Falling oil prices

Vivek Kaul

Oil prices have been falling for a while now and have now touched a four year low. As per the data published by the Petroleum Planning and Analysis Cell, the price of the Indian basket of crude oil touched $ 82.83 per barrel on October 16, 2014.
There are several reasons for the fall (You can read about them in detail here and here). Analysts expect this growth to continue to fall in the years to come. Several fundamental reasons have been offered as an explanation for the same.
As Crisil Research points out in a research report titled Falling crude, LNG, coal prices huge positive for India “Over the next five years, we expect global oil demand to increase by 4-4.5 million barrels per day (mbpd). However, crude oil supply is expected to increase by 8-10 mbpd. This, we believe, will bring down prices from current levels.”
This augurs well for India as falling oil prices will ensure that the under-recoveries suffered by the oil marketing companies(OMCs) on selling diesel, cooking gas and kerosene, will fall. The government has been compensating the OMCs for these under-recoveries. Falling under-recover will mean lower government expenditure leading to a lower fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
Analysts Harshad Katkar and Amit Murarka of Deutsche Bank Markets Research in a report titled Breaking Free point out that “Fuel subsidy could fall to an annual level of $7billion – a 70% reduction over financial year 2014 – by financial year 2020 and potentially reduce the government’s fuel subsidy burden to zero by 2021 driven by elimination of the diesel subsidy and rationalization of the cooking fuel subsidy.”
These arguments sound pretty good. The only problem is that predictions on which direction oil prices are headed invovle too many variables and predicting all these variables at the same time is not an easy thing to do.
On several occasions in the past, well renowned experts have ended up with eggs on their face while trying to predict the price of oil. In January 1974, the Organization of Petroleum Exporting Countries (OPEC) raised the price of oil to $11.65 per barrel. This was after OPEC’s economic commission had determined that the price of oil should be $17 per barrel.
It was around then that the economist Milton Friedman wrote in a column in the Newsweek magazine where he predicted that “the Arabs … could not for long keep the price of crude at $10 a barrel.”
By early 1981, the price of oil had risen to $40 a barrel. A spate of reasons including the politics of the Middle East were responsible for this rise. Other than the politics of the Middle East, in April 1977, the Central Intelligence Agency (CIA) of the United States had come up with a highly influential report which predicted that the growth of the world oil demand would soon outpace production.
This was primarily because of constraints on the OPEC production. The Soviet Union, another big oil producer, would reach its peak soon. This meant that by the mid-1980s, oil would become very scarce and expensive, the report pointed out.
Customers, including some of the biggest international oil companies, were queuing up to buy oil. The report succeeded in generating sufficient paranoia among the oil-consuming nations as well as the big oil-producing companies. Hence, they wanted to buy as much oil as they could.
All the doomsday predictions regarding the price of oil turned out to be wrong. By 1983, the average OPEC price had fallen to $28 per barrel leading to some members of OPEC offering additional hidden discounts in an attempt to boost their stagnating sales.
By 1986, the price of oil was quoting again at $10 a barrel, proving the CIA prediction to be all wrong. Milton Friedman, though, was right about the price in the end. And Friedman would write a “I told you so” column in Newsweek which appeared on March 10, 1986, titled “Right at Last, an Expert’s Dream.” This, of course, was in jest. As Friedman confessed, “Timing, as well as direction, is important…I had expected the price of oil to come down far sooner.”
What this tells us is that it is very difficult to predict the long term direction of the price of oil. One reason why oil prices have not risen in the recent past despite the rise of Islamic State of Iraq and Syria (ISIS) is because the outfit has not been able to move into the southern part of Iraq where a major part of the country’s oil is produced. Southern Iraq is dominated by the Shias who do not support the ISIS.
Then there is the so called deal between Saudi Arabia and the United States, where the ruling dynasty of Saudi Arabia is believed to have engineered a fall in the price of oil so as to ensure that the security guarantee that they have from the United States, continues.
The trouble is that with the price of oil now lower than $85 a barrel, the shale oil boom that is happening in the United States and Canada, might not be able to continue. Shale oil is expensive to produce and it is financially viable only if the price of oil remains at a certain level. As analysts of Bank of America-Merrill Lynch point out in a report titled Does Saudi want $85 oil? “With production costs ranging from $50 to $75/bbl at the well head, a decline in Brent crude oil prices to $85 would likely be a major blow to US shale oil players and lead to a significant slowdown in investment.”
The shale oil boom can lead to a situation where the United States no longer needs to depend on the Middle East and other countries to meet its oil needs. Hence, to some extent it is in the interest of the United States that oil prices continue to fall. At the same time, one reason that dollar continues to be the international reserve currency is because oil continues to be bought and sold in dollars.
Saudi Arabia over the years has cracked the whip among the OPEC nations to maintain a status quo on this front. It is in the interest of the United States that the dollar continues to be the international reserve currency. While every country in the world needs to earn dollars, the United States can simply print them.
And to ensure that dollar continues to be a reserve currency, the United States, needs Saudi Arabia on its side. The Saudis currently would prefer a lower price of oil, in order to make the production of shale oil unviable. At the same time they would like the security guarantee they have from the United States to continue, in order to protect them against the ISIS.
As the Bank of America-Morgan Stanely analysts point out “It should perhaps not come as a surprise that the threat of a stateless group that challenges the status quo by attempting to redraw national borders is shifting incentives for key regional and global players…The Islamic State could present a direct threat to the Arab monarchies at a time of growing social discontent…In our view, Saudi and other regional rulers may prefer to re-engage the US to help protect established borders from the expanding caliphate. What could Arab countries offer the West to help contain this threat? Lower oil prices.”
This issue is too complex to make a prediction on. Nevertheless it will have a huge impact on the direction in which oil prices will go in the years to come. Further, the chances of the current turmoil in the Middle East escalating, still remain. As Milton Ezrati writes in a piece titled ISIS, Oil, and the Economy on Huffington Post “There is no mistaking the huge remaining importance of Persian Gulf supplies. If the turmoil there were to take a significant portion of this output off line suddenly, the world would be hard pressed to replace it, and prices would rise with all their ill effects.”
He further points out that “the Persian Gulf itself is also a choke point of no small significance in oil transport. The EIA reports that upwards of 35 percent of sea going oil and gas passes through the Gulf and the narrow Strait of Hormuz at its head. If Iran were to become further embroiled in Iraq’s problems or otherwise come to a confrontation with Western powers, the strait would close and the world would find itself without any of this still crucial supply.”
The price of oil is not just determined by the demand and supply equation. The politics of the Middle East and which side of the bed Uncle Sam wakes up from remain very important factors. For any analyst trying to predict the price of oil, taking all these “qualitative” factors into account remains very difficult.
To conclude, what are the lessons that we can draw from this. First and foremost we need to ensure that the price of diesel is decontrolled. And more than that we need to ensure that it continues to be decontrolled in the years to come, even if the global price of oil rises.

The article originally appeared on www.FirstBiz.com on Oct 18, 2014

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