Petro prices:complex mix of economics, tech,geopolitics

Of all prices, the prices of petroleum products have the biggest implications for fiscal deficit, balance of payments, the exchange rate of rupee, inflation and GDP growth rate. What determines petro prices is a complex mixture of economics, technology, government regulations, tax-subsidy policy and geopolitics.

In a free market, today’s price of petrol is determined by today’s demand and supply of petrol. Today’s demand -- in addition to depending on today’s price, purchasing power of buyers and availability and prices of substitutes (like diesel, natural gas, electricity, solar power, alternative public transportation in the form of trains, buses, share taxis and autos) — also depends on expected future prices and incomes.

For example, if petrol price is expected to rise (may be because of an anticipated supply disruption in a major oil producing country), oil traders would build stocks for future scarcity, which would increase today’s demand and jack up the price today. Similarly, if growth is expected to pick up in some major economies (raising future demand and price of oil), its impact would be felt right now in the form of a rise in petro prices. Thus, even if nothing happens in today’s conditions, a simple expectation of a future event gets reflected in today’s price.

On the other side, supply of petrol to the market (which is equal to current production plus net release from stocks) is influenced by current as well as the projected future profitability of producing petrol (both crude and refined), relative to alternative energy sources which, in turn, is determined by available technologies (both current and emerging) in the areas of petroleum and substitute products.

Environmental regulatory restrictions and tax-subsidies like emission norms of cars and coal-fired power plants, standards for mixing bio-fuels with fossil fuels, safety norms for atomic power plants, subsidisation of renewable energy sources like solar and wind power would also have implications for both demand and supply of petro and other alternative fuels and hence their prices. In India, hefty taxes on petro products (justified on revenue and environmental grounds) by both central and state governments account for more than 50% of the market price of such products.

In technology, there have been several major developments in recent times. First, horizontal drilling and ‘fracking’ technologies are enabling extraction of huge unexplored reserves of shale oil. As a result, the US has become the largest producer of oil in the world, surpassing Saudi Arabia and Russia. Second, the emergence of new technologies in harnessing solar and wind power. Though initially much more expensive, the cost of production of renewable energy has come down to levels at which it is competitive with conventional power.

Third, hybrid cars that hugely economise on the use of petroleum are already here. Fully battery-operated electric cars are becoming rapidly practical. All these developments have already reduced and are going to further lower the demand for conventional oil. Consequently, the power of the Organisation of Petroleum-Exporting Countries (OPEC) and non-OPEC countries like Russia to set the global prices of petro products is being steadily eroded.

The time lag to increase supply from new shale oil wells in response to a price rise has become much shorter, compared to extraction from overworked conventional oil fields. So, high prices of petro products, though possible with short-run supply disruptions, demand spikes (like a bad winter causing a rise in demand for heating oil) or cartel-determined production cuts, cannot prevail for long. Price cycles are becoming shorter.

Next, geopolitics. In the past, Russia, the biggest non-OPEC producer of oil, used to be the major beneficiary of any OPEC-engineered price rise through collective production cuts. Russia was not a party to any production cut arrangement by OPEC but enjoyed the benefit of high prices. That has changed. Now, OPEC and Russia are jointly determining crude oil production quota, which makes it more effective in controlling prices. At the same time, the US is now much less dependent on Persian Gulf supplies. So, one would expect US to meddle less in Arab politics.

But the US, under Trump, is not following that route. It is pushing harder for sanctions on countries buying oil from Iran. The forced cut-off of oil supply by Iran (the fourth largest producer of oil) has produced an immediate spiking effect on petro prices, though, for reasons already explained, it is likely to be short-lived. Despite the US trying to make inroads, Russia’s huge gas reserves, already built network of pipelines and the consequent market power in natural gas supply in Europe are likely to remain unchallenged for the foreseeable future.

Reducing dependence

For India, the longer term focus has to be on reducing dependence on imported crude oil and natural gas by exploring new sources of domestic deposits. Here, one major hurdle, on top of the economics and technology factors, is the inherent political risk of inviting charges of corruption while setting terms of contract and choosing among competing private companies. Even if the winner is selected through an open competitive auction, future complications involving the need to revise the terms in case of mismatch between initial estimates and later findings of actual reserves (as in the case of Reliance in Godavari Basin) of oil and gas cannot be ruled out.

Finally, the tax-subsidy policy of the government, which all the time talks of the need for market determined prices. In the last few years, the government, instead of passing on the full benefits of falling global crude prices to consumers (as it should be in a market-determined system), raised petro taxes and built up fiscal surplus. Equity and the principle of revenue neutrality over the price cycle demand that they should now reduce taxes when global prices are shooting up. Otherwise, the state becomes a predator (like despotic kings), maximising revenue at all costs.

(The author is a former Professor of Economics, IIM-Calcutta)