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

Jaitley may end up doing a Chidambaram to meet fiscal deficit target

P-CHIDAMBARAMVivek Kaul 

In yesterday’s column I had explained how the fiscal deficit of the government of India between April and October 2014 was at its highest level since 1998. Fiscal deficit is the difference between what a government earns and what it spends.
This despite the fact global oil prices have been falling for a while now. This has not helped the government primarily because like his predecessors the current finance minister Arun Jaitley also assumed a low oil subsidy number at the time he presented the budget in July 2014.
When the previous finance minister P Chidambaram presented the budget for the financial year 2013-2014, he assumed that Rs 65,000 crore would be spent towards oil subsidy. The actual number came in at Rs 85,480 crore, which was 31.5% higher.
This has been standard operating procedure for finance ministers over the years, where they start with a low oil subsidy number at the beginning of the year and end up spending much more by the time the year ends. What this does is that it makes the fiscal deficit number look more respectable at the time the budget is presented.
Jaitley did the same thing as his predecessor by assuming that oil subsidy for the year would work out to Rs 63,426.95 crore. This despite the fact that subsidies worth Rs 35,000 crore which were to be paid in 2013-2014, had been postponed to this financial year. So, in effect Jaitley only had a little more than Rs 28,400 crore to play around with on the oil subsidy front.
Oil prices started falling a few months back. This wasn’t known at the time the budget was presented in July earlier this year. In the budget it was assumed that oil prices
would average at $110 per barre during the course of this financial year. As on December 10, 2014, the price of the Indian basket of crude oil stood at $63.16 per barrel.
Given that, Jaitley assumed a lower number to start with, the government is not going to benefit on the fiscal deficit front, due to a fall in oil prices. As Neelkanth Mishra and Ravi Shankar of Credit Suisse write in a recent research note titled
2015 Outlook: Growth at any price?: “The…budgeted amount for fuel subsidies (Rs 63,400 crore, 0.5% of GDP)…may not change much for financial year 2014-2015, as Rs35,000 crore of the oil subsidy is already spent.”
The analysts also wrote that there won’t be much change in the fertiliser subsidy amount of close to Rs 73,000 crore, as well. Mishra and Shankar write that “it will be difficult for the government to reduce food subsidies”.
Given this, Jaitley isn’t really in a position to cut down subsidies. What he will have to do is to start cutting down on plan expenditure, like Chidambaram had done. As I had explained in yesterday’s piece, the government expenditure is categorised into two kinds—planned and non planned. Planned expenditure is essentially money that goes towards creation of productive assets through schemes and programmes sponsored by the central government.
Non-plan expenditure is an outcome of planned expenditure. For example, the government constructs a highway using money categorised as a planned expenditure. But the money that goes towards the maintenance of that highway is non-planned expenditure. Interest payments on debt, pensions, salaries, subsidies and maintenance expenditure are all non-plan expenditure.
As is obvious a lot of non-plan expenditure is largely regular expenditure that cannot be done away with. The government needs to keep paying salaries, pensions and interest on debt, on time. These expenses cannot be postponed. Hence, the asset creating plan expenditure gets slashed.
This is what the previous finance minister Chidambaram did in 2012-2013 and 2013-2014. In 2012-2013, he had budgeted Rs 5,21,025 crore towards plan expenditure. The final expenditure came in 20.6% lower at Rs 4,13,625 crore. In 2013-2014, the plan expenditure was budgeted at Rs 5,55,322 crore. The final expenditure came in 14.4% lower at Rs 4,75,532 crore.
This helped Chidambaram to cut down on the overall government expenditure majorly. Jaitley will have to do something similar, if he wants to achieve the fiscal deficit target of Rs 5,31,177 crore or 4.1% of GDP, that he has set.
As economists Taimur Baig, and Kaushik Das of Deutsche Bank Research write in a recent research note titled
India 2015 Outlook: Turning the cycle and structure around: “The government’s 2014-2015 fiscal deficit target of 4.1% of GDP will likely be achieved, but by cutting capital expenditure for the third straight year in a row. We estimate that the government will have to cut capital expenditure by at least Rs 70,000 crore…to make up for the significant shortfall in tax collection and disinvestment target.”
Supporters of Jaitley say that Chidambarm left him with unpaid bills of more than Rs 1,00,000 crore. Fair point. But Jaitley knew about this at the time he presented the budget. So, what stopped him from taking these unpaid bills into account while presenting the budget earlier this year?
If he had done that he wouldn’t have been able to present a fiscal deficit number of Rs 5,31,177 crore or 4.1% of GDP. The number would have been much higher. Nevertheless, that would have been the real fiscal deficit number, instead of the unrealistic and fictional number that was presented at the time of the budget. It is not surprising that Jaitley will have a tough time in meeting this number.
As I said in yesterday’s piece, the first step towards solving a problem is acknowledging that it exists. Jaitley and the BJP had an excellent opportunity to do this. And they let that go.
Another reason for the government to worry is the disinvestment target of Rs 58,400 crore. With basically three months left for the financial year to get over, the disinvestment of shares that the government owns in government and non-government companies has barely started.
As Baig and Das point out: “We expect the government to rely on disinvestments as a key source of revenue to reduce the fiscal deficit, but as seen from this year’s experience, there is no guarantee that such a strategy would work. Further, trade union activism could come in the way of the government pursuing an aggressive disinvestments/privatization agenda, which then will likely put pressure back on expenditure compression (particularly capital expenditure) to achieve the headline fiscal deficit target.”
Also, what does nothelp is the fact that growth in tax collections is nowhere near what had been assumed initially. The direct taxes (corporation and income tax primarily) were assumed to grow at 15.7%, in comparison to the last financial year. They have grown at only 5.5% between April and October 2014.
The indirect taxes (customs duty, excise duty and service tax) were supposed to grow at 20.3%. They have grown by only 5.9%
The situation clearly does not look good. And given that finance ministers do not like to miss targets they set, it is more than likely that Jaitley will now do a Chidambaram and slash asset creating plan expenditure majorly in the months to come. In fact, the plan expenditure for the first seven months of the financial year fell by 0.4% to Rs 2,66,991 crore.
As the old French saying goes: “
plus ça change, plus c’est la même chose. The more things change, the more they remain the same.

The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on Dec 12, 2014

Despite low oil prices, India may not gain much. Here’s why

oil

Vivek Kaul

Oil prices have been falling for a while now. The price of the Indian basket of crude oil as on December 10, 2014, stood at $63.16 per barrel. At the beginning of this financial year, as on April 1, 2014, the price had stood at $104.56 per barrel. Hence, prices have fallen by close to 40% since then.
Analysts expect that oil prices will continue to remain low in 2015. In a report titled
2015: It Likely Gets Worse Before It Gets Better analysts at Morgan Stanley give three possible scenarios for the price of oil. In the worst possible scenario they expect the price of oil to touch $43 per barrel in the second quarter of 2015 (i.e. the period between April and June 2015).
As the Morgan Stanley analysts write: “ With OPEC on the sidelines, oil prices face their greatest threat since 2009…Without intervention, physical markets and prices will face serious pressure, with 2Q15[April to June 2015] likely marking the peak period of dislocation.”
As I have explained on previous occasions the Saudi Arabia led Organization of the Petroleum Exporting Countries(OPEC) is interested in driving down the price of oil to ensure that shale oil firms operating in the United States and Canada become unviable. This is why OPEC hasn’t cut oil production majorly in recent months, even though oil prices have fallen dramatically.
The conventional thinking is that a fall in oil prices will benefit India tremendously. A major reason for the same is that India imports nearly four fifths of the oil that it consumes. Hence, a fall in oil prices will mean that there will be lower oil imports and this will mean a lower trade deficit (i.e. the difference between imports and exports).
Further, lower oil prices will also mean lower inflation and a lower fiscal deficit for the government. Fiscal deficit is the difference between what a government earns and what it spends. In the years gone by, the government did not allow the oil marketing companies to sell diesel, cooking gas and kerosene oil, at a price that was viable for them. The government compensated these companies for a part of the under-recoveries.
This led to the government expenditure shooting up which pushed up the fiscal deficit. While this sounds good in theory, things are not as straightforward as they are made out to be. Neelkanth Mishra and Ravi Shankar of Credit Suisse discredit this argument in their recent research report titled
2015 Outlook: Growth at any price?
Let’s look at these points one by one.
The government had budged Rs 63,426.95 crore as oil subsidy for this financial year. This as always has been the case in the past was a very optimistic assumption, given that a significant part of the oil subsidies for the last financial year were unpaid. The oil subsidies that had not been paid for during the course of the last financial year amounted to Rs 35,000 crore. This has been paid from this year’s budget. Given this, despite a dramatic fall in oil prices there isn’t going to be a huge impact on the fiscal deficit. If oil prices continue to remain low during the course of the next financial year (April 2015 to March 2016) it will benefit the government on the fiscal deficit front, feel the Credit Suisse analysts.
What about inflation? Petrol and diesel together make up for around 2% of the consumer price index. Over and above this, the government has raised the excise duty on petrol and diesel twice in the recent past. This has reduced the “passthrough to consumer prices”. Hence, consumers haven’t benefited as much as they should have.
Further, “LPG[domestic cooking gas] and kerosene, which have higher weights[in the consumer price index],are still subsidised, so the fall in crude will not directly impact retail prices,” write Mishra and Shankar.
Now let’s look at the trade deficit or the difference between imports and exports. Oil imports in the month of October 2014 fell by 19% to $15.2 billion in comparison to the same period last year. Despite this, the overall trade deficit for the month rose to $13.3 billion from $10.6 billion a year ago.
Why is that the case? With global growth slowing down, exports slowed down by 5% to $26 billion. Further, India seems to have rediscovered its appetite for gold with gold imports rising by 280% to $4.17 billion from $1.09 billion in October 2013.
So, despite falling oil prices India may not gain much immediately. Also, falling oil prices mean lower incomes for oil exporting countries and this will slow down their consumer demand, which will have an impact on Indian exports.
Professor Eswar Prasad of Cornell University
explained this in an interview to CNBC. As he said: “Right now if oil goes to USD 65 or even slightly lower it is not a big negative but it does imply that there is going to be a lot of weakness in external demand and countries in Latin America like Venezuela which already have a very difficult situation, emerging markets like Russia and of course the Middle Eastern countries plus some of the European economies like the UK and Norway that rely on oil exports to a significant extent are going to be facing fairly difficult situations. This will affect their budgets and their current account balances which in turn will affect their consumption demand. So, softness in consumption demand is ultimately not good for anybody in the world including India.”
Neelkanth Mishra of Credit Suisse also made a similar point
in an interview to The Economic Times. Mishra’s argument was that if oil exporting countries earn lower, their sovereign wealth funds will invest a lower amount of money in other countries, including India.
As he said: “Further, capital flows get impacted, too — if you look at the sources of funds that invest in India, it’s primarily the sovereign wealth funds (SWFs), the pension funds and the insurance funds. If Norway, Saudi Arabia, Abu Dhabi, Qatar, or Kuwait are not going to see the kind of surpluses that they used to then they will have less capital to send out, which will mean that capital flows into India will not be as strong as they were.”
Norway, Abu Dhabi and Saudi Arabia run the three biggest sovereign wealth funds in the world.
To conclude, what these points clearly tell us is that a fall in oil prices will not benefit India as much as it is being made out to be.

The article originally appeared on www.FirstBiz.com on Dec 11, 2014

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

Of BJP and Congress: Why governments hate markets

light-diesel-oil-250x250Vivek Kaul

Over the years I have come to the conclusion that governments don’t like markets. Markets are too unpredictable for their taste. And they don’t do what the government wants them to do. They don’t move in directions the government wants them to. In short, markets can’t be controlled. Or to put it even more simply, markets have a mind of their own.
And no government likes that.
Hence, when the diesel price was decontrolled in October earlier this year, I had my doubts about how long will it last. The
finance minister Arun Jaitley had said on that occasion “Henceforth, like petrol, the price of diesel would be linked to the market and therefore depending on whatever is the cost involved …the consumers will have to pay.”
At times things sound too good to be true. This was one of those statements. And now only a few weeks later, the government has sideline the market and decided to go about setting the price of petrol and diesel.
Earlier this week on December 2, 2014, the government decided to raise the excise duty on petrol and diesel. This was the second time the government increased the duty in less than a month. The excise duty on petrol was increased by Rs 2.25 per litre and that on diesel by one rupee per litre.
This increase in duty will not be felt at the consumer level. Nonetheless, if the government had not decided to increase the duty it would have meant that consumers would have benefited from a further fall in the price of petrol and diesel. Hence, the government is essentially creaming off the consumer surplus.
This also explains why the price of petrol and diesel in India hasn’t fallen as much as the global oil prices have. And that means the petrol and diesel prices are no longer linked to the market, as Jaitley would have had us believe only a few weeks back.
As an editorial in the Business Standard points out: “If the government is forcing the oil marketing companies to set prices according to the dictates of political masters, then it can hardly claim deregulation has happened.”
The government is having a tough time meeting its expenditure and this is a very easy way to raise its income. The fiscal deficit for the first seven months of this financial year (April to October 2014) was at 89.6% of the annual target. Last year during the same period, the number was at 84.4%. Fiscal deficit is the difference between what a government earns and what it spends.
Hence, if the government has to meet its fiscal deficit target it has to increase its income or decrease its expenditure or possibly do both.
An editorial in The Indian Express points out that the two hikes in excise duty, will help the government earn an additional Rs 10,000 crore. This should come as a welcome relief for the government given that estimates now suggest that indirect tax collections will see a shortfall of around Rs 90,000 crore in comparison to what had been assumed at the time the budget was presented in July this year.
The editorial goes on to suggest that instead of increasing the excise duty the government could have levied a cess and collected that money to go towards a specific purpose like a national highway fund. But that hasn’t happened and the increase in the excise duty will just disappear into the consolidated fund of India.
But that’s just one part of the story. Every government has the right to increase or decrease taxes, after taking into account the situation that it is operating in. Nevertheless, if the government had allowed the market to operate, the oil marketing companies would have been allowed to pass on this increase in excise duty to the end consumer. The fact that they haven’t been allowed to do so means that the government is deciding on the price of petrol and diesel.
Further, now that the government has decided to set the price of petrol and diesel, it will be interesting to see what happens when the price of oil starts to go up again (That may not happen immediately with Saudi Arabia looking determined to drive down the price of oil to make US shale oil unviable, but its a possibility nonetheless).
The previous Congress led United Progressive Alliance(UPA) government did not allow the oil marketing companies to sell petrol and diesel at a price which was viable for them.
Instead, the government along with the upstream oil companies like ONGC and Oil India Ltd, compensated the oil marketing companies for their “under-recoveries”. This drove a huge hole into the government finances. The total oil subsidy bill during the period the Congress led UPA government ruled the country was a whopping Rs 8,30,000 crore. This along with other subsidies pushed up the government expenditure and in the process its fiscal deficit.
Once the government was borrowing more, it crowded out other borrowers as there was a lesser amount of money available for others to borrow. This pushed up interest rates. It also led to a rupee crisis between late May and August 2013, when the value of the rupee crashed against the dollar.
It had other repercussions as well. But before we get into that it’s important to repeat what Henry Hazlitt writes in
Economics in One Lesson: “We cannot hold the price of any commodity below its market level without in time bringing about…consequences. The first is to increase the demand for that commodity. Because the commodity is cheaper, people are tempted to buy, and can afford to buy, more of it.”
This is precisely what happened in India. The demand for diesel went up because for a very long period of time the government completely delinked diesel prices to international oil prices. Hence, there was a substantial difference between the price of petrol and diesel. This led to a huge market in diesel cars. Given this, rich consumers ended up consuming more than their fair share of diesel.
As Hazlitt writes in this context: “Unless a subsidized commodity is completely rationed, it is those with the most purchasing power than can buy most of it. This means that they are being subsidized more than those with less purchasing power…What is forgotten is that subsidies are paid for by someone, and that no method has been discovered by which the community gets something for nothing.” So, while the rich went around in their diesel cars, the nation ended up with a huge subsidy bill.
Like the Congress led UPA before it, the current BJP led National Democratic Alliance (NDA) has decided to set the price of petrol and diesel and not leave it up to the market. There will be great pressure on the government to hold back the price of petrol and diesel, once oil prices start to go up again. And that as we have seen can be disastrous for the economy. 

The article was published on www.equitymaster.com on Dec 5, 2014