Oil price rise: OPEC’s mission accomplished, what about Modi’s?

Oil price rise: OPEC’s mission accomplished, what about Modi’s?

When international crude oil prices climbed to a three-year high of over $74 per barrel, the Organisation of Petroleum Exporting Countries (OPEC) might have felt that it has “accomplished its mission”. But oil-importing countries, led by India and the US, started to question such high oil prices.

Prime Minister Narendra Modi called for “responsible pricing” to balance the interests of producing and consuming countries at the International Energy Forum on April 11. He was followed, within days, by US President Donald Trump, who threatened OPEC against increasing the price artificially. Trump can use strategic petroleum reserves. But, for how long?

How do you define ‘responsible’ price? How can one claim that the current price is artificially high when just three years before it was above $100 a barrel and in 2008 it had reached a high of $145? 

Capital flowing into oil industry has more than halved in three years. As a result, new oil discoveries in 2017 were at a record low. The International Energy Agency (IEA) is concerned that the oil supply capacity may be inadequate to meet the increasing oil demand by 2022. Under these conditions, can the recent price increase be called artificial? 

To understand the dynamics of recent oil price movements, it is useful to look at the changing strategies of OPEC. In February 2016, oil prices fell below $30 per barrel after staying above $100 for three years before 2014. However, the most influential country in OPEC, Saudi Arabia, adhered to its much-publicised strategy of maximising market share rather than defending the oil price. 

When prices continued to remain low, OPEC changed their strategy of maximising market share and decided to cut production by 1.2 million barrels per day (mmbd) in November 2016. They were joined by 10 non-OPEC members, led by Russia, to cut their production by 0.6 mmbd. In seven months, prices went up to $55/b and then fell below $46/b. It looked as though OPEC was not succeeding in securing higher prices. 

Historically, OPEC has not been successful in enforcing production quotas.  However, this time most OPEC and even non-OPEC members have not only been adhering to their quotas, the actual reduction was 38% above the quota in March 2018.  

While most of this reduction was by design, some of it was forced upon OPEC. Specially in the case of Venezuela, its cash-strapped national oil company has not been able to invest money to maintain production and it has fallen from a high of 2.5 mmbd in 2015 to less than 1.6 mmbd. It is anticipated that production may fall to less than 1.34 mmbd by the end of 2018. 

As a result of the production ceiling observed by OPEC and its non-OPEC partners, oil stocks in developed countries, as of mid-April 2018, are just 43 million barrels above the five-year average. This shows that the current world oil supply and demand are in reasonable balance.

At present, it is not easy to argue whether the increase in oil price is because of geopolitical factors commanding risk premium or a result of a fine balance in supply and demand brought about by production cuts. 

Currently, total world oil spare capacity is about 3.7 mmbd, according to the IEA, and Saudis alone account for 60%. In recent years (2011 to mid-2014), when OPEC’s spare capacity has been less than two mmbd, oil prices had risen over $100/b. However, during 2015 to mid-2017, even when spare capacity was less than two mmbd, prices were less than $50/b. This may be because of continuing increase in non-OPEC production, specially the shale oil production increase in the US even after the oil price collapse.

In recent months, it has been suggested that Saudi Arabia and many OPEC countries want higher price to balance their budgets. There is more than a whisper that Saudis want a price of $80/b to $100/b. Russia and Saudi Arabia have already expressed their desire to continue with the production ceiling beyond 2018. 

In the case of the Saudis, there is another compelling reason. They are planning to have an IPO of their flagship company, Aramco, the largest oil company in the world. Higher oil prices will fetch higher revenues to Saudis. But it is not such desires that drive the market, but the perception of oil futures traders, actual or predicted balance between supply and demand, marginal cost of production, perception of geopolitical factors affecting oil supplies, etc. 

Supply will trail

At the current rate of investment by oil industry, it is more than likely that supply will be less than demand and there will be a price shock within the next three to five years. This may be reflected in the current increase in oil price. 

The Modi government has enjoyed the benefit of low oil prices so far. However, with the likely reduction in world oil production capacity, oil prices are likely to be higher over the next few years. If the government is serious in achieving its goal of reducing oil import by 10%, it needs to take tough decisions now.

In downstream, the government has liberalised the residential LPG price by giving subsidies through direct benefit transfer. It has started to implement the same policy for PDS kerosene. It has rightly decided to get more revenues by increasing excise taxes on petrol and diesel in the background of lower international oil prices.

However, when oil prices increase in the future, it should not revert back to playing with petroleum product prices like the UPA government did by forcing public sector oil companies to sell below cost for short-term political gains. 

With much anticipation, the government had announced the ‘New Hydrocarbon Exploration Licensing Policy’. But it failed to attract even one foreign oil company to submit an “Expression of Interest”. Unless India develops a win-win strategy for oil companies to attract foreign investment, India’s dependence on petroleum imports will continue to remain high. 

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