Causes and effects of plunging crude 0il prices

Last Updated 24 January 2015, 19:12 IST

The crude oil prices have fallen by more than 48 per cent since June 2014 when it was $115 a barrel. It is now below $50.

The biggest slide in energy prices since 2008 recession is shaking up things in every conceivable sphere. The plummeting price of oil has affected oil producing nations as much as the oil consuming ones.

An example of the plight of an oil - producing nation is the closure of Coromoto, an ice cream parlour in Merida, Venezuela, famous for its 900 flavours, during its busiest season in November because of milk shortage caused by the country's 64 per cent inflation rate, the world’s fastest. At the same time, consuming countries like the US are taking advantage where trucks, which burn more gasoline, outsold cars in December by the most since 2005, according to data from Ward's Automotive Group.

While on the one hand demand fell, on the other, supply grew significantly. The major contributors were US light tight oil (LTO) production as well as  Iraq and Libya- two big oil producers with nearly 4 m barrels a day combined production — their output has not been affected by strife but rather increased. And cumulatively, effect of shrinking demand and supply glut pushed oil past threshold after threshold to a six - year low of $ 49-50. 

The oil price is predominantly a function of actual supply and demand, but is also partly determined by expectation. Demand for energy is closely related to economic activity. The producers invest if they believe the price will remain high which lag boosts supply, though after a lag. Similarly, low prices lead to an investment drought.

There are six factors driving this price. First and foremost, low demand due to weak economic activity, increased efficiency, and a growing use of alternate fuels. Secondly, turmoil in Iraq and Libya not affecting output.

Thirdly, America becoming the world’s largest oil producer, though not an exporter of crude oil yet, but reduced imports have created a lot of spare supply. Fourthly, the negative economic growth in European countries . Fifthly, the tepid Asian demand due to slowing of China.

And finally, the Saudis and other OPEC members’ decision not to sacrifice their own market share to restore the price to deprive any benefits going to countries they detest such as Iran and Russia. Though the break - even costs of crude in West Asian countries is also not low due to their  high social budgets, they can tolerate lower oil prices easily at least for some time due to their accrued foreign exchange reserves.

Economic consequences

This freefall in crude price has significant economic consequences around the world and predictably so on major oil producing countries like Russia and Venezuela.

Russia is hugely dependent on oil and gas production as the oil revenue constitutes 45 per cent of government budget.  Economists estimate that Russia’s economy will shrink by 4.5 per cent in 2015 if oil remains at $60/bbl.

The plunging crude has also caused Ruble to depreciate by 84 per cent against US Dollar and Russian Central Bank has responded by hiking the interest rates from 10.5 to 17 per cent in an attempt to stop people from selling off Rubles.

There's growing concern that the oil crash could cause Venezuela, another major oil producer, to default. The nation's economy shrank by nearly 3 per cent last year and as per the IMF, it is likely to shrink by 7 per cent this year.

According to an Oxford Economics Limited’s December analysis of 45 national economies, the biggest winner would be the Philippines, whose economic growth would accelerate to 7.6 per cent on average over the next two years if oil fell to $40, while Russia would contract 2.5 per cent over the same period.  As for growth, a long-lasting price of $60 would add 0.5 percentage point to global gross domestic product.

For the US, it will have mixed effect on the economy with varied impacts. For the common man, it will offer a nice economic boost as cheaper oil means lower gasoline prices. But it's not all good news. Oil-producing states like Texas and North Dakota are likely to see a drop in revenues and economic activity. The falling price of oil is also putting severe pressure on American shale gas/oil operators who have borrowed heavily on the expectation of continuing high prices to continue their operations or invest in new projects.

Impact on India

For India, with dependence on imported crude to the tune of 75 per cent, the ever burgeoning import bill is likely to have a much - needed relief of about $ 32 billion in the budget of the current financial year, and if the trend continues, it may reach about $ 50 billion.

Well, no one can say how long will it continue at this level. If oil demand remains weak and production keeps up, prices might not bounce back for some time. If cheap oil is the result of a drop in demand, prices will rise when economy picks up. If lower prices stem from increased supply, then cheap oil is here for at least a while.

The economy needs oil to function, and oil prices will increase as the economy grows, but that may take some time, some say before end of current year. Going by the assertions of OPEC chief Abdullah Al-Badri at World Economic Forum, Davos, the oil price have already seen the bottom and  not likely to decline further. Interestingly, the former head of Oil markets & Industry division at the International Energy Agency has said that oil prices will not recover to $100/bbl.

Should India take advantage of current low prices and raise taxes on oil or fuel?  Lower oil prices give governments the chance to increase fuel taxes and cut subsidies without incurring immediate harm to the economy or the consumers.  India, Indonesia and Malaysia are cutting their fuel subsidies, and India is slowly increasing taxes. Well, like they say “make hay while the sun shines.”

(The writer is former Chairmanand Managing Director, Oil and Natural Gas Corporation)

(Published 24 January 2015, 19:12 IST)

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