Abheek Barua: A primer on oil prices

If the US starts selling from its oil reserves to China, the oil market could cool down considerably

Oil prices are not just about oil. They are perhaps the most sensitive barometer of global macroeconomics and politics. So if you're wondering why prices on the New York Mercantile Exchange (NYMEX) are currently touching 50 dollars a barrel, the answer perhaps lies in the fact that China did not revalue its currency.

Or that a combination of tax cuts and inventory corrections has triggered a rebound in the US economy pushing up consumer demand for a whole bunch of things, including gasoline. And that Vladimir Putin is out to destroy the fat cats of the Russian oligarchy who had become independent centres of power.

But first, let's get some preliminaries out of the way. Market prices of crude have nothing to do with the cost of extraction. I am told that the cost varies between two dollars a barrel if you are getting it from the oil-soaked dunes of Kuwait, and about 15 dollars if you are squeezing it out of the tar sands of Canada.

Even if you were to take a simple average, it would make the marginal extraction cost eight and a half dollars a barrel. Historically, market prices of crude have on average a little more than twice the marginal cost of production.

I guess this kind of skewed pricing is what cartelised markets are all about. OPEC targets roughly a minimum average revenue of 25 dollars a barrel and ensures this through periodic squeezes on production. Beyond this, prices are determined by the balance of demand and supply.

The demand side of the oil balance highlights the role of Asia, particularly China, in the oil price jigsaw. Going by apex think-tank International Energy Association's (IEA's) estimates and forecasts from its September 2004 oil market report, the biggest increase in oil demand has come from China, whose average increase in oil consumption in 2004 over 2003 is about 900,000 barrels a day.

Other Asian countries tie with North America for the second place with increases of 400,000 barrels each. If the demand across countries is aggregated, the consumption climbs up from 79.6 million barrels in 2003 a day to 82.2 million barrels in 2004, a jump of 2.6 million barrels.

On the other side of the equation, supplies from non-OPEC producers are expected to increase only by about 300,000 barrels a day in 2004. That leaves OPEC to service the residual demand or supply roughly 2.3 million a day more.

The question then is: does the cartel really have the resources to bridge this gap? To be fair, OPEC members have risen to this challenge of rising demand rather well. If NGLs (natural gas liquids) are included in supply, OPEC has supplied on average 2.15 million barrels extra in the first half of 2004 compared to 2003.

The problem is that in trying to put this extra supply in the market, it has eaten into its spare capacity for extraction. IEA estimates peg a "comfortable" level of spare capacity at 2""3 million barrels per day""the current spare capacity of the OPEC producers is less than a million barrels a day.

In short, in the absence of adequate spare capacity, the balance of demand and supply in the oil markets rests on a knife-edge. Any threat to supply in the short term""be it a skirmish in Iraq, or the takeover of Russian oil giant Yukos by the government, or a hurricane in Florida""can send prices skyrocketing.

While this analysis explains why average price levels are high, does it explain prices that have moved above the $50-a-barrel mark? Perhaps not. As with all traded commodities, prices tend to "overshoot" with the slightest bit of bad news.

Oil prices are no exception. Unfortunately, there's been a flurry of news of possible supply disruptions over the last six months that have tended to push prices above what the fundamentals of demand and supply would warrant.

The latest is the threat of Nigerian rebels to blow up installations in the oil-rich Niger delta. However, while 50 dollar levels might be unsustainable over the medium term, the adverse fundamentals themselves suggest that 40 dollar plus levels are likely to persist.

But for how long? Much depends on how global demand pans out next year. China's growth seems to have gone through a phase of correction without any signs of rapid deceleration.

Unless China decides to revalue its currency (that seems really quite remote at this stage) or hike domestic interest rates, it's unlikely that the growth in Chinese demand for oil will taper off dramatically. Thus, the future of the US economy will determine where oil prices will settle next year.

If the spike in oil prices is sufficient to arrest its growth momentum and the US economy slides into a slowdown, it could have a moderating influence on oil markets. If on the other hand, relatively high growth rates sustain for a couple of quarters more, high prices are likely to persist.

The US central bank, incidentally, is likely to try and support the growth momentum and hold off on interest rate hikes after another quarter percentage point increase in the target Fed funds rate.

On the supply side, additional capacity takes time to create since investments typically come with a gestation lag. Thus, any significant increase in "spare" capacity in OPEC could take a while to materialise. The bottom line is that high oil prices are likely to continue for some time in the near future unless the US goes into a tailspin. This does not mean, however, that prices will maintain a steady level. Prices would tend to flare up if there's a "scare" and soften if there is a let-up in negative news flow.

There is, however, a way out of this high price gridlock as analysts like Fred Bergsten of the Institute for International Economics have suggested.

The US is sitting on large "strategic" reserves of oil estimated at about 700 million barrels. If the US starts selling from these reserves possibly directly to China and other economies through a set of bilateral arrangements, the oil market could cool down considerably.

It would simultaneously stave off the threat to consumer spending, which high retail prices of oil products present.

This is essentially a short-run analysis of the oil market. There is a fair share of "doomsday" forecasts for prices in the long term. These are predicated on the fact that high-yielding, low-cost fields in the Middle East have "peaked" off and there is likely to be growing dependence on higher-cost sources.

This would lead to an entire paradigm shift in the pricing regime where the bottom of the cycle could be about 35 dollars a barrel and the ceiling of the price-band well over 50 dollars.

This, one hopes, is a tad far-fetched. As new investments in oil extraction flow in, supply pressures could ease significantly and restore a saner balance in the oil market.

Persistently high oil prices are, to use a cliche, a "wake-up" call for policy makers across the globe to set right fundamental imbalances. A correction in Chinese growth rates for instance is long overdue and can come only with currency revaluation and higher domestic interest rates; on the other hand, the US can't keep adding to strategic reserves. Efforts at increasing fuel efficiency and the search for alternative fuels, which typically take the backseat during periods of low prices, are also likely to revive. High prices would also push up the profitability of producers and create incentives for investments in new extraction.

However, while the process of correction is under way, consumers have to bear the cost.