean? It simply means that oil is a finite resource. And so long does the demand for its consumption continue uninterrupted from the developing economies led by the economic growth in China and India and so long does the Western economy continue with its reluctance to learn lessons from the recurring price rises, the oil-crisis is sure to persist. Against this backdrop, some analysts are forecasting that oil prices may hit the $200 per barrel mark. This, however, sounds less plausible, at least in the immediate future, for there appears to be no significant imbalance between global supply and demand positions—excess demand was quite marginal at 0.2 million barrels per day during 2007. Secondly, there are no supply-side glitches: almost all the known oil-fields are functioning to their full capacities. Thirdly, efficiency levels in transportation sector—particularly in North Americas and Europe—is likely to improve substantially, which means a fall in consumption. Indeed, the latest data from the US reveal that its demand for oil has fallen by 7% a year ago, and this matters the most; for, the US accounts for one-fifth of the global oil consumption. And if past experiences are of any value—a fall in commodity prices lag a major economic slowdown by four to five months—oil prices shall finally settle down around $95 per barrel. And this shall not cause much anxiety, for today’s economy—unlike in the 1970s—is well set to absorb such price-shocks. But for that to happen, oil supply should grow in response to the rising demand, else the resulting price rise is certain to cause serious disruptions in the global economy.  It is, of course, only a hope and for that to translate into reality, the world must invest heavily in finding out alternatives for this finite source. Also, it must explore forming a consumer cartel for reducing volatility in crude oil market.

The next question is: What does all this mean for India? For a country that imports close to 70% of its oil consumption, it means a lot: first and foremost, it must allow the oil prices to be transferred to the ultimate consumers. It is a fact that due to our faulty subsidy policies, oil companies are left with huge under recoveries on account of sale of petrol, diesel, LPG and kerosene. Of these, petrol and LPG are mostly consumed by the urban population, which can pay more than what it is being charged today. This poses the obvious question: Why not restrict subsidies just to the economically weak rather than making it available across the board? Such a move is sure to make people more efficient in their oil usage. Secondly, it is necessary to make people less and less dependent on private transportation by improving public transport system. In the same vein, the government should encourage oil exploration and production in the country and, if required, should scrap the anachronistic levy on crude oil output. We must also invest in basic research that not only paves the way for more and more usage of alternative energies but also improves efficiency in energy use. Such demand management for oil is a must in the long run. As otherwise, the growing demand for oil coupled with rising prices can punch bigger holes in the central government’s budget in terms of increased issue of oil-bonds, leading to larger fiscal deficit. And issuing oil-bonds during the growth phase may not matter much, but during a downtrend they would simply become a drag on the economy.

Given that oil is always slippery, either a disruption in supply side—be it in Nigeria, Venezuela, Algeria, Angola, Ecuador, or Russia—or a spike in demand can always drive prices higher.  And any rise beyond a particular level is sure to fuel inflationary pressures across the globe. Such volatility in oil prices is sure to disrupt our economic growth.

(June, 2008)