Posted by: Pradeep | July 16, 2008

Crude oil with its realities in world markets

If one thought that the credit crunch triggered by subprime market seemed to be passing, an ominous crisis in the escalation of oil prices seems to be looming. As the oil price keeps up its relentless climb, it threatens to be more damaging to the world economy than the credit crisis. Ever rising crude prices are throwing up new challenges to developing countries to contain their adverse effects on their economies. But before addressing them, it is necessary to keep in mind two important perspectives currently emerging on the likely continuance of such a high price regime.
  
Since a long time, prices of the physical barrel is determined more by the oil futures market and less by demand supply considerations. As the price is moving towards $150/bbl, analysts believe that at a conservative calculation, at least 60% of the price is estimated to come from unregulated future speculation by hedge funds, ‘gambling’ desks of banks and financial groups. Even pension funds have entered this market in preference to bonds and equities, to better their yields. They play in the London ICE Futures and New York Nymex futures exchanges and the uncontrolled inter-bank or over-the-counter-trading to escape scrutiny. In fact they have since long replaced Opec as price makers in the oil market.

The theory of peak oil — that the era of cheap oil has peaked and is on a downward slide — has helped perpetuate these uncontrolled price manipulations. Even the bogey of surging demand from China, etc., do not stand close scrutiny. An analyst at the JP Morgan Fund recently stated that growth of oil demand as a whole in the world is not that strong. US government’s Energy Information Administration (EIA) in its latest energy outlook reports that US oil demand is expected to decline by 190,000 b/d this year, mainly owing to deepening economic recession. The Chinese consumption, according to EIA, far from exploding, is slated to rise only by a modest 400,000 b/d — hardly a ‘surge’. In sum, a drop in US demand along with a very modest increase in that of China hardly dents the current oil production of the world of some 85-86 million b/d.

The second perspective is that the oil price rise is a classic case of a bubble and therefore bound to bust any day. Its characteristic is that prices become detached from market fundamentals. By no account is there a shortage of oil and every demand is being met. There are reports of Gulf being crammed with supertankers chartered by oil-producing governments to hold the oil they are pumping but cannot sell. In other words, there are few buyers for physical barrel at today’s prices, but there are plenty of buyers for pieces of papers (futures) linked to the price of oil next month or next year. This situation is very similar to the bubble in credit markets a year ago, where none wanted to buy subprime mortgage bonds, but plenty of demand for derivatives that allowed investors to bet on the future value of these bonds.

So what are our choices? If it is a bust, we will have a respite, but are we prepared for the continuing rise in prices? We were never prepared, but always resorted to the simple arithmetical solution of raising prices. No pricing strategy is seen in any of the price hikes done so far. Unless the fundamentals in the present pricing system are tackled, we will find ourselves helpless in all crises.

The present retail price build-up is totally flawed. It is not correct to administer the end price without similarly administering the other elements in the value chain. The import parity ends at the refinery, whereas actually it should have been at the retail end. This has led to unbridled addition of marketing expenses, without any norms or caps, as pass-through costs to consumers. It is partly helping to raise the bogey of underrecoveries. With the country now having achieved export capability in oil products, export parity price should ideally be the benchmark for compensating refineries.

The current price build-up also includes the equivalent of custom duties on domestic produce and then ad valorem excise is added, making the Indian consumer pay both duties, unheard of in any pricing system. The effective duty protection is still uncalled for and this should be zero for a country with export capability. As oil producing companies are also asked to bear part of the subsidy, the net price per barrel accruing to them should be taken as input cost to refineries. All these would immediately bring down the artificially jacked up selling price and along with it, the subsidies and the socalled under-recoveries. The total absence of a pricing strategy is clear from what happens to kerosene users now.

While making a political point in favour of the poor, it is thoughtless to ignore the ground reality of further incentivising adulteration without simultaneously putting in place a viable means of delivery. A price stabilisation fund also needs to be created, as long as prices are administered, through the imposition of a windfall tax on all oil producers, just like ONGC is asked to bear part of the subsidy burden. These are the minimum that should be done to remove the anomalous pricing system and insulate the economy from price fluctuations.

All the above at the most address only short and medium term issues. For a long term solution, there is no alternative but to free the entire sector from price management and create a vibrant competitive market. This entails removal of entry barriers, third-party access to key oil infrastructure like ports, terminals and tankages, so that more and more parties are encouraged to play under a truly independent regulator. We have examples of this in the telecom and aviation sectors. This alone will result in a proper price discovery, eliminating the huge wastages and inefficiencies now embedded in the PSU monopoly and cartelised prices, and give real choice to the consumer in terms of quality and price. Economic price for various fuels will get established which promote its efficient use.

The topmost priority ought to have been to reduce energy intensity, which alone is the sure solution to the problem, and not nuclear energy or any other source as is being touted, as long as we are profligate wasters of energy. But this important concept of energy efficiency is not a national priority and does not figure in any public debate.

It is obvious the remedies required are all well known and recommended by several expert committees over the past decade. But unfortunately, poor political leadership and its pandering to vested interests and crony capitalism have subordinated public interest to private corporate interests. Unless government refrains from outsourcing petroleum policy-making to favoured corporates, public interest will hardly prevail.

Adapted from TOI written by T. N. R. Rao

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