Oil Price Volatility and India’s Energy Security: Policies and Options

The recent downslide in crude oil prices from a peak of US $147 a barrel to below $40 and speculated to fall further to $25 has evidently provided relief to oil importing countries, which have been triply inflicted by huge oil pool deficits, growing food prices and global economic downturn. But based on current oil market fundamentals and past experience, there is no reason not to believe that the current fall in oil prices is likely to be temporary. Sooner or later prices will rise and may even be higher than the recent peak because of two particular reasons. One, the fall in prices has been precipitated by expected cuts in demand as a result of the global economic downturn. In contrast, prices had fallen in the 1980s and 1990s because of an excess of supply over demand. Second, the steep fall in prices is unfavourable to current and planned investment in the oil industry. This would potentially constrict fresh supplies of oil and thus fail to meet the additional demand which is expected to be generated when the world economy in general and emerging economies like India and China in particular revive. The expected timeframe of economic recovery is around 12 to 18 months. These concerns and apprehensions were expressed by the Saudi Oil Minister Ali al-Naimi on December 19, 2008, during an address in London to oil producing and consuming countries. Al-Naimi stated that the steep fall in oil prices is causing havoc with investment plans in oil producing countries and is jeopardizing future oil supplies. He further stated that $75 “is the price that marginal producers need to maintain investments sufficient to provide adequate supplies for future oil consumption needs.”

What is the Fair Price to Boost Oil Production?

It is difficult to decide on an appropriate oil price that could induce or maintain a sustained inflow of investment capital in the oil industry. This is most likely because of the nature of oil, which qualifies as both an economic and strategic commodity, making price analysis truly complex and controversial. Nevertheless, there are two approaches to the ‘great oil price debate’ – structural and cyclical. Structuralists maintain that an abnormal spike in prices is the result of structural changes in the oil industry reflecting the huge investment gap in the past or expected in future, whereas the cyclical group believes in the ‘bubble’ analogy caused by certain mutually reinforcing adverse factors pushing prices upwards. The latter approach believes in physical shortages as a result of geo-politically influenced supply bottlenecks, excess demand and bull-run in the futures market. The current downturn in oil prices reflects the situation portrayed by the ‘bubble’ approach. The global recession has burst the bubble and pushed oil prices to one of the lowest levels. Prices have come down by 74 per cent in the last four months. This has depressed the fundamentals of the oil market and potentially circumvents the inflow of investible funds to the oil industry. This is not a good sign to ensure stable and adequate oil supply in the future. In fact, the global economic downturn is strongly expected to reverse in a couple of years. This scenario predicts possible structural limitations of the oil industry in meeting future demand.

In fact, before the current economic recession set in, some agencies like the International Energy Agency (IEA) had already assessed the future oil demand and estimated the possible volume of investments required, particularly under a business-as-usual scenario, to meet it. In a 2004 report, the IEA estimated that by 2030 the world would be consuming around 121 million barrels per day (mbpd) and, to achieve this, the global oil industry requires an investment of approximately $3 trillion. In a 2006 report, the agency revised the estimated investment volume upwards to $4.3 trillion to produce a little less quantum of oil, 116 mbpd, by 2030. This rise of 43 per cent in investment volume to produce 5 mbpd less oil for the same period has been attributed to the end of ‘cheap oil era’. This in turn is a function of the ageing of existing giant and super giant oil fields as well as the need to drill for oil in new and small sized wells, whose marginal cost would be much higher than that of existing giant and super giant fields.

Thus, under this scenario future oil prices would be in the range of $75 to $90 a barrel. This would perhaps be an appropriate price line to induce a sustained inflow of investment in the oil industry, at least for the foreseeable future. According to Goldman Sachs, 30 ongoing oil projects require $55 a barrel to break even. Due to the current comparatively lower prices, oil companies and those producing oilfield equipment are putting some projects on hold. As a representative of OPEC, Saudi Oil Minister al-Naimi has repeatedly asserted that $75 a barrel was a “fair and reasonable” price for crude oil. During his December 2008 speech in London mentioned earlier, he stated that “when oil is priced lower, such as it is now, there will be less investment and less future supply.” Lufkin Industries, a maker of oil and gas equipment has expressed the same apprehension. According to the median estimates of 33 analysts compiled by Bloomberg, “Oil may rebound next year to average $60 a barrel as the OPEC makes record production cuts to counter the deepest economic slump since World War II.” The IEA has projected that oil prices will rebound to more than $100 a barrel as soon as the world economy recovers, and will exceed $200 by 2030. This view was understandably shared by oil-producing countries, and was articulated by UAE Energy Minister Mohammad al-Hamli, who told reporters that “it is very important to continue investing to maintain and increase capacity in order to be prepared for the next [price] cycle.” He characterized the decline as just a “price cycle”, having structural implications.

What India Should Do?

India’s case is that of a severely crude oil deficient country. While domestic production has reached a plateau, the fast growing economy is strongly pushing up demand. In the foreseeable future, India’s oil dependence on outside sources would grow to more than 90 per cent of total oil consumption and the bulk of the supplies would be procured from Middle Eastern countries. What is required at this juncture is a plan that can deal with medium term price volatility. First and foremost, India should grab the opportunity created by cheap oil markets. Oil prices are expected to plunge even below the present rate owing to dismal consumption and ballooning stocks around the world. India should ‘lock’ or ‘bind’ supplying countries on medium to long term basis. It should sign long term agreements or bind the supplying countries through ‘contracts’, rather than continue the traditional practice of ‘spot’ market purchases. India should hedge its oil security though oil futures at today’s negotiated rates which have declined to $37.68, the lowest since July 1, 2004, and minimize tomorrow’s price shocks. This is one of three dimensions of ensuring ‘energy security’ at a cheaper rate. This is of utmost importance because oil accounts for approximately more than 42 per cent of India’s total commercial energy mix. At present, India consumes approximately 3.1 million barrels of oil a day and this is expected to grow to a couple of million barrels more, making India the third largest consuming country in Asia and the fourth largest in the world. Expenditure-wise, year-on-year basis, a rise in the price of oil by a single dollar costs the economy approximately Rs.17.7 million. Besides, it would trigger oil-induced cascading effects, including inflation, unemployment, and social unrest. The rise in oil prices witnessed over the last few years has caused havoc to Indian finance. According to the latest data released by the Reserve Bank of India, the current account deficit widened to $12.54 billion during the second quarter of the current financial year, as against $4.29 billion in July-September 2007; net trade deficit has widened to $17.2 billion in the second quarter of fiscal 2008-09 on account of a 45 per cent increase in oil imports partly due to increase in prices. This is an opportune moment for India to initiate and test non-traditional tools to minimize future losses.

It is significant to note that oil exporting countries are also equally anxious to manage the volatility of oil markets and stabilize their oil incomes. Because of ‘Dutch Disease’, their economies have failed to develop other sectors and are more dependent upon the hydrocarbons industry. For them, oil importing countries are very important and they too prefer ‘contracts’ with large oil importers. According to the International Monetary Fund (IMF), calculated in an annualized basis, a decline of $1 in the price of crude would translate into a loss in revenues of $3.5 billion for Saudi Arabia, $300 million for Qatar, $1 billion for the United Arab Emirates (UAE) and $960 million for Kuwait. A cut in demand has drastically reduced prices leading oil refineries to build up huge stocks, both stable and mobile. According to the Wall Street Journal (December 18, 2008) oil supplies are now building at such a rate that over 40 million barrels are being held in idle supertankers around the world. The size of the inventory floating in supertankers is sufficient to meet France’s monthly oil requirements. Thus, it is obvious that the present situation is opportune for both oil producing and consuming countries to enter into ‘contracts’ to hedge their losses from unforeseen shocks and spikes.

Another significant tool that is widely used to ensure uninterrupted oil supply is an integrated energy investment plan. The Government of India should develop a long term integrated energy investment plan with major oil producing countries. Signing of integrated energy agreements would bring a number of benefits: (i) ensure stable and uninterrupted flow of oil during both peace and crises; (ii) oil exporting countries would invest money in India’s refinery sector, thus ploughing money back and generating employment. In fact, this would be just like energy ‘offsets’ coming to India from oil exporting countries; once they set up refineries in India they would develop an economic stake and thus be averse to stopping crude supplies even in a crisis situation. China and Saudi Arabia have signed such integrated energy investment agreements. Saudi Aramco and Chinese Sinopec are in talks to construct a second line facility in Shandong province. The first shipments of Saudi crude arrived at Qingdao in May-June 2008.

As a part of the acquisition plan of oil acreages abroad, India should also invest in the gas sector in these countries. For instance, Gulf countries, except Qatar, have opened up their Gas sector for foreign capital and technology with the objective of feeding gas domestically and exporting oil for revenues in order to finance their economic development. ONGC-Videsh Limited should invest in the gas sector of Gulf countries, which would also enable India to develop the scope for increasing mutual co-operation and reciprocity in diversified fields over the long term.

In a nutshell, the present oil market situation posits both a ‘risk’ as well as an ‘opportunity’ to both oil importing and exporting countries. The fundamentals of the oil market suggests the maximum possibility of rising oil prices in the future, a risk that needs to be warded off by oil exporting countries. The present slump in oil prices offers opportunities to importing countries to hedge against future shocks. This, they can obtain through meticulous use of the commodity market instruments as well as through energy specific policies such as oil futures, forward trading, contracts, integrated agreements, etc. This obviously provides a common basis for interaction between oil exporting and importing countries to strike a balance between their risks and opportunities on mutually agreed terms and conditions. Thus, it is high time India adopts a pro-active hydrocarbons policy and secures its economy against shocks and distress. It is worthwhile to have a few contracts in hand at a few dollar losses today than to be left at the mercy of ruthless oil markets in the future.