The Hindu Business Line : Where is world oil headed?

There are differences among specialists about which way oil prices will go. As past events have proved, to a large extent, the price level is determined by the expectations of the futures investor and, perhaps, to a smaller extent by the realities of the supply-demand situation. It remains to be seen which way the scales will tip.

IN MARCH, this column had quoted analysts who had alluded to a possible world crude price of around $60 a barrel, one of the main reasons behind the expectation being the channelling of hot money flows into the oil futures sector. Today, the price has hit the $65 a barrel level and talk has shifted to the $70 psychological benchmark.

As usual, there are differences among the specialists about which way oil prices will go from here, and whether the $70 level will be reached by the end of the year, or even sooner. As past events have proved beyond doubt, to a large extent, the price level is determined by the expectations of the futures investor and, perhaps, to a smaller extent by the realities of the supply-demand situation. It remains to be seen which way the scales will tip; at the moment, both are poised to push prices to even higher levels.

To take the oil futures aspect first, it is now a well-established fact that investors have found crude to be a good parking slot for funds because of the expectation that the supply situation will be tight in the period ahead resulting in higher returns. While this has been the trigger for hot money finding its way into the crude futures market, the enhanced flow of such funds have in turn led to futures prices rising, which in turn has kept intact the upward pressure on prices.

The only way in which the basic dynamics of this particular type of price increase can be effectively interrupted is when hot-money finds a more lucrative haven and is withdrawn from the crude futures market leading to a decline in demand and an easing in the pressure on prices.

An important variable in this scenario is the US interest rates, a relatively appreciable increase in which could result in funds flowing from the crude futures market to US investment instruments. As of now, this has not happened, which means that the upward pressure on crude futures prices will remain unabated for some more time, thus increasing the chances of the world crude price breaching the $70 a barrel.

Reverting to the `real' world, that is, the world of actual physical demand and supply of crude oil as opposed to that controlled by the "veil of money", most studies point to a very tight situation indeed, the general conclusion being that there is a knife-edge stability between demand and supply at the moment, an equilibrium which is waiting to be disturbed by the slightest movement on either the demand or the supply side.

Given the prevailing situation in the world economy today, the crucial variable is demand, the all-important question being whether the continuing growth in demand from the US and the newly-emerging economies such as China and India will outstrip the ability of the world's crude producers to fill in the required gap as and when the need arises to do so. If the capability is adequate, the effect on prices will be minimal; if not the effect could be magnified many times over.

Studies suggest that, despite the momentary dips in overall demand (such as the one that has just taken place), the secular direction is upward. Indeed, this is just what is to be expected as far as the international crude-demand scenario is concerned if both the established economies and their newly-emerging competitors maintain their current growth profiles. The issue then boils down to whether there is adequate supply of crude to meet this increased demand. If there is, prices will be under control, if not, they will rise, perhaps exponentially because of the speculative factor.

Significantly, there are very few authoritative studies on the world crude supply-demand economics which have said that there is an abundant supply of crude available to look after the incremental needs of the international economy. On the contrary, the burden of most findings has been that there is no spare capacity as far as OPEC is concerned that can look after the additional demand expected over the next few years. The scene is not promising either as far as the non-OPEC players are concerned, which leaves the current demand-supply picture skewed against the prospects of price stability in the years ahead.

Adding to the pressures fuelling a price increase are the reports which say that there are few new exploration and production projects in the pipeline which will increase crude supply in the future. On the contrary, existing centres of supply could falter which could have a serious impact on the existing `equilibrium' leading to exploding prices.

Take the case of Saudi Arabia, which is currently pumping around 10 million barrels a day into the world oil supply effort (that is around an eighth of total daily world supply). Some experts feel that this source of crude supply is becoming increasingly unstable because of two things: First, the indiscriminate use of existing capacity over decades leading to production wells being driven to the point of collapse and, secondly, the total absence of adequate replacements in the shape of new oil-wells.

To quote one report: "Dying oilfields are not an issue if others are discovered to replace them. No such luck in Saudi Arabia. In the past 35 years, all but one attempt to find oil outside of the eastern region of the country, where Ghawar and the other big fields are located, has been unsuccessful. Most of the fields were discovered in the 1940s, 50sand 60s. If these senior citizens falter, the import-dependent West would be in serious trouble".

The scenario described above does not mean that there will be a stable, linear increase in the world crude price which will take it past $70 and $75a barrel in no time. Far from it. Indeed, the immediate forecast is that prices may decline to around $55 and perhaps even lower by the end of August as demand for gasoline declines in the US. The important point, however, is to recognise that the band within which the price fluctuation is taking place is gradually shifting upwards, and that very soon the current $55-$60 range will be replaced by the $60-$65 band. In other words, even if the crude price were to dip to, say, $50 a barrel, it would no longer be treated as the normal price to pay for a barrel of oil. It would be seen to be a welcome aberration, a price much lower than the existing norm.

Certainly, world economic activity will not come to a grinding halt because of the crude price development, but costs are going to increase sharply, which will pose an increasingly difficult problem to overcome for heavily crude-imports dependent economies like, say, India. There is one school of thought which holds that the higher price of oil will automatically lead to more investments being channelled into oil exploration and production which, after a time period allowed for gestation of the projects concerned, would translate into additional crude supplies and more reasonable prices.

The big question mark is whether this very logical sequencing of price-increase and higher production still holds good today not least because of extra-economic factors, such as an `unfriendly' onshore environment, associated with oil exploration and production. There is in fact a growing body of oil analysts which feels that higher crude prices will not by themselves lead to substantially higher investments for exploration and production activity.

Where does all this leave an economy such as India, which has seen the value of its crude imports shoot up by around 50 per cent in the current year? Not in a comfortable situation at all, to say the least. Not only has the average price of the basket of crude which the country buys from the world market risen to nearly $59 a barrel from $38 in 2004-05 and $27 in 2003-04, the work on finding new sources of oil and gas has been far from satisfactory.

According to the parliamentary standing committee on petroleum and natural gas, "extensive exploration activities" are being carried out in only seven of the 19 basins taken up for such work.

What this means is that there is little hope for the economy to free itself from the shackles of crude imports in the immediate future which, among other things, is indirectly weakening the public sector oil marketing companies by harming their finances through a resurrected administered pricing mechanism for petroleum products.

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