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October - November 2004

Business Forum

Living with an Oil Shock

by Sashanka Sekhar Banerjee

As the deserts in the Arabian Peninsula touched their high noon with summer temperatures shooting up to a scorching 50 degrees C, crude oil prices soared to an unprecedented USD 50 per barrel around August 20, 2004, the highest in recent times. The oil market looked like having reached its tipping point at a time when segments of the world economy were showing signs of recovery - albeit slowly - after a spell of nearly three years of downturn. It could not have come at a more inopportune time for the global economy. With the trappings of a looming crisis, the oil shock heightened concerns among the world’s leading economists, businessmen, governors of central banks, government leaders and others that sustained high energy costs could drag the economies of the most powerful nations and trading blocs into a second round of recession so soon after the last one had eased.

USD 50 a barrel represented a price increase of about 68 percentage points over the average of USD 29 per barrel that had prevailed since early 2000. Stephen Roach, Chief Economist in Morgan Stanley, in an interview in New York took the view that if the high oil prices had continued up to six months the global economy would have certainly fallen back into recession. There is no reason to disagree with him on this point.

Luckily, the oil shock did not last long enough to transfigure into an oil crisis, at least as of yet. It left only a manageable dent, not a serious damage, on the global economy. Amid the news of relative calm returning to Iraq, October crude futures in New York Mercantile Exchange on August 26, 2004 slipped to USD 42.50 a barrel, falling for the fifth day running, while London Brent crude fell below USD 40 to USD 39.75 a barrel, its lowest for almost a month. Yet crude oils continue to remain at an average of USD 15 a barrel higher than the price levels that had come to stay since the year 2000. One can see that the threat of a crisis has not completely receded yet.

The oil shock forced the consumer countries to foot enormously enhanced oil bills on the back of steep price levels in the spot markets producing a negative impact on consumer demand and enhanced budget deficits. The producing countries on the other hand made a killing netting unethical levels of profits neatly pouring into their already fat treasuries.

Where India Stood in this frenzy
The turmoil in the oil market combined with a 12 percent annual increase in demand and rising further are set to catapult India’s oil import bill to over USD 30 billion in the financial year 2004-5 from USD 18.2 billion a year ago. This year’s import of crude oil, at its present levels of consumption, is estimated to be around 125 million metric tons. India’s domestic production stands at about 40 million metric tons. It also exports 4.648 million metric tons of speciality oil products.

The rise in the oil import bills is weighing on the Indian rupee and fuelling inflationary pressures by making imports costly. By August 7, 2004 the domestic inflation rate based on whole sale price index hit a three and half year high of 7.96 percent. High inflation could spell disaster for the newly sworn-in Manmohan Singh Government. The national truck drivers and the bank employees strike, which have just ended, may turn out to be early samples of the shape of things to come. There are fears that rising inflation may turn out to be Manmohan Singh Government’s nemesis.

The Reserve Bank of India Governor Y.V Reddy speaking in Bombay on August 24, 2004 before industry associations highlighted the importance of maintaining "price stability" in the Indian economy in the backdrop of higher energy costs and warned that he would dig into the substantial foreign exchange reserves in an effort to contain inflationary pressures and maintaining macro-economic stability.

India’s forex reserves had reached a record USD 121.1 billion in mid-July 2004 but as the Reserve Bank of India stepped into the market to support the Indian rupee, the forex reserves shrunk to USD 118 billion as of August 30, 2004 enough to cover the costs of one-a-half years of import bills . RBI’s defence of the Indian rupee however did not harm exports which rose by 20 percent so far this fiscal year while the rupee also appreciated by about 10 percent.

Taking note of the current volatility of the oil market and the possibilities of repeating itself with greater virulence in an increasingly politically unstable world, Mani Shankar Iyer, the Petroleum Minister in the Manmohan Singh Administration took the long-awaited decision following what was mooted by Ram Naik, the Minister of Petroleum in the Vajpayee Administration to build a "Strategic Oil Reserve" of 5-6 million metric ton to cushion the nation’s mainly defence related oil needs in times of emergencies.

India’s sudden decision on building an oil reserve created an instant flutter in the world oil market and contributed significantly to the hardening of the crude oil prices in an already volatile oil market. Although the decision was most welcome in terms of building the nation’s energy security, arguably the announcement could have been better timed postponing it to calmer times. On the other hand, considering India’s steeply burgeoning oil needs, the strategic oil reserve to be effective may have to be upped to 10 or 15 million metric tons in the not too distant future. Five million metric tons will look after India’s oil needs from 6 to 8 weeks only. This could turn out to be too short-termed and prove extremely costly. The need to meet emergency short falls almost always arises when the world is in a political turmoil. It is precisely the time when the spot markets levels invariably are running high. Although it is only a modest beginning in meeting short-term crises, India has at long last learnt a useful policy lesson out of an adversity. The long- term solution to satisfactorily meet the nation’s energy needs must lie in increasing domestic production of oil and gas apart from investing in alternative sources of energy aimed at reducing dependence on fossil fuels from foreign sources. There are reports that major oil finds have been recently discovered in Rajasthan, Gujarat and other sites. It is good news for the nation’s future oil security. Irrespective of measures that India may take to reduce dependence on foreign oil, its rising thirst for oil will ensure continuing heavy import of oils to meet these demands.

Arranging storage facilities for the oil reserves present several critical security and technical challenges. The storage facilities will have to be so located that they remain outside the range of attacks by potential enemies from all three fronts - land, air and sea. Building metallic containers for long-term storage of large quantities of crude oils is technically a daunting task. Corrosion from long-term storage is another big problem. India has rightly decided to follow the example of what the US does to maintain its own strategic oil reserves. They store them in non-porous, natural, geologically formed underground rock caverns. Luckily the required geological phenomena large enough for the required purpose have been found near the Port of Vizag. There is a large oil refinery in place in the area as well. Being located in the hinterland of a major port will have its own cost and logistical benefits when replenishments are required. The caverns are currently being made ready with US technology and expertise and the first inward supplies will begin in the not too distant future. One problem however remains with the location. These oil caverns potentially lie within the range of naval attacks from enemy deployments. Protection of these strategic installations will add to the responsibilities of the Indian Navy.

The Indian oil market is shackled by huge subsidies on account of domestic cooking gas and kerosene. The justification for these financial handouts is poverty alleviation. Purely in commercial terms these subsidies create unfortunate distortions in the profit and loss accounts of the Oil Public Sector Undertakings (PSUs). Consequently when international oil companies clock huge profits on the back of rising energy prices as and when they occur, the bottom lines of Indian Oil PSUs turn rickety when faced with similar situations. Subsidies are meant to feed an "administrative price mechanism" intended to keep prices below market levels for them to be affordable for the poor.

Information on "drop in profitability" of the oil majors among the public sector undertakings is so far sketchy. From whatever information is available we understand that for Bharat Petroleum Corporation Ltd during the first quarter of the current fiscal year 2004-5 the drop in profitability is already Indian Rupees 750 crores. The final year-ending figure could ratchet up to Rupees 3000 crores taking account of the high energy bills of fiscal 2004-5. If we add the losses of Indian Oil Corporation , IBP and Hindustan Petroleum Corporation from the August oil shock the total losses could run up to Rs 12,000 crores, a staggering figure on its own. Top it up with the cost of import of crude oil set to jump to about 125 million metric tons in 2004-5. It has the potential of leaving a giant hole in the nation’s finances.

If market forces were allowed to play their full part, these would have created grounds for the Indian Oil PSUs to high profitability in the current oil turmoil enabling them to launch substantial investments in infrastructure projects. Backed by an enhanced growth curve in demand, increased investments would have been followed by the generation of employment. Although the Indian politician’s penchant for socialism acts as a drag-anchor on the growth of the full potential of Indian economy, the imperative for a social safety net in circumstances like the present oil shock cannot be ignored.

In Britain the fuel bills for millions are set to rise by more than four times the rate of inflation as the decade of cheap energy prices comes to an abrupt end. The British Gas announced on August 24, 2004 their highest single price increase since 1996. According to a report in The Times of August 25, 2004, British Gas, which supplies 18 million customers, announced gas prices would rise by 12.4 percent and electricity by 9.4 percent from September 20, 2004. A typical family would pay £145 more than last year for gas and electricity. BG blamed soaring wholesale energy prices and record oil prices for the increase. The report claimed that the depletion of North and Irish Sea gas reserves will see Britain becoming dependent on gas imports from next year which is why gas prices are hardening. Wholesale gas prices for next winter are now 50 percent higher than in 2003. Mark Clare MD of British Gas said "The era of cheap energy is over". BG’s increases are matched by rivals Powergen, Scottish and Southern, EDF Energy and others. The rising energy costs will put a heavy burden on consumers particularly on low income families and pensioners. Gordon Brown, the Chancellor of the Exchequer will come under pressure to devise some help - a social safety net a la India - for the low income families.

What caused the oil shock and what is the future?
As crude prices touched USD 50 barrel, fears were expressed in informed circles in the US, world’s largest energy consumer, that it could rise to USD 65 or even to USD 75 a barrel producing long-term a recession in the global economy. According to David Ignatius writing in the Washington Post of August 20, 2004 "The oil shock was propelled by its own momentum of anxiety and bad news, Wherever analysts look for reliable sources of oil, they see nothing but trouble – in Iraq, in Saudi Arabia, in Russia, in Venezuela".

On the demand side, analysts have identified the inexorable rise of the Chinese economy and its new hunger for oil imports as a critical contributing factor to the sudden and sharp rise in oil prices. China has already overtaken Japan as the second largest oil consumer in the world after the US, burning 6.3 million barrels per day. The reality however is that China has been purchasing since well before the first quarter of the current fiscal year an additional 1 million barrels of crude per day over the figure of actual daily consumption. Why? According to Merrill Lynch, the investment bank, it suggests that China is perhaps busy building a stockpile of oil. In other words, like India China is also in the process of building a strategic oil reserve of its own. Until the Chinese hoarding phenomenon has run its course, world oil prices are not likely to gravitate to lower levels.

Knowledgeable commentators, both in the print as well as the electronic media, took the view that the exponential rise in the demand for oil imports came not only from China but also from India and together they became the latest phenomenon on the demand-driven rise in oil prices. In this scenario the towering oil demands of the US is taken as read. India has emerged as the hub in the manufacture of small cars, unthinkable only 10 years ago. With its GDP consistently growing at 7.5 percent annually, India has emerged as a new energy hungry nation in the world.

The prospering Chinese and Indian economies helped by their need to import large quantities of crude oil apart from steel and cement created conducive conditions in pulling up sagging freight rates out their doldrums and placing the shipping industry back on a good healthy footing.

According to Philip Verleger, a well known energy economist in the US, the price pressure will probably get worse over the next few years. He believes that prices could rise to USD 75 a barrel and they are likely to remain there until growth in petroleum demand slows down enough to match available refining, logistical and productive capacity.

The greedy army of oil traders – they are the movers and shakers of the market or in other words the speculators – looking for a fast buck were the worst offenders in bidding up the price of oil in a difficult situation fuelled by the instability in Iraq and Saudi Arabia . Fidel Gheit, a senior analyst in Oppenheimer & Co of New York throwing his hands up added his voice saying "The speculators have totally, totally run away with this market. It is no longer driven by any resemblance to sanity or fundamentals".

Meanwhile, conspiracy theorists have been working overtime. Some went to the extent of believing that since the middle-eastern oil producers without exception were angry with US President George W Bush's War on Iraq and Afghanistan - both Islamic countries – Saudi Arabia, Iran , the oil pipeline sabotaging insurgents in Iraq and others were either secretly under-producing below their allocated quotas or disrupting supplies probably to jeopardise Bush’s chances of winning the US Presidential elections due on November 2, 2004. Moscow’s legal shenanigans with Yukos, the Russian oil major, only made matters worse. Was Moscow in cahoots with the Arab oil producers, aiming to punish Bush for his unilateralism?

James Akins, formerly US Ambassador to Saudi Arabia in 1973 in an article in the prestigious magazine Foreign Affairs published from New York titled "The Oil Crisis : This time the wolf is here" had predicted the 1973 oil crisis well in advance. Philip Velger ominously commented "I have a ghastly feeling that we are about to repeat the 1973 crisis cycle". During the last three years oil prices have gone up by USD 13 to 17 a barrel. "Never before have we witnessed such a dramatic upward shift in the entire price curve" says Verleger adding that this trend does not appear to be a short-term phenomenon. He believes that the collision course between the US and Iran was likely to bring more grief as time passes.

Understanding US Policy
The Democratic Presidential candidate Senator John F Kerry has proposed a strategy for reducing US dependence on "Middle East oil", while the Republican candidate President George W Bush has called on Congress to pass his energy bill aimed at reducing costs which he believes will make the US economy less dependent on "foreign oil".

It is apparent that a bipartisan consensus is taking shape in the US towards reducing or even giving up American dependence on Arab Oil. Policy planners in Washington might have suddenly thought that as long as US dependence on Arab oil remains in place, America’s wider objective of winning the war on terror may not be achieved. But which quarters will the US turn to, to quench its insatiable thirst for oil? No easy answers there. On the other hand, pursuing such a policy may turn out to be strategically valueless considering that China and India will soon replace the US as consumers of Arab oil. If the American intention is to deny petro-dollars to the protagonists of religious extremism, certain critical questions need to be tackled : Can America successfully pressurise Beijing and New Delhi to look elsewhere for oil and if so will it be economically and politically viable ? No clear answers there too, although India has shown early sign of its willingness to diversify its sources of oil to countries like Malaysia .

US President George W Bush has devised a solution to address these difficult problems. He is determined, as it looks, to introduce democracy in the Middle East believing that it will free the region from the strangle-hold of corrupt authoritarianism. This will deny terrorism its petro-dollars and bring world peace. Will he succeed in his campaign? There are no clear answers there too. Whatever be the end-result in this game, the fact remains that when America sneezes the rest of global oil economy catches cold. And the US, with its giant economy, will make sure that it stays that way.

The author has served as a Director in an International Oil Company for over 15 years.

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