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Oil On The Boil

BW Online Bureau Nov 08, 2014

<?xml version="1.0" encoding="UTF-8"?><root available-locales="en_US," default-locale="en_US"><static-content language-id="en_US"><![CDATA[(Bloomberg) You can no longer fill it, shut it and forget it. With average oil prices likely to go only higher from the present level of about $130 a barrel, the government finally raised fuel prices on Thursday. Petrol went up by Rs 5 a litre, diesel by Rs 3 and cooking gas by Rs 50 a cylinder. At between 10 and 18 per cent, these hikes were the largest India has ever seen. As more bad oil-related news seeps in from across the world, a simple question emerges: how did policymakers the world over fail to anticipate the phenomenal rise in crude oil prices? It is the primary responsibility of governments to making long-term decisions and they should have their fingers on the pulse of the global economy. But most capitals were as clueless as anyone else when it came to this one. Worse, most governments were unprepared for the extent of the rise. For example, in an energy white paper published in February this year, the UK Department of Business Enterprise and Regulatory Reform laid out three illustrative fuel price scenarios. The high price scenario had oil at just $70 a barrel (bbl) in 2010. But oil had already crossed the $100 a bbl mark in January, a month before the report was published. Most analysts predict that a combination of demand growth, supply constraints and commodity speculation, will keep oil priced at present rates, or higher, for the foreseeable future. Part of the problem is that some of the largest new oil finds are geopolitical hotspots, such as Central Asia. Not only does this hamper the ability of oil companies to exploit these oil fields, it raises the risk of oil wars breaking out. With the US, China, Russia, Iran and India already duking it out for influence in Central Asia, many say a new version of the “Great Game”, which saw colonial powers competing in the region, is already afoot. The failure of the US government to bring about stability in oil prices despite the trip Treasury Secretary Hank Paulson’s attempt to persuade OPEC countries to raise output and calm prices — are a reflection of the international political dimensions of the problem (see ‘Oil Price Hypocrisy’ on page 36). If prices continue to go up as they have been, oil could well become the world’s first industrial scarcity — the first resource of which relatively cheap and accessible supplies are approaching exhaustion. Which begs the question: as a nation that imports most of its crude oil, and whose pace of growth is critically dependent on oil imports, how well are we prepared for oil at $200 a barrel? After growing at 9 per cent a year, the impact of higher oil prices on investment, producers and consumers is going to be considerable. The potential impact on government finances, interest rates and inflation is even scarier, a political nightmare for this government and the one that succeeds it. These high oil prices could well derail India’s economic growth ambitions. PAST TENSE: Crude prices had spiralled during two previous oil crises: in 1973 during the Arab-Israeli Yom Kippur War (below), and in 1979 during the Iranian revolution A Global Disruption How real are the prospects for oil to hit $200 a barrel soon? In 2006, Robert Westcott, an economic consultant and member of the US President’s Council of Economic Advisers, wrote a paper about the impact of oil at $120 on the global economy, at a time when oil was $60 a bbl. At that time, his idea was not taken seriously. Analysts and experts are more circumspect in dismissing such forecasts. “If that happens, all bets are off,” says Sachchidanand Shukla, economist at Mumbai-based securities firm, Enam Securities. “Prospects for India’s economic growth rates could take a huge beating. It is just untenable.” The upper bound in the estimates of most people BW spoke to suggest that even $150 a bbl would be close to impossible to manage. A number of primary and secondary reasons — and combinations of them — have been put forth to explain the exponential rise in oil prices. Growing demand from emerging markets, but not matched by production increases, declining sources of new oil, the collapse of spare capacity in the largest producers who are members of the Organisation of the Petroleum Exporting Countries (OPEC), are considered primary, and speculative investments that have discovered commodities — mainly oil — as an asset class, are among the secondary ones. In November, the International Energy Agency (IEA) is expected to revise its forecasts of future oil supply — based on research on 400 existing oil fields. Production growth in the new estimates will not be as high as the 116 million barrels a day — the IEA’s forecast in 2007 (the current level is at 87 million barrels a day) — but a much pessimistic number. The IEA forecast a gap of 12.5 million bbl a day: a demand for 37.5 bbl a day versus new capacity additions that would produce 25 million bbl. The Wall Street Journal suggests that the conclusions of the report could shake up the oil business. Peter Jackson of Cambridge Energy Research Associates, an oil consultancy, estimated the average decline rate of oil fields — a measure of declining oil flows — at 4.5 per cent per year: that implies that new production of 3.8 million bbl a day is needed to just keep production at current levels. Add to that OPEC’s spare capacity having nearly reached zero, and the picture begins to look dismal. To make matters worse, doubts are raised about estimates of current oil reserves. These figures haven’t been audited for decades, but OPEC countries — the Middle East, accounting for about 40 per cent of global oil production — have continued to raise estimates over the years. Click here for more stories on Energy Fuel Price Hike May Push Inflation... Succour For Oil Retailers A Crisis Looms Slowdown? Don't Bet On It Gas Prices Up? All In Your Head The world has used up its best reserves — the so-called light sweet crude produced onshore from the best reservoirs. Heavy crude is more expensive to extract and refine, which impacts prices. The energy return on energy invested (EROEI) — the energy in extracted fuel as a proportion of energy invested in extraction — is high historically, but is approaching the point where the ERoEI is becoming uneconomical (less than 1). Speculation has frequently been blamed for the run-up in oil prices. “But that’s nonsense,” says a commodities trader on the Chicago Board of Trade who did not wish to be named. “Yes, there is speculation: for every long position, there is a short one. But ultimately, the price is struck by whoever takes delivery of the oil.” Inventories of crude and petroleum products have been falling for a year, he says. ALTERNATIVES: Coal liquefication projects by Tatas and Ambanis plus Reliance Industries’ gas finds could ease India’s dependence on oil imports (Pic by Tribhuwan Sharma & Sanjay Sakaria) Growth Under Threat At $120 a barrel, the world’s oil bill will amount to 8 per cent of global GDP, says Westcott. Assuming a global GDP of $40 trillion, that will be $3.2 trillion, or three years of India’s GDP. Analysis by the research department at the International Monetary Fund (IMF) says that a permanent $5 a barrel increase in oil prices will decrease global GDP by up to 0.3 of a percentage point. This means that a $60 increase in oil prices we have seen over the last two years, from $60 to $120, will cut the level of world GDP by approximately 3.6 per cent. A reduction in world GDP of 3.6 per cent stemming from oil at $120 a bbl will be the beginning of a global recession. For an economy whose oil amounts to 70 per cent of its total imports, such high oil prices will have a deleterious impact on India’s growth prospects. And that is putting it mildly. Higher oil prices reduce the spending power of consumers and cause a reduction in demand for all categories of products, from furniture to movie tickets. Consumption demand accounts for about 60 per cent of GDP in India. And with the recent petrol and diesel price hikes announced by the government this week, the next two quarters could be hard times for consumers. {mospagebreak} “GDP growth could fall to about 7.3 per cent in FY09,” says Sonal Varma, economist at US investment bank Lehman Brothers, based in Mumbai. “From producer through consumers to the government, the direct and indirect effects can have a significant negative impact.” Further increases in raw materials, transport and input costs could add to the uncertainty about economic growth for companies. Rising oil prices eat into profit margins, particularly in energy-intensive sectors; companies could reduce services and cut production. Already, domestic airlines are cutting flights and raising prices to make sure their losses don’t get bigger than they already are. As in the US, the auto industry will be the first to feel the effects. Car sales, which have been riding high demand, are likely to decline. Transport companies could also reconsider fleet replacement plans. Apart from consumer and producer confidence, high and rising oil prices influence investor confidence, too. Importing oil to keep its economic growth engine humming comes at the cost of a worsening trade balance. “The current account deficit will grow from 1.2 per cent of GDP to 3 per cent,” says Varma. “And the fiscal deficit, after including the off-balance sheet oil and fertiliser bonds could go as high as 9 per cent of GDP from its current 7.5 per cent.” The impact on stockmarkets and foreign institutional investor (FII) interest is likely to be a double whammy. FIIs have already been net sellers, and declining confidence could push them to sell off even more. Valuations of companies — and consequently shareholder and household wealth — could take a big hit. Political (Mis)Calculations Finance Minister P. Chidambaram will be familiar with this Tamil saying: when the water level rises above your head, it doesn’t matter whether it is by one foot or ten feet. The targets in the Fiscal Responsibility and Budget Management Act are unlikely to be met. Finance ministry officials, however, disagree. By combining price hikes with customs and excise duty cuts on petroleum products, his government will bear the most. The deficit gap can be bridged, maintains Expenditure Secretary Sushma Nath. The revenue loss amounts to about Rs 22,600 crore, whereas tax collections have increased by 45 per cent this year. “Whether and how we will make good those losses will be decided later,” says Revenue Secretary P.V. Bhide. Finance ministry officials are unwilling to talk about the impact on the macro-economic situation, preferring to wait and watch. A stoic Chidambaram declined to comment. Prime Minister Manmohan Singh, in a nationally televised address on 4 June, said consumers could not be fully insulated from the rise in global oil prices. For the Congress, this could not have come at a worse time. The country is already reeling under the impact of an inflation rate of 8.1 per cent. The price hikes are likely to contribute another 1 per cent almost immediately. For every rupee increase, about 0.18 per cent gets added to wholesale price inflation. A Reserve Bank of India (RBI) study undertaken a couple of years ago sought to identify indirect effects of fuel price increases. Based on that study it is likely that as fuel price increases filter down through the economy, another percentage point is likely to be added as transport costs add their bit to consumer prices. “With inflation already as high as it is at 8 per cent, it will exacerbate inflationary expectations,” says Siddartha Sanyal, economist at Edelweiss Capital, a Mumbai-based securities firm. “The price hikes reinforce these expectations; it will be built in by manufacturers and service providers, and become a self-fulfilling prophecy.” GOING UP IN SMOKE: The war in Iraq has led to a steady increase in crude prices over the years (Bloomberg) For the RBI, raising already-high interest rates to combat inflation, in the face of a slowing economy, adds to the difficulties of making hard monetary policy choices. To the mix, add the effects of the farm loan waiver, the Sixth Pay Commission’s recommendations, and the prospect of a price-wage spiral looms large. “We are paying the price for not increasing prices earlier, with a difficult and large hike now, which in the long run may prove inadequate,” says an analyst with a securities firm in Delhi. Scenario Planning For The Future Is the government’s response to rising crude oil prices — duty cuts, issuing oil and fertiliser bonds while keeping subsidies and marginal increases in fuel prices — sustainable over the long run? No one appears to have the answer to that one. But this much appears clear: if the government had not decided to raise fuel prices, the state-owned oil companies would have run out of working capital by the end of September. Three solutions suggest themselves in the current situation. First, and contrary to conventional thinking, developments at this stage of the political cycle — it is an an election year — present an opportunity for the next government to plan for and publicly debate a long-term plan about energy policy. That would make politically difficult decisions more palatable for the population, and dispel the idea of the government as the people’s mai-baap. The people — yes, even the poorest ones — needed to be treated as being intelligent, capable of making informed choices as customers and citizens, and willing to pay the price for them. Drilling For More   Here’s an alternative scenario: oil at $80 a barrel (bbl). Sounds fantastic? Not according to some. A trader on the Chicago Board of Trade — he declined to be identified for this story — says that he is short on oil right now, and expects oil to decline to about $75 to $85 a bbl in the next six to eight months. His rationale: a significant part of the price of oil is the premium related to terrorist attacks or sudden disruption is supply. “Look at what happened when there was a storm in the Gulf of Mexico”, he points out. “Oil is presently so volatile that prices move on any suggestion of supply changes.” Over the next few months, that premium — estimated at about $35 a bbl — is likely to come down. Others point to the revised reserves numbers of British Petroleum’s North Sea fields; a report said that those reserves were at least a fifth larger than originally estimated. Mike Thornton, development director at UK Oil & Gas — an industry body — said that another 26 billion bbls remain to be recovered from the North Sea. Oil flow has been declining for a few years now at about 3 per cent. About 37 billion bbls have already been recovered thus far. And orders for exploration and drilling equipment from Baker and Hughes, the largest provider of such equipment in the world, have increased dramatically. Libya — long out of the international oil market — is expected to raise its production from 1.8 million bbls a day to 3 million bbls, a 40 per cent increase, by 2012. Libya has ‘proven’ reserves of 29.5 billion bbls, much of which is yet to be extracted. Western countries — the UK and the US in particular — which had banished Libya from western markets because of the country’s involvement in the 1988 Lockerbie bombing, are now satisfied that the country does not espouse or encourage terrorism any more. The world is waiting, watching and hoping. Second, the government should use its oil exploration company ONGC to try and secure oil and other fuel supplies much like China does: entering into partnerships with other governments and offering to use our capabilities in that area to identify and exploit new oil finds all over the world. While some such deals exist — with Nigeria and Brazil, to name two — there is a case to be made for being more aggressive and emulating the Chinese in this context. Third, if we are going to live with fuel subsidies for some time to come — we may be able to do away with most and just keep those necessary for the poorest sections of the society — why not subsidise alternative fuel technologies? There are many who suggest that we can be more enterprising and move beyond carbon development mechanisms and other band-aid solutions to climate change, and focus on moving away from fossil fuel-based technology over the next few decades. That would be both environmentally responsible and forward looking. Another option could be liquefying coal, of which there are abundant supplies. The world over, crude oil prices are moderating. “To tackle under-recoveries we are hoping global prices will correct,” says Bhide. Perhaps. But it appears unlikely. Instead, it might be worthwhile to emulate Albert Einstein’s thought experiments: devices of the imagination to prepare for what we might need to do when oil does reach $200 a barrel.   With inputs from Puja Mehra srikanth.srinivas@abp.in (Businessworld Issue 10-16 June 2008)  