Slipping on oil

Published : Apr 25, 2008 00:00 IST

OIL is one area where recent developments threaten to derail the Government of Indias anti-inflation agenda. High and rising levels of oil prices have been around long enough to give cause for concern. But the problem today is the persistence of these high levels and the rising trend, so much so that international prices crossed the $100-a-barrel mark this year.

This has obviously affected Indias import prices as well. Price movements for the two varieties of crude that enter Indias import basket (Graph 1) show that since May 2003 international prices have, despite fluctuations, been on a continuous rise. In the event, the prices per barrel of these varieties have moved from less than $25 in May 2003 to close to or well above $100 today.

This has changed one feature of the oil price situation that held during much of the past two decades. During those years, despite high nominal prices, the real price of oil (adjusted for increases in the general price level) was far lower than what it was during the 1970s. As chart 2 shows, when measured by the price-deflated refiner acquisition cost of imported oil in the United States, in the years since 1974 the real price of oil was higher than that in 2006 only during a brief period between 1980 and 1982.

Since 2006, nominal oil prices have risen further at rates much higher than the average level of prices. As a result, oil producers are regaining the real price benefits they garnered during the 1979-81 shock. According to one estimate, the peak in oil prices in the late 1970s-early 1980s works out to $100-110 a barrel in terms of current prices. That is a figure that we are fast approaching.

Underlying the buoyancy in prices is the closing gap between global petroleum demand and supply at a time when the spare capacity is more or less fully utilised. Much of the increase in demand is coming from China, but that is affecting stockpiles everywhere. This trend, combined with the uncertainty in West Asia resulting from the occupation of Iraq and the standoff in Iran, has created a situation where any destabilising influence such as political uncertainty and attacks on the oil supply chain in Nigeria has triggered a sharp rise in prices.

What needs noting, however, is that prices are where they are because speculators have exploited these fundamentals. It is known that energy markets have attracted substantial financial-investor interest since 2004, but especially after the recent decline in stock markets and in the value of the dollar. Investors in search of new investment targets have moved into speculative investments in commodities in general and oil in particular. Hedge funds and other investors have been buying into the commodity, fuelling the price increase even further. Not surprisingly, the Organisation of the Petroleum Exporting Countries (OPEC), which is normally held responsible for all oil price increases, has asserted that oil has crossed the $100-a-barrel mark not because of a shortage of supply but because of financial speculation.

Yet, as recently as March 2008, President George Bush accused the oil producers cartel of damaging the U.S. economy by pushing oil prices to levels that were making it harder here in America for working families to save and for farmers to be prosperous and for small businesses to grow. In particular, he stated that he was disappointed by OPECs decision to leave production unchanged in the face of record prices.

The President may have as usual got it wrong. OPEC had perhaps played a role but of a completely different kind. A.F. Alhajji, Energy Economist and Associate Professor at Ohio Northern University, recently advanced the following argument in the Financial Times: As oil prices have increased, so have their [OPEC countries] revenues. Some of these revenues found their way into funds that speculate in oil futures. In his view, ironically, petrodollars have helped drive oil prices to new record levels.

The point to note is that it is precisely the financial forces that the Bush administration has encouraged, with devastating effects in subprime and related markets, that are major influences on current oil-price trends. As far back as April 29, 2006, The New York Times reported: In the latest round of furious buying, hedge funds and other investors have helped propel crude oil prices from around $50 a barrel at the end of 2005 to a record of $75.17 on the New York Mercantile Exchange.

According to that report, oil contracts held mostly by hedge funds had risen to twice the amount held five years ago. To this one had to add trades outside official exchanges, such as over-the-counter trades conducted by oil companies, commercial oil brokers or funds held by investment banks. And price increases had also attracted new investors such as pension funds and mutual funds seeking to diversify their holdings. All these trends have only intensified since.

In fact, in November 2007, when Royal Dutch Shell, Europes biggest oil company, presented its third quarter results, it reported that earnings had fallen 8 per cent to $6.39 billion as a result of lower refining margins and sales volumes. Whether in defence or on the basis of fact, Chief Financial Officer Peter Voser argued that high oil prices only meant that profit attributable to shareholders rose 16 per cent to $6.916 billion. His conclusion was that: The price seems to be driven by some speculation and also has a political premium in it rather than actually some of the fundamental drivers.

Countries like India seeking to manage this effect of global speculation on the prices of a universal intermediate like oil have to decide how important it is to insulate the domestic economy and the consumer from its effect. Given the huge revenues being derived from duties on oil products, one way this can be done is to forego duty while holding oil prices. This would require compensating for revenue losses with taxes in other areas which a growing economy can contemplate. But, as argued elsewhere, the government is unwilling to take this route, increasing pressure to hike oil prices further and aggravate an inflationary tendency that is already proving to be economically and politically damaging.

C.P. Chandrasekhar
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