By Jayant Manglik
Recent weeks have seen a fall in crude oil prices leading many to predict year-ago prices. Methinks it is a temporary phenomenon and while the US$ 147 per barrel prices were a spike (markets frequently go into excess territory, not surprising at all), there is nothing so far to indicate that prices will stay depressed. Look at the facts. In December 1998 crude oil prices were US$ 10, almost ten years later they were touching US$ 147– well, ok US$ 115 now. That makes it one of the best investments to make across all asset classes in the last ten years. And it only seems to get better – or worse depending on which side of the petrol-pump you’re on!

Though recent favourable issues did see the price fall some 20% from its highs, I wouldn’t bet on two-digit prices in the foreseeable future. And here’s why.

Over the last decade, it has been a steady climb with a graph that looks like the rising side of a hill. Looking ahead, OPEC has indicated that the period of low crude prices is over and expects it to continually hover above US$ 100 in the foreseeable future. Coming from the world’s major supply group, that may be considered a hawkish stance. Of course, that could just be positioning from a potential beneficiary but geopolitical instability, speculation, a weak dollar and lack of other investment alternatives are clearly fundamental to the increase in prices.

Even then some perceive that there is no relation between the price and the purported reasons. Be that as it may, it is true that spare global capacity (the amount of incremental oil that can be brought to the market quickly) is at its lowest in three decades and a current shortage of refining capacity (which will get rectified within 6 to 9 months as new refineries are slated to start processing) adds to the price impact. Besides oil fields are ageing, there have been no large finds in decades and the Reserve Replacement Ratio is less than one i.e. less oil is being discovered each year than is being consumed – which in the longer term can be a matter of serious concern.

It is estimated that over 75% of the oil produced today comes from oil fields older than 20 years, again underlining the fact that while there is no shortage today, and we’re skating on thin ice in the longer term. Crude oil is a crucial energy source over which wars have been – and will continue to be – fought and it is a news and price volatile commodity. So far there is not much on the energy horizon which makes it seem that crude prices will come down in a hurry.

Though we hear about alternative fuels, there is none which is a true replacement – in fact, there are no real prospects so far. Without exception, alternative fuels are more expensive than crude oil to produce and implement. Alternatives like shale oil and oil from biomass are still commercially and environmentally unviable.

Therefore, there is the inevitable likelihood that our grandchildren too will fret about crude prices! Whether it is transport, agriculture, aviation, drugs or defence, every single sector is highly dependent on fossil fuel – typically crude oil and its derivatives. And the 13 countries which make up OPEC produce some 40% of the world’s production and control three-fourths of the known reserves in the earth. Which means the chief suppliers are unlikely to change over the next few decades – unless it is found that the Antarctic is floating on oil!

As far as suppliers (read OPEC countries) are concerned, they have a point of view. The world has had immense prosperity in the last 4 or 5 years and a lot of it has been powered by the availability of crude oil and its derivatives. If the world can absorb higher prices, why would they be willing to drop prices? There is no shortage of oil and demand is being met, comfortably so far. The prices increases seem to be simply a function of what the market can take. Of course, history has shown time and again that there is one level where the relation between demand and price does not remain inelastic and the consequent degrowth leads to a downward spiral i.e. a fall in demand followed alternatively with a fall in price. However, it is estimated that a drop in world GDP from 4.5% to 3.2% will only lead to a drop in demand by 2%.How much effect that actually has on crude oil prices remains to be seen and, in any case, currently demand continues to rise. On a slightly tangential note, restricting growth for low energy prices may not necessarily be a wise choice.

The producers’ money-maths too is compelling. Of the 86 million barrels produced every day, about 30 million barrels are produced by OPEC member countries. At a price of US$ 140, the revenues are US$ 4.2 Billion – per day! And that on a product where the cost of production in these countries is less than US$ 15 per barrel on average. Which explains why it is so difficult to convince them to increase production just so that prices come down.

All these factors make for serious uncertainty and all markets hate uncertainty and convert it into volatility which can singe the deepest of pockets. Look at the Indian situation. We produce roughly 700,000 barrels of oil and import about 2 million barrels a day to meet our requirements. Therefore, our import bill at current prices excceds US$ 280 per day or close to US$ 100 Billion a year!

Suddenly our reserves of US$ 300 Billion plus don’t seem like a lot. Therefore it is necessary for us to raise prices of petroleum products and curtail subsidy because demand will not reduce if prices are kept artificially low and in fact it encourages misuse. If India continues to grow at 8% for the next decade it will require an incredible amount of energy with projected crude oil imports of US$ 1 Billion a day! A radical approach and a firm hand will be required to fuel that growth.

Subsidy has become a political necessity but is the enemy of economics leading to further wastage and less investment. Speculation too has been blamed but inventories haven’t gone up and in the absence of data, the link is tenuous at best. US$115 seems low compared to the spike of US$ 147 per barrel but it is still historically very high and likely to remain so because of the basic demand-supply issues.

Demand is being driven by growth in China and India and supply issues are being highlighted. World GDP continues to grow at well over 4% and the negative growth and oil consumption of developed countries is more than balanced due to business expansion in developing countries. In this scenario, the only thing that can spook the crude prices is a consistently strong US$ - which is an unlikely scenario right now with the US battling recession as well as the well-documented subprime housing finance crisis. Therefore the stage is set for crude oil to remain above US$ 100 per barrel for the next year unless economic uncertainties erode demand considerably. But if the fall in crude prices is due to reduced growth, that may be a decidedly worse option.

Jayant Manglik is head, Commodities at Religare