The world`s top energy consumers must act quickly to control soaring oil prices before they trigger a global recession. According to experts, the situation regarding energy prices is becoming extremely challenging, if left un addressed, it may well cause a recession in the global economy.
Prof. M. Guruprasad / 11:20, Jun 27, 2008
Background
The world's top energy consumers must act quickly to control soaring oil prices before they trigger a global recession. According to experts, the situation regarding energy prices is becoming extremely challenging, if left un addressed, it may well cause a recession in the global economy.
Oil prices made their biggest single-day surge recently, soaring US$11 to US$138.54 on the New York Mercantile Exchange, an 8 per cent increase. On the same day, the United States announced a rise in unemployment. The burst higher, which also came on rising Middle East tensions, also raised the prospect of accelerating inflation by adding to already strained transportation costs. That gloomy outlook sent stocks tumbling, taking the Dow Jones industrials nearly 400 points.
The Indian Government has raised the domestic retail selling price of petrol, diesel, and domestic liquefied petroleum gas on June 4,2008, taking into account Indian basket prices at $113 a barrel. The global crude prices were holding above $123 a barrel inNew York Mercantile Exchange electronic trading on June 4. Apart from the price hike, the Government had also announced duty cuts, oil bonds, and higher upstream contribution to compensate the oil marketing companies, which were suffering heavy revenue losses for selling petroleum products below the cost price.
The Government of India announced an increase of Rs. 5 per liter in petrol, Rs. 3 per liter diesel prices and that of LPG by Rs. 50 per cylinder.Government explained that the price hike had become necessary to curb the losses of oil marketing companies. Many states have already slashed sales tax on petrol and diesel and VAT on cooking gas to cushion the impact of the hike on consumers.
Impact on the Indian Economy
The revenue loss for the fiscal was estimated at Rs. 2,45,000 crore. Had it not been for the increase, the three-state run oil firms BPCL, HPCL and IOC would have lost overRs. 245,000 crore in revenues this fiscal and would have run out of cash to import crude. States ruled by Left parties observed a shutdown, including two days in West Bengal, to protest the price increase.
India has somehow weathered the previous oil shocks, but the current one poses the worst threat yet to its economy. Oil price may soon move past $150 per barrel and as per some expert predictions, it will climb close to $400 per barrel by 2015. TheGovernment will need to do a lot of outside the box thinking to solve the catastrophe in the making.
The mind-boggling losses of Rs. 245,000 crore of the oil companies have to be made up if they are not to go bust. Raising the prices of petrol and diesel notionally is neither here nor there, and only puts off the evil day. Tentative tinkering will only mean the double jeopardy of the crisis continuing unabated and postpone the fires of inflation.
Persistently high oil prices will soon start putting plenty of pressure on the major economic systems of the world. The government has artificially maintained prices at a certain level and this has meant saddling the country’s oil companies with mounting losses. This cannot possibly continue. Quite apart from the short-term impact of high prices, there are crucial questions that need to be answered about the management of India’s economic future given our growing dependence on crude oil imports.
The final price that we pay for petroleum products is based on the import parity price of petrol and includes freight costs, customs, excise and various state government levies as well as the education cess.
Even after the hike, we are partially insulated from the increase in prices in the international market. That’s the burden the oil companies have to bear after thegovernment pays a part of the subsidy. If they don’t get the prices they seek, they will chalk up losses, since their input costs are going up with the rise in global prices.
But what will happen if the entire price rise is passed on? Household budgets will be affected. The immediate impact will be on fuel bills. Cooking will get more expensive with LPG cylinders costing more. So will commuting to work, sending children to school and traveling for holidays.
The increased transport costs will have a ripple effect as transporters pass on the hike to consumers. That will immediately push up the costs of agricultural products. Those prices may go up for another reason: diesel generator sets are increasingly used to pump water in fields. So expect the cost of fruits and vegetables and other non-processed food products to go up soon after.
Reasons for the Rising Prices
Increasing consumption in the United States, which accounts for 5 per cent of the world’s population but consumes 25 per cent of the oil produced globally. Meanwhile, oil is being pumped out at close to full capacity around the world. The global demand for oil grew at its fastest in three decades in 2005. A large proportion of this demand has come from India and China, whose economies have been growing at breakneck pace.
Add the politics of oil to this situation. Iran, the world’s second-largest producer of oil after Saudi Arabia, has been a source of worry because of the controversy surrounding its nuclear programme. Venezuela and, more recently, Bolivia are recasting their oil policies and this is stressing out western governments, multinational oil companies and oil traders. The fallout? Even higher prices.
Over the years a lot of the black gold has flown out of oil fields of the Middle East countries, but the oil reserves of these big exporters report has not shown any proportional fall.
As a result, some oil analysts have begun questioning the amount of reserves Saudi Arabia and others actually have, and this has made oil traders jittery and pushedoil prices northwards. Oil trading, and the speculation that drives it, has been making the situation worse.
Since the past few years, the US financial sector has begun to turn its attention from currency and stock markets to commodity markets. According to The Economist, about $260 billion has been invested into the commodity market -- up nearly 20 times from what it was in 2003.
Coinciding with a weak dollar and this speculative interest of the US financial sector, prices of commodities have soared globally. And most of these investments are bets placed by hedge and pension funds, always on the lookout for risky but high-yielding investments. What is indeed interesting to note here is that unlike margin requirements for stocks which are as high as 50 per cent in many markets, the margin requirements for commodities is a mere 5-7 per cent.
As oil is internationally traded in New York and London and denominated in US dollar only. Naturally, it has been opined by experts that since the advent of oil futures,oil prices are no longer controlled by OPEC ( Organization of Petroleum Exporting Countries). Rather, it is now done by Wall Street. This shift in the determination of international oil prices from the hands of producers to the hands of speculators is crucial to understanding the oil price rise.
In June 2006, when the oil price in the futures markets was about $60 a barrel, a Senate Committee in the US probed the role of market speculation in oil and gas prices. The report points out that large purchase of crude oil futures contracts by speculators has, in effect, created additional demand for oil and in the process driven up the future prices of oil.
What is interesting to note is that the US strategic oil reserves were at approximately 350 million barrels for a decade till 2006. However, for the past year and a half these reserves have doubled to more than 700 million barrels. Naturally, this build-up of strategic oil reserves by the US (of 350 million barrels) is adding enormous pressure on the oil demand and consequently its prices.
The global crude oil price rise is complex, equation (read economics and politics) theories of demand and supply. It is speculation, geopolitics and much more. And unless this truth is understood and the link broken, oil prices cannot be controlled.
Indian Oil Scene
India is dependent on imported crude for more than 70 percent of its requirement. In terms of refining capacity the country is self-sufficient and expect for LPG. No import is required for other products. However, because of the dependence on imported oil, the economy is vulnerable to any volatility in international oil prices. Consequent to deregulation of the oil sector form April 2002. Product prices were expected to be aligned to international prices on import parity basis and hence the prices were to increase or decrease with the fluctuations in international prices, however with the steep increase in oil prices, oil companies were finding it difficult to pass on the same to the customers.
Consumption growth
(MMT)
FY01
FY02
FY03
FY04
Diesel
38
36.5
36.6
37.3
(%) change
-3.9
0.3
1.9
Petrol
6.6
7
7.6
7.9
(%) change
6.1
8.6
3.9
LPG
7
7.7
8.4
9.3
(%) Change
10.0
9.1
10.7
Till the year 1998, the Indian Petroleum sector was controlled by the Administered Pricing Mechanism (APM), which provided the players with assured returns on capital employed. The APM necessitated that the prices of crude oil/products were fixed in a manner so as to assure returns (based on net worth/capital employed) to the exploration and production (E&P) companies, refiners and marketing companies.
The deregulation of the domestic petroleum industry, which was initiated in April 1998, broadly involved the following;
[*]Providing adjusted import parity prices to refineries
[*]Decontrol of all products with the exception of MS, HSD, LPG, SKO and ATF. ATF was subsequently freed from marketing controls with effect from April 1, 2001.
[*]Partial rationalization of the duty structure on petroleum products.
[*]Providing crude realizations indexed to international prices to the exploration companies.
[*]Introduction of the New Exploration Licensing Policy (NELP) in the upstream sector with the intention of inducing capital flows into the sector. The complete decontrol of the sector was proposed from April 2002.DECONTRODECONTROL STORY FINALLY UNFOLD
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In the Union Budget of FY2002 presented on February 28, 2002, the government finally announced deregulation of the petroleum sector. Key announcement included: -
[*]Administered Price Mechanism (APM) in the petroleum sector to be dismantled as on April 1, 2002
[*]The pricing of petroleum products to be market determined
[*]Issue of oil bonds to the oil companies concerned to liquidate the Oil Pool Account
[*]Private companies to be permitted in distribution subject to specified guidelines.
[*]A Petroleum Regulatory Board to be set up to oversee the sector.
[*]Subsidy on domestic LPG and PDS Kerosene to be provided in the Budget.
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With the administered price mechanism (APM) dismantled post March 2002, the marketing channel is open to private and foreign players. This has seen the competition increasing in the marketing front and the government owned players (On the marketing front there are four major companies HPCL, BPCL, IOC and IBP) are aggressively trying to increase their market share by providing value added services to the consumers.
The dismantling of the administered pricing mechanism means that oil companies are free to take independent decisions based on import parity and market forces in pricing of petroleum products rather than being governed by the dictates of the Government. The public sector oil companies have also to face a competitive marketing environment now.
As the oil industry moves into decontrolled era the oil companies will be free to set their prices linked to fluctuations in global crude prices. Before setting prices the oil companies will calculate the net overall impact of the free market on their margins. This will determine whether prices will move up, down or remain static. Due to freight costs, the prices in the hinterlands may be higher than in coastal areas, though the Government is trying to narrow any difference by using the market leader, Indian Oil Corporation, to determine the market prices. However, the rules of the game are expected to change dramatically when private sector oil companies enter the retail marketing. The pace of competition will pick up with the privatisation of HPCL and BPCL. Then retail prices could differ by 1-2 per
cent from company to company.
Once the initial dust of deregulation settles down and the oil companies figure out the market mechanism, consumers can expect fluctuations in the prices of petroleum products. Once private firms step in and set up their own marketing infrastructure and retail outlets, competition could even spur undercutting, which could only benefit the consumer. Domestic prices of petroleum products would be a reflection of increase or decrease in global prices plus freight and local taxes. Retail prices of petrol and diesel will vary from one place to another. Essentially, this would mean that coastal areas would have lower prices compared to inland locations, which would be saddled with additional freight.
Impact of Deregulation
During the first year of transition to a free-market economy for the oil sector, it has been a truly remarkable one. The scale and pace of changes witnessed by the industry since April 1, 2002, have been far greater than in the five preceding years put together.
Of course, some of the so-called changes, such as the freedom to marketing companies to set retail product prices, have been cosmetic - the Government still pulls the strings from behind the scenes. There is still the major issue of subsidies on liquefied petroleum gas (LPG) and kerosene, which the Government needs to address. With the upward spiral in global oil prices in recent months, the refining and marketing (R&M) companies are forced to bear a part of the subsidy, as the Government has refused permission to revise the retail prices of these two products. The freeing of product prices has seen the earnings of these companies jump within the first few years of dergulation.
Source : India Infoline