Oil: cutting demand is the way out

Virendra Parekh (India Monitor)
Filed on July 8, 2008

IN UNDERLINING the concerns of the developing countries over high oil prices and roundly berating speculators for pushing them up, India's Finance Minister P Chidambaram made right noises at the Global Energy Dialogue in Jeddah on June 22. His suggestion for adopting a price band for oil, however, lacked realism and was unsurprisingly given a short shrift by oil producers.

If Chidambaram is worried over oil, it is understandable. With crude at $145 a barrel, India's oil import bill this year is expected to shoot up to $110-120 billion, up from $68 billion last year, pulling down the GDP growth to eight per cent from over nine per cent.

No doubt, his concerns are widely shared. Oil prices have now become the single biggest issue facing the global economy. The long-term negative impact of the sharp surge in oil prices far exceeds any effects of the sub-prime crisis.

High oil prices affect the poor disproportionately, and will increase global poverty. Unlike the credit crisis, it is not investment bankers but the man on the street who is feeling the pinch. The rise in prices from $70 to near $140 a barrel will alone transfer more than $2 trillion from oil consumers to producers. Countries and politicians can no longer afford the luxury of waiting for markets finding their own equilibrium.

It is generally agreed that a variety of factors have contributed to the surge in crude oil prices-market fundamentals, dollar weakness, geopolitical tensions and speculators, though not to the same degree.

The role of the first three is well recognised and widely commented upon. It must be said, however, all these factors taken together cannot explain what has happened over the last 12 months. How is it that oil prices were $70 a barrel in August 2007 and now they have doubled when there has been no dramatic change in demand or supply?

A major cause for the current pandemonium in oil prices lies elsewhere: in unregulated over-the-counter markets and futures trading in oil. There is ample evidence that large financial institutions, pension funds, hedge funds, etc, have channelised billions of dollars into commodity investments and commodity derivatives. It is common knowledge that these financial transactions are unregulated and highly opaque. The demand for oil generated by these funds is purely speculative demand.

But this rank speculation yields hefty profits. All you need to access these profits is nerve, a head for numbers, a large amount of ready-cash, and a gambler/robber baron's instinct to keep playing it for double or quits. The best part is that it takes less money in commodity futures trading, including oil, to put down a deposit, called 'margin money' in the trade. In equity futures one needs to pay 15 or 20 per cent as margin to buy a 'futures contract'. But in commodities, including oil, all it takes is five per cent.

So, if you had a million dollars to invest, you could, notionally speaking, buy oil futures worth $20 million. Of course, you'd need to have $20 million stashed away to cover your bet, if the chips do not fall your way on 'settlement' day. At the New York Mercantile Exchange (NYMEX), you need to buy a minimum Futures Contract for a 1,000 US barrels (42,000 gallons), or about $140,000 worth at $140 a barrel. But, you would only have to fork out $7000 up-front, before they hand you an option for 'One NYMEX Division light, sweet crude oil futures contract'.

An Indian oil speculator has it 10 times better. He can get into the action by purchasing a minimum lot of only 100 barrels of crude oil, through a broker like Religare, which consolidates 10 like-minded punters to buy one contract on NYMEX. To purchase a futures option like this, valued at Rs600,000 at the self-same $140 per barrel, you would need a mere Rs30,000 up front.

Next, you would learn that the crude oil futures market is traded for 30 consecutive months before going long for 36, 48, 60, 72 or even 84 months ahead. So, not only can you bet on oil prices going forward seven years ahead, but also for each one of those 30 consecutive months, using, if you like, just a single contract. Do you begin to see how you can keep oil prices high, especially if you can work in concert with a number of like-minded people?

Chidambaram, coming from a country where the government can impose price controls, ban exports and suspend trading at will, suggested a lower and upper price band at Jeddah. Most Opec members would have giggled into their sleeves at the suggestion had they not been too polite to react.

Oil producers cannot be expected to accept a ceiling on prices when the sky appears to be the limit. Speculators cannot be faulted if they buy into a commodity the price of which is expected to rise. The answer for consumers lies therefore not in pleading with oil producers for compassion, but in actively modifying the supply-demand equation.

Some steps are being taken to cool this red hot commodity and, though ignored by the market for now, will have an impact later. First, many big Asian consumers who earlier kept demand booming through price controls are finally changing course. India, Indonesia, Malaysia, Taiwan and now even China have hiked retail prices by 12-40 per cent and have plans for more hikes. That should cool demand in the second half of 2008. Consumers in these countries will now have to adjust to permanently higher fuel prices. Given the income profile in these countries, the impact on consumption should be far steeper than price hikes in the OECD economies.

Secondly, demand for petroleum products is already shrinking in the OECD, with gas demand in the US dropping by six per cent year-on-year. Demand for gas-guzzling SUVs has evaporated.

Thirdly, many countries are promoting research on alternatives such as bio-fuels, energy saving technologies, electrical or hydrogen-operated vehicles etc. As oil becomes costlier, its alternatives would become more viable.

On the supply side, Saudi Arabia has started pumping an additional 0.3 mb/day from its new Khursaniyah field, and this should rise to 0.5 mb/day next year. Brazil hopes to expand production by 0.54 mb/day in 2008. Azerbaijan, Russia, Kazakhstan and Canada will also increase production.

Even after adjusting for declining production from several old fields-the North Sea, Alaska and Mexico-total global production should pick up in the second half of 2008, just as higher Asian consumer prices begin to slow consumption. Refiners, including Reliance in India, have also been increasing their ability to process low-grade crude.

What about speculation? Speculative buying in futures is predicated not on current shortages but on expectations of sustained growth in future demand. If future demand is seen to be faltering in major consumer economies, speculative ardour of the bulls may be dampened and we may see a fast unwinding of long positions, leading to a crash in prices.

Meanwhile, we can expect legislative changes designed to reduce speculation in the commodity futures markets. The loophole that currently allows investment banks to be treated as commercial hedgers, rather than financial participants, could easily be plugged. Institutional investors may face the same prudential and disclosure norms that currently govern ordinary commodity speculation. The governments in the US and Europe could reconsider the tax-free status of investments in commodities by endowments and pension funds etc.

There is still hope for oil consumers if they work single-mindedly on changing the supply-demand equation and minimising the role of speculators.

ERROR: Macro /ads/dfp-ad-article-new is missing!
MORE FROM Business
MORE FROM Khaleej Times
CurrentRequestUnmodified: /apps/pbcs.dll/article?AID=/20120323/ARTICLE/303239998/1036 macro_action: article, macro_profile: , macro_adspot:
KT App Download
khaleejtimes app

All new KT app
is available
for download:

khaleejtimes - android khaleejtimes - ios khaleejtimes - HUAWEI AppGallery