Month: January 2015

Falling oil prices: Modi and Jaitley should be thanking Saudi Arabia

narendra_modiVivek Kaul

Urjit Patel, one of the deputy governors of the Reserve Bank of India (RBI), recently explained the benefits of the dramatic fall in crude oil price for India. As he put it: “The dramatic fall in oil prices is a boon for us. It saves, on an annualised basis, around US$ 50 billion, roughly, one-third of our annual gross POL (petroleum, oil and lubricants) imports of about US$ 160 billion. This is on a back-of-the-envelope, top-line basis. Of course, there will be leakages and other set-offs. But our external situation undoubtedly improves. The welcome development enhances our disposable income (which will increase consumer demand for other goods and services), reduce input cost of our businesses (which will increase margins and help to enthuse investment demand), and aid government finances by reducing the energy subsidy burden in the budget.”
This paragraph needs a detailed discussion. On May 26, 2014, the day Narendra Modi took oath as the prime minister of India, the price of the Indian basket of crude oil stood at $108.56 per barrel. Since then the price of the Indian basket has fallen dramatically and on January 13, 2015, it stood at $ 43.48 per barrel.
Hence, the oil price has fallen by nearly 60% since the Modi government came to power. This, as Patel puts it, has led to a dramatic fall in our oil import bill. He goes on to say that it also increases our disposable income, which in turn will increase consumer demand.
The logic here is very straightforward—people will spend a lesser amount of money to buy oil products, and the money thus saved would be spent on other goods and services. Nevertheless, things aren’t exactly like that. The government hasn’t passed on the entire fall in the price of oil to the end consumer.
As mentioned above the price of the Indian basket of crude oil has fallen by 60% since May end. Nevertheless, petrol prices haven’t fallen by 60%. In Mumbai, the petrol price has fallen by around 14% since April 2014. The same logic stands true for diesel as well.
This has happened because the government has increased the excise duty on petrol and diesel thrice since October 2014, in order to shore up its revenues. The tax growth had been assumed to grow at 16.9% at the time the budget was presented, whereas the actual growth in tax collections between April to November 2014 has been around one-fourth of that at 4.3%.
Analysts Chetan Ahya and Upasana Chachra of Morgan Stanley estimate that the Modi government will collect nearly Rs 14,600 crore between December 2014 and March 2015 through the higher excise duty on petrol and diesel.
What this tells us is that the major benefit of the fall in oil price has gone to the government and has not led to the disposable income of the citizens going up majorly as suggested by Patel. I don’t see this increase in disposable income being big good enough to lead to an increase in the consumption of goods and services.
As author Satyajit Das points out in a recent research note titled Reverse Oil Shock: “While positive for public finances and economic efficiency, the diversion of the benefits from consumers to the government is contractionary, reducing the effect on growth.”
The index of industrial production (IIP) data suggests the same. IIP is a measure of the industrial activity in the country. When looked at from the use based point of view, for the period April to November 2014, the consumer goods number was down by 5.7% and the consumer durables number was down by 15.7%, in comparison to the same period last year.
Patel then talks about falling oil prices reducing the input cost of our businesses. This, he goes on to say, will increase margins and help to enthuse investment demand. Again this sounds very logical, but it does not take into account the biggest problem facing Indian businesses today, which is excessive leverage (i.e. very high debt).
In the Mid Year Economic Analysis, the Chief Economic Adviser to the finance ministry Arvind Subramanian pointed out: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.” This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing.
Hence, while a fall in oil price will help corporates, it can’t be a major driver in corporate investment picking up.
Now that brings us to Patel’s final point which is that a fall in oil prices will “ aid government finances by reducing the energy subsidy burden in the budget”. In this case the answer is slightly complicated.
In the budget presented by Arun Jaitley in July 2014, it was assumed that the total oil subsidies for this financial year would work out to Rs 63,426.95 crore. Jaitley was assuming a low number to start with, given that Rs 35,000 crore of oil subsidies hadn’t been paid for in the last financial year.
Hence, Jaitley only had around Rs 28,400 crore to play around with in the oil subsidy account.
With a massive fall in the price of crude oil, the oil marketing companies are no longer suffering any under-recoveries on the sale of petrol and diesel. Nevertheless, they do suffer under-recoveries on the sale of domestic cooking gas and kerosene.
Data released by the Petroleum Planning and Analysis Cell (PPAC) shows that in case of PDS(public distribution system) kerosene and cooking gas, the under-recoveries for the month of January 2015 will be Rs 19.46 per litre and Rs 235.91 per cylinder respectively.
The oil marketing companies need to be compensated for these under-recoveries. In fact, the under-recoveries for the first six months of this financial year were Rs 51,110 crore. This number is already higher than the Rs 28,400 crore that was left in the oil subsidy account. Given this, there can’t be any cut in oil subsidies that were budgeted for.
Nevertheless, as explained earlier, the government has raised excise duty on petrol and diesel thrice since October 2014, in order to shore up its revenues. And that would not have been possible if the oil price had not fallen.
Also, Modi and Jaitley should consider themselves lucky that the crude oil price has crashed by 60% since they came to power. If that had not been the case, then the amount allocated by Jaitely towards oil subsidies would have been wholly inadequate. This would have pushed up the fiscal deficit of the government. Fiscal deficit is the difference between what a government earns and what it spends. In fact, the fiscal deficit of the government is already at 99% of its annual target for the period between April to November 2014. This number has also been achieved only after a massive fall in oil prices.
Given this, Modi and Jaitley need to thank the Saudi Arabia led Organization for the Petroleum Exporting Countries(OPEC) which hasn’t cut production despite falling oil prices. This has driven down the crude oil price even further.
Saudi Arabia is doing this in order to ensure that it does not lose its market share in the global oil market. At the same time, it is trying to make things difficult for shale oil firms in the United States, which have suddenly started producing a lot of oil over the last few years.
As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. Only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range.”
In the past, the Saudi Arabia led OPEC had cut production in times of falling oil prices. But that has not happened this time around. In January 2014, the nations in the Persian Gulf were pumping out 23.41 million barrels of oil per day. By September 2014, this number had remained more or less constant at 23.49 millions barrels of oil per day, despite falling crude oil prices.
n fact, an AP newsreport points out that the energy minister of the United Arab Emirates, a member of OPEC, said yesterday that “there are no plans for OPEC to curb production to shore up falling crude prices, and instead put the onus on shale oil drillers for oversupplying the market.”
Nevertheless, it needs to be pointed out that the difference between supply and demand for oil is not huge. As Das writes: “The structure of the oil market entails fine margins between demand and supply. The current oversupply is around 2 million barrels a day.”
Data from the Energy Information Administration of the United States points out that the average daily production of crude oil between January and September 2014 stood at 77.17 barrels per day. In comparison to this, the difference between the oil supply and demand works out to 2.6% (2 million barrels expressed as a percentage of 77.17 barrels) of total global production.
Despite this small gap, oil prices have fallen by close to 60% since May. As Jensen points out: “even modest changes in the balance between supply and demand can have a dramatic impact on price, provided demand for, and supply of, the commodity in question is inelastic, and that is precisely the case as far as oil is concerned.”

The column appeared originally on www.firstpost.com on Jan 15, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek) 

Despite recent fall, oil prices will touch $100 per barrel again

light-diesel-oil-250x250Vivek Kaul

This column should complete the trilogy of columns on the price of crude oil. In yesterday’s column I had argued that it is difficult to predict which way the price of oil would go in the short-term, even though it seems that it will continue to remain low.
The more important question is which way the price of crude oil will go in the long term. While exact forecasting is risky business, the direction of the price rise can be predicted especially when structural factors are at work.
Nevertheless, before we get around to doing that, we first need to understand why is oil so important for the progress of human civilization. As Jeremy Grantham of GMO puts it in a newsletter titled The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose: “The quality of modern life owes almost everything to the existence of fossil fuels, a massive store of dense energy that for 200 years had become steadily cheaper as a fraction of income. Under that stimulus, the global economy grew ever larger.”
By fossil fuels Grantham means coal and oil. But what is it that makes oil so important? Grantham explains it through an example of one of his sons who is a forester. Grantham talks about a situation where wood is needed for heating purposes and hence, trees need to be cut. This can be done by hiring local labour who will use their axes to cut trees, and paying them a respectable minimum wage of $15 an hour. The other option is to fill a chainsaw with a gallon of gas and use that to cut trees.
As Grantham writes: “One of my sons, a forester, tells me he could cut all day, 8 to 12 hours, with a single gallon of gasoline and be at least 20 times faster than strong men with axes and saws, or a total of 160 to 240 man hours of labor. For one gallon!”
If people had to be hired to do the same job around $2,400 (160 x $15) to $3600 (240 x $15) would have to be paid. That’s the value created by one gallon(or 3.79 litres) of gasoline(or what we call petrol in India) which costs around $3 in the United States.
This “surplus value” created by gasoline and other petroleum products were a major reason which helped usher in the industrial revolution in the Western world. Before the world discovered fossil fuels it was totally dependent on wood from trees for its energy requirements.
As Grantham writes in another newsletter titled Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever: “[Wood]…was necessary for producing the charcoal used in making steel, which in turn was critical to improving machinery – a key to progress. (It is now estimated that all of China’s wood production could not even produce 5% of its current steel output!) The wealth of Holland and Britain in particular depended on wooden sailing ships with tall, straight masts to the extent that access to suitable wood was a major item in foreign policy and foreign wars. Even more important, wood was also pretty much the sole producer of energy in Western Europe.”
Other than being used for making charcoal, wood was also used to power steam engines and for heating purposes. What this meant was that forests were rapidly cut down for wood which was required to produce energy. “Not surprisingly, a growing population and growing wealth put intolerable strains on the natural forests, which were quickly disappearing in Western Europe, especially in England, and had already been decimated in North Africa and the Near East. Wood availability was probably the most limiting factor on economic growth,” writes Grantham.
If the world had not discovered first coal and then oil, it would have run out of trees by around 1850, estimates Graham. And there would have been other impacts as well. “By 1900 wars would have been fought over forests, and the population – without oil-intensive agriculture, both for growing and transportation – would have peaked out probably well under two billion and our species would indeed have had its nose pushed up against the limits of food,” writes Grantham.
That is the importance that fossil fuels, in particular oil, have had on the human civilization over the last two hundred years. So, it is important that the world continues to have access to “cheap” oil. But will that be case?
As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “The world will still run out of cheap oil (cheap as in approx. $25 per barrel of production cost, as is currently the average production cost in the Middle East) over the next decade or so. It is hard to predict exactly when, because OPEC members are not the most informative people in the world.”
This, despite the fact that over the last six to seven years the world has managed to increase the production of shale oil. In the United States oil production has gone up by 4 million barrels per day to 9 million barrels per day and almost all of it has come through shale oil production.
Even with this, the future does not look very encouraging. And there is a reason for the same. As James K. Galbraith writes in The End of Normal: “There is no doubt that shale is having a strong effect on the American economic picture at present…But the outlook for sustained shale…production over a long time horizon remains uncertain, for a simple reason: the wells have not existed long enough for us to know with confidence how long they will last. We don’t know that they won’t; but also we don’t know that they will. Time will tell, but there is the unpleasant possibility that when it does, the shale gas miracle will end.”
Grantham goes into detail about the point that Galbraith makes. The process used to drill out shale oil is referred to as fracking. As Grantham points out: “The first two years of flow are basically all we get in fracking…Because fracking reserves basically run off in two years and can be exploited very quickly indeed by the enterprising U.S. industry, such reserves could be viewed as much closer to oil storage reserves than a good, traditional field that flows for 30 to 60 years.”
Hence, shale oil will be what Jensen calls a “relatively short-lived phenomenon”. It is not replacing cheap traditional oil which is becoming more and more difficult to find. “Last year for example, despite spending nearly $700 billion globally – up from $250 billion in 2005 – the oil industry found just 4½ months’ worth of current oil production levels, a 50-year low!,” writes Grantham.
Hence the oil industry in the “last 12 months” has replaced “only 4½ months’ worth of current production!” This, despite the boom in shale oil production.
What this clearly tells us is that the recent fall in the price of oil is at best a temporary phenomenon. Over the long term, oil prices can only go up. As Jensen puts it: “we will see the oil price at $100 again, and it won’t take many years, but it could be an extraordinarily bumpy ride.”
Meanwhile,watch this space.

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 14, 2015

Oil in the 40s: Falling oil price has several negative effects as well

oil

Vivek Kaul

The price of brent crude oil fell by 5.65% yesterday (January 12, 2015) to close at $47.43 per barrel. Many experts who follow oil closely have talked about how a fall in the price of oil will be beneficial for the world at large. The logic is straightforward.
Most countries do not produce all the oil that they consume. Hence, they need to import oil. A fall in the price of oil means that these countries will pay a lower price for oil and in turn petroleum products like petrol, diesel etc.,will become cheaper. This means that citizens of these countries will have more money to spend on other things, which, in turn, will benefit businesses.
There are various estimates about how much this benefit will amount to for oil consuming countries. As Niels Jensen writes in The Absolute Return Letter for the month of November 2014, titled Snail Trail Vortex: “A $20-per-barrel drop in oil prices transfers $6-700 billion from oil producing nations to consumers worldwide or nearly 1% of world GDP. Assuming consumers will spend about half of that on consumption, which historically has been a fair assumption, the positive effect on GDP in consumer countries is c. 0.5%.”
Author Satyajit Das in a recent research note titled The Reverse Oil Shock makes a similar assessment, when he writes: “A US$ 40 fall in oil prices equates to an income transfer of around US$1.3 trillion (around 2 percent of global GDP) from oil producers to oil consumers. A sustained 10 percent cut in the oil price is generally assumed to increase global GDP by 0.20 percent per annum.”
The price of oil has fallen by around $60 per barrel since end of May 2014. Using the numbers provided by Jensen and Das, we can conclude that an income transfer of around $2 trillion will happen from oil producers to oil consumers.
This money when spent by citizens of oil consuming countries will lead to economic growth. This is a straightforward conclusion that can be drawn from this data to the condition that governments of oil consuming countries pass on the benefits of low oil prices to their citizens.
But this hasn’t happened everywhere in the world. As Das writes: “A number of governments, such as Indonesia and India, have taken the opportunity presented by low prices to reduce fuel subsidies. While positive for public finances and economic efficiency, the diversion of the benefits from consumers to the government is contractionary, reducing the effect on growth.”
The Indian government has increased the excise duty on petrol and diesel thrice since October 2014, in order to shore up its revenues. There are several other negative effects of a low oil price. The world at large is still in the process of coming out of a huge debt binge and hence, will use the money saved from the low oil price to repay debt. As Das writes: “A significant overhang of debt, employment uncertainty and weak income growth may result in the transfer being saved or applied to reducing borrowings, reducing the boost to consumption and growth.”
Further, with falling oil prices the amount of money being spent on “energy exploration, development and production,” will come down. “One estimate puts the decrease in investment spending as a result of the fall in prices at almost US$1 trillion. This entails the deferral or cancellation of deep water, arctic oil, tar sands and shale projects as well as further investment in mature fields such as the North Sea projects, which require high prices to be economically viable,” writes Das.
This can’t be good for energy security over the long term. A newsreport suggests that there has already been a drop of  “almost 40% in new well permits issued across the United States in November.”
A major reason for a fall in oil prices has been the massive amount of shale oil being produced in the United States. Oil production in the United States has jumped by 4 million barrels per day since 2008. Almost all of this increase in production has come from an increase in production of shale oil.
Shale oil is expensive to produce and much of it is only viable if oil prices remain higher than $70 per barrel. As Jensen puts it: “A high percentage of the industry breaks even with an oil price in the $55-65 range…With an oil price around $50, oil producers could go belly up, left right and centre.” This can’t be good news for the United States because shale oil companies have been a major reason behind the job boom in the United States. And if they start shutting down, this will have an impact on job creation, which will in turn have an impact on consumer spending and US economic growth.
The United States is the shopping mall of the whole world and if consumer spending slows down, it will have an impact on many exports of many countries.
Further, the oil exporting countries are losing out because of lower oil prices. “Many oil producers are now fiscally profligate, using strong oil revenues to finance ambitious public spending programs or heavily subsidise domestic energy costs. Lower oil prices will force these governments to curtail programs and subsidies or increase debt, which might reduce the positive effects on growth,” writes Das.
These countries are now in a major problem. Saudi Arabia leads this pack and is now forecasting the biggest fiscal deficit in its history. Fiscal deficit is the difference between what a government earns and what it spends. The deficit for 2015 is expected to amount to $38.6 billion and was recently announced on state television. The Saudis can ride through this because they have a huge amount of foreign exchange reserves amounting to over $700 billion. Other oil exporters are not so lucky.
Nevertheless Saudi Arabia has plans to limit wage growth. As a Bloomberg report points out: “The Finance Ministry said the government will continue to invest in areas such as education and health care, while exerting “more efforts” to curb spending on wages and allowances, which make up about 50 percent of spending.” This can’t be good for global economic growth.
What all these points suggest is that there are many negative impacts of falling oil prices, which are not being highlighted at all.

The article originally appeared on www.firstpost.com on Jan 13, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Short-term crude forecasts are, well, crude forecasts

oilVivek Kaul

“The only function of economic forecasting is to make astrology look respectable.” – John Kenneth Galbraith

In response to yesterday’s column a journalist friend asked “where do you see the price of crude oil heading in the days to come?”. A perfectly innocent question which does not have an easy answer.
First and foremost it is important to understand why the price of crude oil has fallen in the recent past. One explanation lies in the fact that the demand for oil has not risen at the same pace as it had in the past.
As Satyajit Das author of Extreme Money writes in a recent research note titled Reverse Oil Shock: “ Weak demand contributes perhaps 30-40 percent of the fall. In 2014, oil demand grew by around 500,000 barrels per day, below the 1.3 million barrels growth projected earlier, reflecting weak economic activity in Europe, Japan and emerging markets, especially China.”
At the same time this slow increase in demand has been met with an increase in the supply of oil. With high oil prices, other sources of oil like shale oil in the United States and oil from tar sands of Canada, have also become viable. As Das points out: “Increased supply contributes 60-70 percent of the decline. In a pattern reminiscent of earlier price cycles, several years of high prices and strong demand has encouraged new sources of oil supply to be brought on stream, causing the price to adjust.”
The production of US shale oil has gone up by 4 million barrels per day since 2008. This has led to a situation where the United States produces 9 million barrels per day of crude oil, only around a million barrels lower than Saudi Arabia.
Also, oil from other traditional oil producing countries like Libya has also hit the market in the recent past. Libyan oil production increased by around 800,000 barrels per day after the “reopening export terminals following a truce agreed between tribal militias in the civil war”.
To add to all this has been the decision of the Saudi Arabia led Organization of the Petroleum Exporting Countries (OPEC) not to cut production with the fall in oil prices, as it has done in the past. It needs to be pointed out that Saudi Arabia has been a swing oil producer in the past, where it has either increased or decreased its production to ensure that global supply of crude oil equals its demand.
But that hasn’t happened this time around as Saudi Arabia hasn’t cut production. Why is that the case? On the previous occasions Saudi Arabia cut production it ensured that crude oil prices continued to remain high and in turn, benefited other countries.
As Das writes: “In the mid-1980s, Saudi Arabia cut its output by close to 75 percent to support weak prices. The Saudis suffered a loss of revenues and also market share. Other OPEC members and non-OPEC producers benefited from higher prices. In recent years, Saudi Arabia has regained market share, benefiting from the disruption to suppliers such as Iran, Iraq and Libya.” And given this, the Saudis are not in the mood to hand over their market share to other countries.
Hence, they would rather hold on to their market share than cut production and sustain a higher crude oil price. Also, shale oil is expensive to produce and by driving down the oil price Saudi Arabia is trying to make the entire shale oil business unviable.
As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. Only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range.”
Brent crude oil is currently quoting at around $50 per barrel. If crude oil continues to sell at $50 per barrel or lower, it is for sure that US shale oil producers will go bankrupt in the days to come. As Jensen puts it: “OPEC (with Saudi Arabia in the driving seat) may exhaust itself and decide that enough is enough, or it may go for broke – in this case it would want U.S. shale producers to go bankrupt and exit the industry forever which, we note, is quite likely to happen, should the oil price stay at current levels or lower for any extended period of time.”
The trouble here is that this assumes that the United States will sit back and do nothing. But as history has shown the politics of oil is never so straightforward. As I had pointed out in yesterday’s column the shale oil companies have been major job creators in the United States.
As analyst Jawad Mian points out in the Stray Reflections newsletter for January 2015: “It is undeniable that the oil and gas sector has become a key driver of US economic activity…It has been responsible for about 30% of the 10 million national increase in jobs since the global financial crisis.” Oil companies have been major job creators in the states of Alaska, Texas, Pennsylvania, North Dakota, Colorado, West Virginia, Wyoming, Oklahoma and Montana.
Given this, chances are that the US political establishment will not sit back and watch if shale oil firms start shutting down. “It is now a highly political chess game and, as I have learned over the years, when politics enter the frame, logic goes out the window,” writes Jensen.
At the same time the shale oil firms are politically very well connected in the United States. This can be made out from the way the shale oil firms are allowed to operate. As Jeremy Grantham writes in the GMO Quarterly Newletter for the third quarter of 2014: “There are few if any constraints, for example, on what chemicals and in what amounts, can be pumped into a fracking well. Nor is the leakage of methane (natural gas) from the drilling and pipeline operations seriously monitored despite the fact that methane is over 86 times as potent a greenhouse gas, at a 20-year horizon, as CO2 is.”
This demonstrates the “the remarkable influence of the energy industry over the U.S. governmental process, if “process” is not too dignified a word,” writes Grantham. Grantham is one of the most well respected fund managers in the United States. And given what he says, the shale oil companies must already be working the United States government to do something about Saudi Arabia driving down the price of crude oil.
At the same time the US benefits from low oil price as well. “A number of U.S.-antagonistic countries around the world (think countries like Russia, Iran and Venezuela) will be seriously weakened as a result of lower oil prices, which will strengthen the position of the U.S. in global politics,” writes Jensen.
Low oil price also benefits the US consumers given that they have more money in their pocket to spend on other things. As Das explains: “Lower oil prices increase disposable income. The average US motorist spends around US$3,000 per annum on gasoline. US households may save around US$500 to US$600 a year. If this money is spent then it will boost growth. There are also indirect channels such as transport costs. It also affects agriculture, which is four to five times as energy intensive as manufacturing.”
Given this, it will be interesting to see how the US political establishment reacts to a fall in crude oil prices and that will to some extent determine where oil prices head in 2015, even though it seems that they will continue to remain low in the short term.
Further it is worth remembering that the price elasticity of crude oil is low especially in the short run. This means even a small disruption in supply can lead to oil price shooting up rapidly. As Das puts it: “The structure of the oil market entails fine margins between demand and supply. The current oversupply is around 2 million barrels a day, less than 2 percent of global consumption…Key uncertainties include weather conditions, unanticipated supply disruptions and geo-political factors.”

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 13, 2015