Deepak Mahurkar,Associate Director - Energy, Utilities & Mining: Oil and Gas,PwC
With the global economy experiencing inflationary
pressures, the recent rally in crude oil prices could serve as catalysts for the
increasing inflationary pressures. After remaining steady near US$80/bbl in
January 2010, the crude oil prices climbed to $95/bbl in January 2011, followed
by US$115/bbl/bbl in April 2011 and hovering above the US$100/bbl since then.
Historically, in 2008, when the oil prices breached the
psychological barrier of US$100/bbl for the first time, rising past $120/bbl and
beyond, this upward surge in prices was prima facie attributed to speculation by
oil traders. With crude oil prices climbing in recent months, oil pundits and
analysts are again alleging the role of speculators in driving up the price of
crude. Thus, the moot question, which is yet to be answered, is it only
speculation and not fundamentals that is driving oil prices?
The answer is an unquestionable no. Broadly, the factors
that explain rise in crude oil prices include crude oil demand in OECD and
non-OECD regions, supply from OPEC countries and in non-OPEC countries,
financial markets and geopolitical factors.
As time elapsed, an in-depth post facto analysis of the
2008 crude oil price rally reinforced the fact that it was indeed the
fundamental factors of demand and supply that had contributed majorly to upward
surge in the crude oil prices. The supply of crude oil was not enough to meet
the burgeoning oil needs of rapidly growing Asian economies of China and India.
The oil suppliers had failed to anticipate the strong global economic growth
from 2002-2007, particularly that from non-OECD countries including China and
India. The lack of OPEC spare production capacity and untimely cutbacks by OPEC
at the end of 2006, which remained unreversed till 2007, were the key supply
side factors influencing crude oil price increase. Over and above these, changes
in the product specifications (low sulfur fuels), lack of spare refining
capacity to handle heavy sour crude oil and subsidies on oil consumption in many
rapidly growing countries in Asia and the Middle East were also some of the
factors leading to a surge in crude oil prices.
With the global economy recovering from the recession in
early 2010, the crude oil prices rose from US$80/bbl to US$95/bbl against the
backdrop of huge global demand increase that took place in 2010. At the start of
2010, world demand was forecasted to grow by 1.4 mb/d (million barrels per day)
with International Energy Agency (IEA) estimating a whopping crude oil demand
of 2.8 mb/d. By end of 2010, world economic growth of five percent and coldest
winter in 30 years led to an increase in crude oil demand. The French oil labour
strike and China coal halt disrupted oil supply driving up crude oil prices. The
events in Middle East and North Africa (MENA) region such as interruption in
crude oil exports from Libya worth another 1.4 mb/d accounts for rise in crude
oil prices in first Quarter of 2011.
The income elasticity of oil demand is quite strong. Rising
incomes lead to increased oil demand for transport, heating and cooling, and
producing goods and services. Going forward, the oil consumption among the
countries in the non-OECD especially India and China is expected to remain
strong in the wake of the economic activity in these countries expected to
remain strong. With one third of the world's population just entering the middle
class, they aspire for a lifestyle which is oil-consuming.
The impact of supply side factors cannot be ignored. Saudi
Arabia, the world's biggest producer of oil produces about 40 percent of the
world's oil. Saudi Arabia's spare oil capacity is expected to be lower than
widely believed, thereby, triggering price spikes in the months ahead. The
Libyan crude is a very low-sulfur crude, which is in high demand for light
products and is hard to replace without some logistical changes by Saudi spare
capacity, which is higher in sulfur content. Saudi Arabia, the world's biggest
producer of oil, produces about 40 percent of the world's oil. Saudi Arabia's
spare oil capacity is expected to be lower than widely believed; thereby,
triggering price spikes in the months ahead. Saudi crude cannot be a perfect
substitute for the Libyan crude, as it is a very low-sulfur crude and is in high
demand for light products thereby making it hard to replace without some
logistical changes by Saudi spare capacity which is higher in sulfur content.
The demand and supply of oil are inelastic with respect to
price changes. The demand is inelastic as there is a time-lag involved in
altering the stock of fuel-consuming equipment and supply is inelastic in the
short-run because it takes time to augment the productive capacity of oil
fields.
Beyond the price elasticity, there is a factor of
speculation in stock market. Any commodity when it is traded as stock in a
market possibly gets dissociated with the generic market forces like demand or
supply. To a trader, it is no longer a product or it offers much beyond the
attributes of just a product. It is seen as a means to multiply investments and
due to this reason is the dissociation from the product market trends. It turns
out to be a commodity, which is indexed in a market where the forces are
speculation driven.
Speculation is not always reasonable and thus not always
directly related to business generics. The downside is that the end user of oil
is also affected by the speculation at NYMEX, which is way too farfetched for
him, like an unknown war or production disruption in a remote part of the world
hitherto unknown to him. There is no fine line, where the supply demand dynamics
in oil price makes way to the market speculation driven prices. These are
component variables existent in any market and for any product. Larger the
market, more universal the consumer network, deeper the market interdependence
in the form of export or import, impact of just supply demand dynamics gets
diluted and makes way for speculation driven pricing.
N C Sridharan,Former Director (Finance),Chennai Petroleum Corporation Limited (CPCL)
As far as supply-demand of oil is concerned, it more or
less remains the same. There is not much movement on this front. And,
geographically, supply-demand gets affected only at places where, say a,
refinery has been shut-down. However, at the same time, there would be places
where the capacity would be going-up. A case in point at present being Asia. If
we take the oil consumption of Asia over the past six-seven years, it has more
or less remained same. The only change that is discernible is when we look at
per day consumption of oil. Here, too, apparent change in supply and demand of
oil is very small. Over the past six-seven years, supply-demand has witnessed a
change of mere two to three percent. At present, the per day consumption of oil
stands at 87 million barrels a day, up from 84-85 million barrels a day in
2004-2005.
Thus, with both demand and supply moving in tandem, there
is nothing that can be termed as oversupply or undersupply. Therefore, at best,
demand and supply has an impact on oil prices only to the tune of five percent.
Also, to put things in perspective, we need to track oil prices since 2004. From
2004 onwards or even a little earlier, the crude was oscillating between US$30
in 1990 to end up at US$20 in 1999-2000. In the intervening period, the crude
price went down as low as US$12 barring 1998-99. Here, I am talking about Dubai
oil. A decade ago, the differential between Brent crude oil and NYMEX was only
US$ two to three. So, between the two, there was not much of a difference.
Subsequently, over the years, the price differential between Brent crude oil and
NYMEX has been steadily increasing.
Since 2004, on account of commodities trading - commodity
prices have been going up with speculation playing a big role. And this was the
first trigger point for oil prices to go up because by this point of time, 25
percent of commodities was on delivery basis and the remaining 75 percent was on
speculation basis. Over a period of time, especially over the past two years,
the next evolutionary landmark in oil prices came in 2010 when the terror
premium got added to the price mix. However, all these years, the demand and
supply worldwide continued to be the same with only geographical redistribution.
In-between with emerging signs of financial collapse of
markets in 2008, the parity between currencies including Rupee, Dollar and Yen
experienced terrific change. Crude oil price turned out to be very sensitive to
these changes. A typical example of this change can be gauged from the fact that
when forex rate was Rs 45, crude price was around US$60. When forex rate fell
down to Rs 40 in 2007-08, on an average, the crude oil price went up to Rs 77.
Now also, there is lots of currency parity interference in the past few months.
Besides oil, the prices of other commodities have also been rising. Strangely,
we still compare the crude oil prices of 1990s and 2000s. But at the same time,
we do not compare those commodities, which were not traded earlier and then came
into trading in exchanges; again those commodities that are already being traded
and again get hyped.
The fact is that the base rate and benchmark rate for
metals and other commodities has gone up considerably in the past few years. The
basic example is metal and gold. And energy is not an exception to it, unless we
go for other sources of energy, which are hard to find. Worldwide phenomenon and
components of crude baskets are now very finely split into proper cost of crude,
plus the inventory level, plus currency exchange parity between one country and
the other.
Another point that we should bear in mind is that as far as
crude oil prices is concerned along with the exchange parity, the problem of
speculation is slightly taking a backseat. What was a major phenomenon in
2004-2006 gave way to terror premium in 2008 and the terror premium also appears
to be fading in the post Osama-Bin-Laden world. Another recent and unique
phenomenon and development relates to the fact that now Brent crude oil is
quoting US$20 more than NYMEX. Earlier the difference between the two used to be
about US$ five to seven. It's a recent phenomenon and is unique and has been
brought out of US recession. Due to a poor show by US, the Brent oil is
predominantly high and Dubai oil is always catching up.
In the past, Brent oil and NYMEX differential used to be
only between US$ two and three. This difference has been hovering between US$
six and seven for the past two years. However, since 2011 the difference between
the two has been to the tune of US$ 20 which is very abnormal and shows the
severity with which US recession is impacting the global economy and oil prices
as well.
The real uncertainty in global scenario with closure of
some of the refineries for the purpose of converting these into terminals
coupled with poor performance by small economies in European countries together
exercises an impact on crude oil prices. Also, European countries are more
concerned about their inventory shortage, when it comes to making crude oil
available at short notice. Of late, the US economy is also not picking up and
the unemployment rate is going-up. Things are further complicated by regular
occurrence of natural calamities such as hurricane hitting the country every
year.
These are various components, which have made crude oil
prices very-very dynamic. These components have too many ponderables - factors
seasonal and non-seasonal; again the quality of crude with more refineries
coming for high sulphur crude processing--no wonder NYMEX crude is receeding.
Mrinal Madhav,Assistant Director (IC),Petroleum Planning and Analysis Cell, Ministry of Petroleum and Natural Gas
It would not be correct to mention here that stock market
alone determines oil's prices and not the supply-demand. Hence I choose to
oppose this motion.
Today, one of the most heavily traded commodities in the
world is oil .The price of crude oil is derived and is based on several
important factors like: overall supply/demand for crude, supply/demand for
petroleum products, freight rates, competition in the crude markets, competition
in the regional and domestic markets for petroleum products.
There is also an element of the stock exchanges, which does
influence the crude oil prices. Stock exchanges do play an important role in
crude oil price, but compared with other factors, which help in deciding the
crude oil prices, stock exchanges may not be considered as the sole deciding
factor in crude oil prices.
On the stock market, crude oil is mainly sold through
various contract arrangements apart from spot transactions. As a mechanism to
mitigate risk, oil is also traded on futures market, but this is not to supply
the physical volumes of oil.
Since early 1990s, there has been a greater amount of
transparency seen in deciding the crude oil prices. This is mainly done by the
use of benchmarking/marker crude oils:
-
West Texas Intermediate (WTI - USA)
-
Brent (Europe, Africa and Asia)
-
Dubai and Oman (Middle East)
-
Dubai, Tapis and Dated Brent (in
Asia-Pacific)
A futures contract for crude oil is a promise to deliver a
given quantity of crude oil, but this rarely occurs as participants are more
interested in taking a position on the price of the crude oil. Futures markets
are a financial instrument to distribute risk among participants with the side
effect of providing transparency on the pricing of crude oil.
It's interesting to note the fact that, nearly two thirds
of global crude oil production is consumed by the leading industrialised
countries - i.e., the countries that make up the Organisation of Economic
Cooperation and Development. But a rising share of oil demand is coming from the
emerging market economies including China, Brazil, Russia and India. This leads
to a very interesting situation per se global consumption v/s demand scenario.
The supply of oil can be categorised into short-term supply
and long-term supply to international markets. Short-term oil supply is mainly
from the known source of oil reserves, also as production gets closer to
capacity limits, this short-term supply tends to erode.
The element of profit motive (quantum of production decided
by OPEC and non-OPEC countries), inventories at the refinery premises (in case
of rise in demand fluctuation in market, the large inventories by refineries can
be released) and external shocks like production loss due to natural disasters,
rig closure, etc, influences the crude oil prices to a great extent in short-
term supply.
Long run world oil supply and its prices are mainly
influenced to a great extent by the reserves of oil field (faster the demand
grows, the quicker the expected rate of depletion), newer ways and areas of
exploration (it makes financial sense to invest more resources in exploring for
new reserves, even though these may not come on stream for some years) and the
kind of latest technologies being implemented in oil extraction.
The role and impact of the cartel
In international oil market, the role of cartel in the form
of Organisation of Petroleum Exporting Countries (OPEC) is always considered to
be critical. With around 40 percent of current world supply capacity, OPEC plays
a pivotal role in shaping the direction of oil prices. It's also equally
important to highlight the fact that when the cartel acts together to control
production and balance supply and demand in the international market, non-OPEC
countries account for the largest portion of total supply and gets an
opportunity to push more oil in the market due to no quota on non-OPEC
countries.
With the recent turmoil and changing dynamics in global oil
industry, it's a foregone conclusion that the era of cheap oil has gone, and we
need to be prepared for paying higher crude oil prices.
Frequent volatility in oil prices is very dangerous for
producers as well as consumers. The fluctuation in oil prices has a cascading
effect on several other sectors, which depend on oil as the key input for their
source of energy.
Recent geo-political events, change of regimes in mostly
oil producing countries, the fast pace of development and the rising demand of
oil in developing countries has also established strong indication to the fact
that there is lot more factors, which influence the crude oil prices than the
stock markets.