The Global Oil Crisis - By Ashima Sekhri

For various people the word ‘Oil’ evokes different feelings. For some it evokes a pinch in the pocket at the thought of the petrol they fill in their cars. For some, it means the rising cost of vegetable in the street owing to rising cost of transport of the same. For others, it brings up the word ‘cartel’ and ‘OPEC’ in the same sentence. And for some, it simply implies Arabs in turbans living in lavish oil-money-funded palaces.

Every few days we read something or the other related to Oil and it affects us in some or the other way. Some times we blame the government, which in turn blames the Middle East, who in turn blame America! All in all, the average reader is more often than not confused as to what exactly goes on in the world of OIL and how it all pans out and ends up affecting all our lives in so many ways. This article will hopefully set some fundamentals straight and help everyone understand the basics.

The History of Oil

Oil is being used since time immemorial, albeit for medicinal purposes and not as fuel. The first oil well was dug in 1859 and led to such prosperity of trade in the region that it henceforth inspired more and more exploration. Oil was originally used as kerosene for lighting and subsequently in furnaces. Following World War II, the Middle East became a major supplier of oil to America.

Formation of OPEC

By the 1950s most of the major oil companies were owned by the US, British and Dutch nationals. These companies exerted a lot of pressure on producers of oil from third world countries to reduce oil prices and also reduced payments to them. In protest, in the year 1960, 12 countries including 7 Arab nations came together to form the Organization of the Petroleum Exporting Countries, in short the OPEC. Initially, this unit operated informally and the agenda was to garner a larger share in the revenue pie of the major oil companies. By the 70s, however, the OPEC realized its powers and began to exert its strength.

During this time, some prominent personalities in the middle-east oil-producing nations realized and openly stated that the US had been purchasing oil at the same low rates, and had, in some cases, increased almost three-fold the prices of wheat and oil products such as petroleum that they were exporting to the middle-east. Once this was openly stated and recognized, the OPEC quadrupled oil prices around 1974. The party, however, got spoilt by member nations from OPEC trying to increase their own market share in the process, driving down prices by nearly half.

The sudden and sustained increase in the price of oil during the 70s led to some economies such as Japan shifting their focus to low oil-intensive industries such as electronics.

1980s / 90s

During the 80s, non-OPEC oil production increased worldwide. During this time, OPEC members drastically reduced production to artificially maintain high oil prices. Around the same time, Saudi Arabia asserted its independence by increasing production leading to surplus oil supply, thus angering OPEC members. During the 80s, world oil consumption from major economies had started dwindling because of the focus on alternate sources of energy.

The 1990s saw a minor oil crisis resulting from the setting on fire of the oil fields in Kuwait during the Gulf war. Oil supply was disrupted briefly during this time.

The 21st century

During 2004, oil prices rose above $50 and by 2005 price had touched $60. A chart below indicates the rise and rise of oil prices from 1994 to the present day. Oil prices crossed $145 a barrel in Aug 2008 and are down to $100 in Sept 2008. 

Fluctuations in Oil Prices

A large part of the fluctuation in the prices of oil is a result of the varying investments by various hedge funds in oil funds depending on the various factors affecting the global economy. There are also some short-term seasonal factors such as hurricanes resulting in shut-down of oil production, or diktats by OPEC bosses to control output, etc. that result in price variations.

Most of the world’s known resources are located in the Middle East. The other major petroleum exporting countries are Russia, Nigeria, Indonesia and Venezuela. Political instability has been prevalent in most of these countries resulting in oil traders demanding a premium.

There is another factor that impacts oil prices – interest rates. The world over, interest rates have been very low and this, in turn, has led to increased consumption because with lower rates, people have less incentive to save. This increased consumption has led to an increased demand for oil and thus the increase in oil prices.

There are several indexes that trade oil the world over like the Brent crude index on New York Mercantile Exchange (NYMEX). This is much like the several indices like Nifty that are tracked and traded on and considered benchmarks of the Indian stock markets. NYMEX is the world's largest physical commodity futures exchange located in New York. One of the reasons for the upward movement of oil prices is speculation in indexes and oil funds. There are many institutions, corporate and otherwise, who participate in this kind of speculation. If oil prices are high, energy costs rise and the cost of doing business goes up. This in turn affects the profit of companies. As a result, big equity funds the world over are investing in oil futures (buying oil futures to buy oil) to hedge against the risk of the value of their other investments falling.

Pension funds, too, have been investing heavily in securitized structures in oil. This has led to sustained high prices of oil. The fact that OPEC has reiterated time and again that it will not allow prices to fall has helped these speculators.

Impact of Global Oil on India

In 2004 the International Energy Agency had to revise upwards its estimates for global oil demand by over 3 million barrels per day. This was mainly because of the strong demand for oil in China and the United States.

Like China, India is also in a growth phase with huge demand for oil within the country. To put things in perspective, one-third of India’s imports consist of petroleum. Oil prices have an impact on everything – the price of fuel in our cars, the price of the cooking gas, the price of the vegetables on the street - everything. Thus simply controlling the price paid for oil imports would have a great anti-inflationary impact on the economy. 

There are very few economies in the world which are net exporters of Oil. India is one such country which is a net importer of oil, along with major economies such as America and Europe. Canada is among the exceptions in this case, and is the only country that stands to benefit when oil prices move up.

In India, the major manufacturing industries that are most affected by the sharp rise in oil prices would include chemicals, transport equipments, textile products, basic metal and non metallic minerals.

One would imagine that an increase in global oil prices would fully translate and be transmitted to oil prices in India. However, in India, this is very unlikely, as the political pressures would ensure that the government and oil companies absorb a large part of the increase in oil prices. This is particularly true in the case of coalition governments which rely on outside support of political groups, many of which fiercely protest any increase in oil prices, often resulting in the ‘roll-back’ of prices.

The overall impact of high oil prices in India is countered by other factors like the comfortable balance of payment position, the large foreign exchange reserves and the access to international capital. These parameters have improved substantially in India’s favor today as compared to the previous period of high oil prices.

However, high oil prices continue to be an area of concern for watchers of GDP estimates of the Indian economy. The first two words that come to mind when we discuss the economy are growth and inflation as the latter often eats up the projections of the former. In a way, finance ministers often spend sleepless nights trying to reduce inflation, as that has a great impact on the health of the economy.

Now what is inflation? Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole. What are the factors that lead to an increase in the inflation rate in the economy? The first way inflation goes up is when the prices of the inputs go up. That, in this case would primarily be the price of oil. Oil constitutes nearly two-thirds of India’s import bills. As a result, any increase in the global oil prices, immediately has an impact on the prices of the goods on the road. The fact that these prices are determined globally leaves us with less hope in terms of managing these to bring down inflation.

However, the fact that the Reserve Bank of India has been allowing the India rupee to strengthen in the past few months, helps the cause tremendously. Let me explain with the help of an example. Let us assume the price of one barrel of oil in the international market is $70. The exchange rate of the Indian rupee was Rs. 46 to a dollar one year back and it dropped to $ 41 to a dollar six months after that. So, while a year back this barrel of oil would have cost the Indian government Rs. 3220, six months later itcost the government Rs. 2870 only. So the impact of the same demand of oil on the prices of goods in the economy would go down, thus reducing inflation.

Current day Oil crisis

The rising prices and apparent scarcity of oil across the world has led to a harried effort by all agencies to look for other sources of energy, whether renewable or otherwise. The anticipated dry-up of the world’s oil resources has led to a focus on solar and wind energy. It is said that transportation is the only industry that is truly extensively dependent on oil. Many governments are therefore encouraging the research and development and commercial application of alternate fuels.

As of now, all factors suggest that oil prices will continue to be high till there is a serious change in the demand of oil the world over.