Dec 29, 2008

World - Flip side to lower crude oil prices

A variety of reasons have been adduced for the phenomenal rise and the equally dramatic fall in oil prices

At a time of low petroleum prices, there will be fewer incentives to step up production or save the environment. Once this is realised, oil prices may start climbing again.

BALANCING ACT: A general view of the meeting of the members of the Organization of the Petroleum Exporting Countries (OPEC) held at a hotel in Oran, Algeria, recently.

The global petroleum scenario has confounded analysts and the most proactive policy makers alike. Until Last July, crude prices were on a relentless upward march touching a high point of $147 a barrel that month against $60 a year earlier. Since then, it has moved down sharply, slipping below $40 two weeks ago. Last week-end, it was trading a shade above $36 in the futures market.

What is significant is that it remained low despite some aggressive cuts announced by the Organization of the Petroleum Exporting Countries (OPEC) and a few non-OPEC countries.

On December 17, the world’s largest oil cartel, OPEC, which controls about 40 per cent of global supplies, decided on a cut amounting to 2.2 million barrels a day over and above the two million barrels a day reduction pledged in September. Despite some important non-OPEC countries such as Russia announcing their own cuts, oil prices did not stabilise.

The picture is still hazy, with a lot depending on the revival of the world economy.

The rise and fall of petroleum prices is one interesting story. Equally topical is whether in the present context lower oil prices are an unmixed blessing, especially as OPEC’s attempts to restrict supplies do not seem to be paying off.

A variety of reasons have been adduced for the phenomenal rise and the equally dramatic fall in crude oil prices. The ‘imbalance’ between consumption and supply has always been an explanation but this has been only partially satisfactory.

While growing demand from India and China (along with current demand from the U.S. and other countries of the developed world) was cited as the principal factor underpinning the huge rise, there is no evidence of demand from these developing countries tapering off so sharply as to warrant such a large downward pressure on oil prices. In short, changes in supply or consumption are not significant enough to explain the petroleum price movements, at least over the recent past.

Oil producers and exporters, who had enormous clout at the time of high prices, have seen their influence wane with lower prices. Some countries such as Venezuela and Iran have based their expenditure programmes on oil remaining at around $85 a barrel.

The biggest producer, Saudi Arabia, had stated that $75 would be a price acceptable to both producers and consumers. India’s then Finance Minister P. Chidambaram had advocated a price band that would be agreed upon and maintained by producers and consumers.

None of such suggestions found acceptance at a time when oil prices were going through the roof. Six months ago, several analysts were predicting prices would touch $200 and go even higher. Such dire warnings from usually credible forecasters raised inflation expectations around the world and in most cases led to tighter monetary policies.

Those who bet on a decline were far fewer in number and were quite understandably not heard by those who mattered.

Speculation blamed

Speculation in oil futures was widely blamed for the price rise. There is no doubt at all that the large liquidity floating around the world found its way into petroleum and other commodity markets.

Hedge funds, as well as mainline financial institutions, were among the largest investors. Paper oil like paper gold or any other financial instrument can be bought and sold without the parties ever taking or giving delivery. Derivative instruments also allow leverage: with relatively small money, very large positions can be built. The ‘pernicious’ influence of speculation was widely condemned: several governments contemplated punitive action against the speculators. On their way down too the oil futures trade must have invited speculators but barring the oil producers not many are complaining about speculation, assuming it exists.

Unmixed blessing?

On the positive side, the fall in oil prices translating into lower fuel costs has come as a big blessing for many countries around the world. Poorer nations which were hit hard by high fuel and food costs can breathe easy. For India and other developing countries, the sharp drop in oil (and other commodity) prices has meant lower inflation. With one major threat appearing far less potent than it used to, monetary authorities around the world are now focussing more on economic growth.

However, lower oil prices are the consequence of a deterioration in the global economy. Practically, all developed economies are officially in recession. India and other developing countries are forecast to grow but at a slower rate. So if the global economy revives demand for petroleum is bound to go up. But sadly, oil supplies cannot be boosted at short notice.

Low oil prices, it has been claimed, may dampen ongoing efforts aimed at protecting the environment. These had received a boost when oil prices were high. The attainment of energy security might have become more difficult for many countries. Alternative fuels, renewable energy and so on involve a high level of investments which may be hard to come by when the traditional energy source petroleum is available at lower costs.

Within the hydrocarbon sector itself, attempts to encourage oil production to maintain supply depend on huge investments coming in. These will be discouraged by the falling prices.

In brief, cheaper oil may lead to complacency: hard decisions required to invest in alternatives, changing consumer behaviour; encouraging energy-efficient plant and machinery or automobiles will become that much easier to postpone.

In India, the crude basket is down to around $40 a barrel. A further cut in the administered prices of petrol and diesel as well as cooking fuel has been hinted at.

Since petroleum pricing has become highly politicised, other vital issues connected with the supply of petroleum do not get the attention they deserve.

It would be good to remember that the period of low oil is not going to last. Complacency ought to be avoided at all costs.



O.B. said...

I believe the minute that the current economic slump is recognized as over, oil will begin a sustained increase to the $80 range.

The prices seen in July were a short term commodities bubble spurred by the devaluing of the U. S. Dollar. Just as now the $40 range we are seeing is undervalued and is spurred by the hyperventilation over the slumping world economy.

The recession won't last forever and neither will the low oil prices.

Anonymous said...

Wow, that's crazy man. They should really try to do something to fix that.