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Financial Express (India): How global demand adjusted to oil prices

EXTRACT: Some hundred years ago, Sir Marcus Samuel, founder of the Shell Transport & Trading Company, British half of the later Royal Dutch Shell, quizzed by a statutory committee investigating allegations of price gouging, responded, “price of oil, gentlemen, is what the market can bear.”


Growth in demand for oil has been contained in those non-OECD countries which have raised administered prices of petroleum products

By Saumitra Chaudhuri

It is just two years and some months back that crude prices crossed the $40 per barrel (/bbl) mark. A perceptive industry analyst (Purvin Barrow, July 2004) had focused on the two ‘engines’ of demand growth—the US and Chinese transportation sectors—and the severe supply side squeeze with spare Opec capacity dropping sharply and inadequate new asset creation by oil companies in the environment of low oil prices characterising the second half of the previous decade. The conclusion was that if everything came out wrong—the ‘train wreck’ scenario, crude prices would rise to nearly $90/bbl in 2006 and gradually fall over the next few years. The moderate picture of ‘controlled’ shortfalls would see prices rise steadily to $55/bbl by 2006, with the up trend continuing to $60/bbl in 2007.

Well, we did not quite get to $90/bbl, but it was hardly a train wreck. The world economy has been growing well above the trend rate and despite high petroleum product prices, general inflation has been in control. Basically oil prices reached the level they did because the world economy was able to afford it. Some hundred years ago, Sir Marcus Samuel, founder of the Shell Transport & Trading Company, British half of the later Royal Dutch Shell, quizzed by a statutory committee investigating allegations of price gouging, responded, “price of oil, gentlemen, is what the market can bear.”

But in bearing those high prices, fairly straight forward adjustment is put into motion. The rate of increase in demand slows down and investors pile on investment to expand production—and eventually prices tend to soften towards the level needed to sustain the more expensive component of production, while the low-cost producers, mostly Opec, take in rents.

However, most markets, unlike novelists, tend to expect the mundane—a series of tomorrows not wildly different from today. To go from below $30/bbl to over $70/bbl needs some high-powered rocket fuel, which can only come from a big shock. In 1973 and 1979, the shock was political; first the embargo on oil exports by Arab nations (followed by nationalisation and Opec’s coming of age) and then by the outbreak of the Iran-Iraq war.

This time round, the shock was purely economic, and since it was not an event feeding into 24-hour television news, it had a strong element of surprise. In 2001 global demand for crude oil was 77.3 million barrels per day (mpbd) and Opec members had an estimated spare capacity of some 7 mbpd. Demand growth had been 1.1 mbpd in the previous year, the developed economies of the globe appeared set to enter a recession, and there seemed no reason for upward pressures on oil prices. Little changed in 2002 and 2003; incremental oil demand was 0.7 and 1.3 mpbd respectively and even the hostilities in Iraq made no big splash. Some surmised that once the US and her allies were able to stabilise the situation in Iraq, oil prices would drop, as Iraqi oil production would be ramped up. Indeed immediately after Baghdad’s fall, oil prices fell. The wait for Iraqi oil has however proved to be a long one indeed. 
The surprise of 2004 came in the form of a massive increase in oil demand by 3.1 mbpd. Economic recovery in the US saw demand mounting by over 1 mpbd. Chinese demand soared by nearly 1 mpbd or by 16%; growth had been 0.6 mpbd (12%) in 2003 and 0.3 mpbd (6%) in 2002. On the supply side, we are told that Opec’s ‘spare’ capacity dropped from the comfortable 7 mbpd to less than 2 mbpd by mid-2003 and has stayed there. Opec lifted production by 2.0 mbpd in 2003 and by another 2.3 mpbd in 2004, apparently exhausting the reserve capacity it had in early 2002. The increase in price did not quite curb demand, which expanded by another 1.2 mpbd in 2005 and is likely to do the same in 2006. Almost all of the demand growth in 2005 and 2006 (expected) is from the non-OECD countries.

However, as recent issues of the Oil Market Report of the International Energy Agency report, demand growth has slowed in 2005 and 2006 in those non-OECD countries where administered petroleum products prices have been raised. While the example usually cited is Indonesia and occasionally India, it is equally and more crucially applicable to China. Latest data show that Chinese oil demand in 2005 increased by a mere 0.17 mpbd in 2006, that more price hikes (up to 15–20% as reported) are in the pipeline, all of which holds out the potential of making actual consumption levels in 2006 to fall short of expectations (7.0 mpbd) and so too for 2007 expectations.

Given that there’s much inefficiency everywhere and so much opportunity to improve and innovate, prices work rather well in realising efficiencies of re-allocation. Fuel use can become far more sparing without affecting quality of life (indeed enhancing it, if we factor in environmental externalities) while alternatives including bio-fuels and other renewable resources get a chance to enter the picture. Sitting on price adjustment only encourages inefficient use, such as the adulteration of expensive diesel with subsidised kerosene, besides constraining the productive use of the nation’s financial resources. The worst of the 2004 crisis appears to be over, which does not, of course, preclude a new one, considering the volatility in West Asia and some other oil-rich regions. However, we in India have yet to make adequate arrangements for the adjustments that were occasioned by the crisis. Before we can move on, the backlog needs to be cleared.

—The writer is economic advisor, Icra 
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