Factors behind the wild oil price swings
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Even after the recent fall, oil prices are much above last year's levels and are hurting particularly oil-intensive Asian economies including India, says Vinish Kathuria.
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THE JUGGERNAUT of oil price hike was finally arrested last fortnight with the price coming down below $45 a barrel after touching an all time high of $56. The downward movement is still continuing as on International Petroleum Exchange in London, Brent crude fell to $40.64 on December 22. When the prices were spiralling, bulls predicted that it may even rise to $70 a barrel. Why did prices rise so high? And why did they fall despite the prediction? And what implications can such a high price have on developing countries like India, which are aiming to grow at a minimum 7 per cent in the next few years. The escalation in oil prices has also exposed, though to a small extent, the inability of the Organisation of Petroleum Exporting Countries (OPEC) to fix the prices. Why is one of the most successful cartels in the world economic history losing its sheen? This article touches these aspects briefly.
In order to understand these issues, one needs to know what determines the price of oil. In economic terms, the equilibrium price of oil is determined when supply and demand meet. For any increase in demand, if supply does not increase by the same proportion, the price will need to be adjusted upward. On the other hand, if demand falls suddenly, the supply will have to be adjusted downward, failing which the price will fall. This is what has happened in the past few months. The following exposition tells what factors pushed up the demand.
Faster rise in demand
An International Energy Agency (IEA) report in August 2004 called the current increase in oil price an `irrational exuberance' but there are a number of fundamental factors that influenced the high demand. Consumption this year has grown at 3 per cent which is much higher than the levels of the last few years. Two major factors cited for the higher consumption rise were robust petrol-guzzling in America which accounts for a fourth of the world's energy demand and China's booming economy. While American demand for petrol was quite strong even in summer low stocks and supply constraints due to environmental regulations and lack of spare refining capacity had a direct effect on the price of crude oil.
Similarly, energy demand from China seems to have gone berserk. In the last decade, its oil demand increased by a huge 140 per cent and this year alone it increased by a whopping 20 per cent. Historically, no other country had a 20 per cent rise in demand in a single year.
Another important factor behind the spurt in oil price is the relatively weak dollar. The recent fall in dollar has robbed it of its purchasing power and this encouraged the OPEC cartel to take a relaxed view about the situation. The relaxed view also emanated from the fact that OPEC members have started paying for their purchases in yen and euro too.
The market grapevine has it that Asian firms made big bets on oil for future delivery on the assumption that the dollar would remain weak. Such bets were one of the causes for the recent sharp rise in oil futures. If consumers consider that spikes in spot prices are temporary, the future prices may not rise the way they did. Unfortunately, high future prices also indicate that spot prices will not fall below $30-35 in the near future.
Official data also show that oil contracts held by hedge funds and other speculators reached an all-time high in the middle of the year.
Despite some fall in speculation, the interests of speculators still remain high. This is because of the prevailing low interest rates and less than expected returns from the stock market. Lastly, the most important factor influencing the above $50 price per barrel is the cartel's fears that oil prices might crash below $10. On the eve of the Southeast Asian financial crises in the late 1990s, the OPEC met in Jakarta and agreed to increase output, thereby misconstruing the severity of the crisis. This sent oil prices crashing to $10 a barrel, which was nothing short of a disaster for all the countries that depend heavily on oil for their growth. As a reaction, Saudi Arabia — the largest oil producer — has propped up the oil prices by keeping its inventory down. It has been argued that by manipulating production levels, the Saudis have ensured that firms in rich countries do not hold stocks. This tightness has bloated the oil prices.
From the supply side, one of the factors that have influenced the price rise is lack of spare capacity. The price crash of the late 1990s discouraged OPEC from investing in capacity expansion.
The high growth in demand in the past 3-4 years has not seen a commensurate increase in investment by OPEC countries, resulting in the world virtually running out of spare capacity. In fact, now there is less spare capacity than at any time in the last 30 years.
Furthermore, in the past 6-7 years, Russia has emerged as the largest oil producing country outside OPEC.
The recent action of the Russian government against the private producer Yukos and its main shareholder Mikhail Khodorkovsky brought uncertainty in the oil supply at a time when demand was peaking. It is estimated that the Yukos affair added at least $5 to the oil price.
In fact, if demand is strong, and supply becomes uncertain, traders talk of a `risk premium' to the tune of $10 a barrel.
<167,4p,1>In the whole saga, the OPEC became virtually impotent for the simple reason that several member countries could barely manage their quotas, let alone increasing production to stabilise the price.
<167,5p,1>Since most of the OPEC countries have not upgraded their machinery, billions of dollars will be needed to be re-invested in the next 10-15 years just to sustain current production levels. The influence of OPEC will be further undermined in future if trend of the world moving from oil to natural gas and coal gasification continues; the social and political conflicts in Venezuela and Nigeria get prolonged; and there is no fresh discovery of oil in the OPEC operated regions.
Recent fall in prices
From November, oil prices started coming down from their historic levels. There are a number of reasons for this development. The first is change in the nature of demand. In the summer season the U.S. places a premium on low-sulphur crude which is more suited to the nation's petrol pumps. In winter months, oil refiners use more of the heavier, high sulphur crude, suited for heating purposes. This shifted the dependence from civil-war ridden Nigeria to Saudi Arabia, which produces plenty of heavier crude. Similarly, Russia stepped up its production after coming out of the Yukos affair. Thirdly, the latest figures from America's Energy Information Administration indicated that the country's stocks of crude are recovering faster than expected from Hurricane Ivan. Lastly, in the last week of September, Saudi Arabia added another 500,000 barrels per day to increase its capacity to 11 million barrels per day by inducting two new oil fields three months in advance. Despite the recent fall, the situation has not improved much as prices are still much above last year's levels. Such high prices particularly hurt the developing countries of Asia including India, which are oil intensive. This means Asian economies consume more oil per unit of output than Europeans or Americans.
According to IEA, Thailand and China consume twice the rich country average for the same level of output. India uses thrice as much.
A high price of oil can impact the economies at three levels: (a) by adding to inflationary pressures as seen in the past few months; (b) increased interest rates - a mismatch between the world oil price and the domestic selling price will push up the subsidy from the government and public debt which in turn will put pressure on interest rates and reduce the capital available to more productive borrowers; and lastly (c) increase energy costs which coupled with the inflationary pressure will slow the economic growth of these countries. Most of the multilateral agencies like the Asian Development Bank and the World Bank have already revised their economic growth projections downward for these countries by one percentage point.
What lies in future?
The price of oil is affected by long-term factors — one of which is the equilibrium between supply and demand. The excess supply leading to the price crashing to $ 10 four years ago has turned into a situation of shortages.
The price may shoot up to $75 if production gets threatened by a terrorist attack in Saudi Arabia, which does not seem improbable.
Furthermore, all the Russian oil companies were created in the same manner as Yukos and any future scrutiny against them will seriously affect supplies and affect the price. In the case of countries like India, heavily dependent on oil, the safe passage lies in reducing dependence on oil and shifting to gas and reducing wastage.
On the other hand, it is in the interest of OPEC and other oil producing countries that the price does not rise to an unmanageable level of $70 or more, as high prices will push consuming economies into recession, leading to reduced demand for oil and a price crash. However, it is in the interest of not only consuming countries but also the cartel itself that investments are made in spare capacity so that prices do not increase beyond a threshold.
(The author is Associate Professor, Madras School of Economics)
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