Business Today

When it comes to oil pricing, politics trumps economics

Jyothi Kainth, Assistant Professor, IMT Ghaziabad, and Neelendra Nath, Senior Business Development Analyst, Cognizant, take a look at the recent crude oil slump the world has seen.

Jyoti Kainth and Neelendra Nath         Last Updated: May 27, 2015  | 10:24 IST

International crude oil price has taken a huge plunge in the past six months or so, going from a high of about $110 a barrel to close to $65 a barrel. This huge slump has triggered a ripple effect across nations, industries and sectors. Crude oil, the most important commodity traded across the world, affects everything from geo-political relations, trade, economic metrics, industrial growth and climate change.

Jyothi Kainth, Assistant Professor, IMT Ghaziabad, and Neelendra Nath, Senior Business Development Analyst, Cognizant, take a look at the recent crude oil slump the world has seen. The duo attempts to understand the recent price plunge, its possible causes, and possible effects, including how India is responding to it.

Introduction

Petrol, diesel, ATF (aviation turbine fuel), kerosene and many other extracts of crude oil are the lifeline of the modern economy. The geographical distribution of crude oil is not uniform across the globe and hence, while some country has ample of it, others need to import for their domestic consumption. The parity of distribution leads to trading between countries with excess production and excess demand.

The Oil Producing and Exporting Countries (OPEC) is a group of 12 nations including Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela. They account for about 40 per cent of the global production and this production plays a major role in international crude oil price fluctuation.

The organisation set targets for the member state production limit and as per the demand in the international market drives production policy. Russia, Saudi Arabia, and the US are the top producers of crude oil in the world, with the US, China, Japan and India being its biggest consumers. These countries are also the biggest importers of crude oil in the world. Since the major economies of the world heavily rely on imported energy source, a lot of global politics is played about the liquid gold, crude oil. Since crude oil is traded mostly in US dollars, it also raises the importance of the dollar and very intractably binds the global economy with it. Now for over a century, crude oil has been used not only as a tool for industrial and economic growth, but also to derive political advantage.

Crude Oil Pricing

Commodity type pricing mechanism for crude oil came in to being about mid - 1980s when the long-term oil contracts established by OPEC came to an end. The pricing is referenced from a benchmark which help in deciding the commodity price based on its similarity or deviation from the nearest benchmark crude. Major benchmarking grades across the globe are, West Texas Intermediate (WTI), Brent Crude and Dubai Crude. Spot markets were established in 1970s and caught on with emergence of a significant non - OPEC oil production. Main spot transaction centres are New York, Singapore and Europe. The same three benchmarks remain the key reference for these transaction. A derivative market, including futures and options, has also developed in light of price volatility. New York Mercantile Exchange (NYMEX) and International Petroleum Exchange (IPE) are the leading financial market and instrumental in leading world oil price. Long-term contracts continue to be widely used, especially in Middle East, while they are no long fixed price but are with renewal clause.

Crude doesn't have any direct end use and must be refined in to different petroleum products. The value of crude is determined the total value of the products processed from the crude: called Gross Crude Worth. It, from the refiner's point of view, sets the upper limit of crude price while the lower limit can be said to be set by the production cost. Multiple factors play role in deciding the price in range of these two limits. The marker crudes are identified by their quality defined by sulphur content, gravity etc. WTI as a reference is often used for financial derivatives market and responds immediately to market response. Brent is closer to international supply crude in quality and hence is more depictive of physical market and international supply - demand relationship. From international trade point of view these two are most important benchmarks.

In 1980s official price system was brought down and a new pricing formula was introduced, Netback Pricing. This formula was based on the spot market price of the total end product produced from the crude and refining margin.

Crude Oil Price (FOB) = GPW in the spot market - fixed refining margin - transport costs Refining margin is given by:

Refining margin = GPW - crude costs - transport costs and applicable fees & duties - financial costs - variable costs - fixed costs

This system continues to be used and has a direct reference to global crude markets. It allows the seller to target specific areas and customers by modifying formulas. To avoid bias arising from one kind of benchmark, a basket of marker crudes are used. For east-bound export from the Arabian region, Dubai & Oman grades are used whereas for west-bound export, the IPE Brent futures price is used. East-bound sales price is normally higher than westbound sales price, the difference being called 'Asian Premium'.

The Oil Price Slump of 2014 - 15: Cause & Effect

From June 2014, the oil price has plummeted about 58 per cent, going as low as $46 per barrel before peaking again, to reach about $65 per barrel. This plunge has affected everyone: producers, exporters, governments and consumers. It was like a shot in the arm for the global economy. It has been the biggest slump since 2008 and does not seem to be stabilising very soon. While there are many complex factors at play, the essential factors are supply and demand. What we are seeing here is an oversupply of crude oil.

The oil price have been fairly stable from 2010 to June mid - 2014 after which it has fallen continuously except for a short jump back on account of reducing rig counts in United Stated of America.

The demand - supply balance plot above sufficiently describe why the prices were going down. Yet, the question remains: What caused the demand to go down? Also, when it did go down, why did the producers not cut the supply to keep prices up? There are many reasons that could be speculated for keeping up the supply or even increasing it, despite the drop in prices; this is a big move and unforeseen as Saudi Arabia and many other OPEC countries depend on an oil price greater than $100 to sustain its welfare scheme and to fund its budget. Some of the reasons which are essentially leading to this parity in supply and demand are:

1. The US import from OPEC has drastically reduced over the last three years pertaining to the Shale boom in the country. Shale produce remain lucrative only when oil price remains north of $100. OPEC will have interest in letting the price go down to negate the shale oil effect of United States of America by making it unprofitable to produce.

The above plot shows a steady decline in US dependence on imported crude oil, and the trend is speculated to grow further. The plot below, of productions from shale play necessarily, shows the reason for the decline. The increasing production from domestic shale plays caused the import to go down and hence the oversupply in international market. The domestic supply are slated to grow further and thus the demand from US is likely to go even low.

2. Stemming the growth of Iraq and the influence of Iran in the region: Iraq has kick-started production particularly South Basra oil , along with the influx of Kurd oil. Saudi Arabia, as the largest OPEC producer might be a little ginger over this new development. The Shia influence spreads over the region giving strong leverage to Iran, which is loggerheads with the Kingdom of Saudi Arabia over sectarian difference and other political factors. The drop in price will affect the Iraqi budget, which had been planned with a higher oil price.

3. Drop in demand from East: the growth projections of China have come down from last year while the demand from Japan, Taiwan and India has tapered. European Union and Brazil consumptions have also come down. This all is happening when production has actually increased from Libya, Iraq and Russia.


4. Thwart the growth of ISIS -It is a mere speculation that Saudi government aligned with the US and NATO, but the fact that ISIS was selling pilfered oil for about $1 million/day makes it a compelling reason to thwart their growth, profits of which goes to fund the terrorist operation (6).

5. Another speculation is to ostracise Russia for the Ukraine aggression and unshackle Europe from its Gas cuffs. While these seems to be the cause why the parity was allowed to build up, the effect of it has been felt by every stakeholder across the world including OPEC themselves.


1. US shale projects are vulnerable with oil price below $80 per barrel. Fracking wells tend to deplete fast and hence there is a need to drill constantly. While many companies can scale down, some have to stay for the huge sunk cost. Big companies can take producing while taking some losses, small companies are likely to default on their loans, and might end up in bankruptcy.

2. Oil revenue makes about 45 per cent of the Russia budget plan and the sudden fall has been ruinous to it. The country's currency-Ruble, has seen its value collapsing and inflation is rising, leading to widespread panic. The central banks have increased the interest rates to 17 per cent to stop people from selling off Rubles. Falling price along with western sanctions have hit the country really bad (7).

3. Even the members of OPEC are not shielded from the effect. Venezuela, despite being a major exporter, is finding it difficult to manage their economy. The economy, already going through tough times, is now teetering on the brink of recession with inflation running about 60 per cent (8).

4. OPEC members such as Iran, Iraq and Nigeria, have great domestic budget demand pertaining to their large population as compared to their oil revenue, and are now feeling the heat by decline in oil revenue. Each of them have a different optimal price based on the contribution of oil in their budgetary plan and if oil remains below that point for long, it will hurt them. Every country has a different, and varying on a large scale, breakeven price for crude oil to meet their budgetary needs. The figure below shows the fiscal breakeven point for different OPEC members which clearly suggests that they have already been running in massive fiscal deficit just on account of declining international crude price.


5.Europe and Asia are mostly smiling away with the development. China, despite the slowdown, is set to become highest importer. Japan imports almost all of its oil and India is dependent on import for about 75 per cent of its need. Europe expect a 0.1 per cent increase in economy for every 10 per cent fall in oil price (10)

The Oil Price Slump & India

India imports approximately 75 per cent of its total crude need, which makes it the fourth largest importer in the world. This position translates directly into really huge oil import bills. For every drop of $1 in per barrel price of oil, India saves about ?40 billion (11). This has had a threefold effect on the Indian economy.

First, as the price plummeted, it greatly decreased the oil import bill for India, resulting in the shrinking of trade deficit. A $50 drop in crude prices equals a saving of about 2.5 per cent of GDP in Current Account Deficit.


Second, the fall in international oil price will ease out the load of subsidies on the government. As the international crude price has gone down by about 58 per cent, the end user fuel price on an average has gone down about 14 per cent. This has happened because government has, since November, increased the taxes thrice. This added revenue and saving on subsidy is helping controlling fiscal deficit (12).

Third, the oil price drop is helping in controlling inflation. Reduction in transportation cost have helped in controlling the inflation of perishables. In January RBI announced a 25 basis point trimming of repo rate bringing it down to 7.75 per cent. The Wholesale Price Index has risen only 0.11 per cent as compared to last year December (11). While these are the upside, there is also speculation that due to budgetary constraints faced in Middle Eastern oil exporting countries, many construction and infrastructure project might be shut down or stalled. These sector in the region employee Indian labour in huge number. Stalling of project can lead to them losing the job, which intern will reduce remittance made by them and also lead to the return of labourers in massive numbers.

Conclusion
As we saw, while there is a formulated method to come to the value pricing of crude oil, the price has predominantly been decided by the market force. On the face of it, all factors boils down to supply and demand gap. But the number of factors at play to decide how wide that gap would be, are numerous and very complex. Everything from technical advancement in the field of study, new breakthrough, industrial growth or slowdown, natural calamity to political imbalance, diplomatic relationship, regulatory change and geopolitics affect it regularly. There have been a long history of oil rush being punctuated by major global events, often regime changes and wars.


Jyothi Kainth
We have seen various cause and effects, which came in play during current oil price slump including technological progress, industrial slowdown, religious fundamentalism etc. A reversal will take place when one of these factors start subsiding. We are already seeing slowdown in Shale oil production in United States and rig count has decline. That one event alone saw oil price jumping back by about 8 per cent. OPEC members are also finding it very difficult to sustain as their economies are also, either stagnant or collapsing. There have been a regime change in Saudi Arabia, the most influential country in OPEC, and an OPEC meeting is scheduled in June. We can see again a climate building up which will definitely lead to some concrete events.

References.

1. EIA. http://www.eia.gov/todayinenergy/detail.cfm?id=7110. EIA. [Online] U.S. Energy Information Administration, 16 July 2012. [Cited: 9 February 2015.] http://www.eia.gov/todayinenergy/detail.cfm?id=7110.

2. Sanghvi, Naman. Clean Energy Making a Comeback? Part II. Business Today. [Online] Business Today, 21 August 2014. [Cited: 9 February 2015.] http://www.businesstoday.org/articles/2014/08/growth-of-the-clean-energy-sector-under-the-obama-administration-part-ii/.

3. Frank Talk Blog. Insight for Investors Frank Talk. U.S. Global Investor. [Online] U.S. Global Investor, 3 December 2012. [Cited: 9 February 2015.] http://www.usfunds.com/investor-library/frank-talk/the-significant-impact-of-us-oil-production/#.VNn8QTGUe3s.

4. Sozen. Crude oil prices could be weaker during 2014. Snake Oil Trading Blog. [Online] 1 May 2014. [Cited: 9 February 2015.] http://snakeoil1.blogspot.in/2014/01/crude-oil-prices-could-be-weaker-during.html.

5. Dalal, Khyathi. China's crude oil imports decline after high inventory stocking. Yahoo Finance. [Online] 29 August 2014. [Cited: 9 February 2015.] http://finance.yahoo.com/news/china-crude-oil-imports-decline-130018440.html.

6. Associated Press Reporter. ISIS is earning $1 MILLION per day in black market oil sales, says Treasury Department official. Mail Online. [Online] Dailymail UK, 23 October 2014. [Cited: 2015 February 2015.] http://www.dailymail.co.uk/news/article-2805033/US-IS-earns-1M-month-black-market-oil-sales.html.

7. Plumer, Brad. Why oil prices keep falling - and throwing the world into turmoil. Vox. [Online] 23 January 2015. [Cited: 8 February 2015.] http://www.vox.com/2014/12/16/7401705/oil-prices-falling.

8. Sabatini, Christopher. Opinion: Venezuela squandered oil riches, now faces default. CNN Money. [Online] CNN, 14 December 2014. [Cited: 9 February 2015.] http://money.cnn.com/2014/12/14/news/economy/venezuela-debt-default-citgo/.

9. Minczeski, Pat and Kent, Sarah. OPEC's Dilemma. Wall Street Journal. [Online] 16 November 2014. [Cited: 9 February 2015.] http://graphics.wsj.com/opec-dilemma/.

10. Bowler, Tim. Falling oil prices: Who are the winners and losers? BBC. [Online] 19 January 2015. [Cited: 8 February 2015.] http://www.bbc.com/news/business-29643612.

11. Bundhun, Rebecca. India's economy on the rise as oil price drops. The National. [Online] 24 January 2015. [Cited: 8 February 2015.] http://www.thenational.ae/business/economy/indias-economy-on-the-rise-as-oil-price-drops.

12. Panadiker, D H Pai. How falling crude prices affect India. Reuters. [Online] 11 September 2014. [Cited: 8 February 2015.] http://blogs.reuters.com/india-expertzone/2014/09/11/how-falling-crude-prices-affect-india/.

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