Demand for energy is not much dependent on price. If an individual needs to commute 20 km a day, she will pay the required transport costs. If the price of fuel rises, she will skimp on other consumption. If the price falls, she will deploy savings elsewhere. This pattern of price-invariant demand pretty much scales up for entire economies. The consequence of relatively invariant demand is that small changes in supply can lead to big price changes.
The Organization of the Petroleum Exporting Countries (Opec) recently came to an agreement to restrict oversupply. This was the first time the cartel cut supply in eight years. Given a slow world economy and over-supply of crude oil and gas, production cutbacks seem obvious.
But, there are stumbling blocks to such agreements and, indeed, it’s hard to say if this agreement will hold. One obvious problem: If many nations reduce and one nation doesn’t, the nation that continues to pump more oil benefits from rising prices. So, there is always a temptation for every party to such agreements to break with the herd.
Two key Opec producers, Saudi Arabia and Iran, don’t get on. They are involved in proxy wars. Ironically, both have been advocates for high production. Iran is hungry for foreign exchange after years of sanctions. Saudi Arabia wants to force the US shale oil industry into bankruptcy by keeping prices low. However, the Saudis now need to balance their budget and want higher prices.
Opec is looking to cut production by about 750,000 barrels per day (bpd) and, crucially, Iran is exempted. This means Iran would be allowed to benefit from rising prices. If the agreement works, Opec supply will reduce by about two per cent, to below 33 million bpd.
Russia, one of the world’s largest exporters, is not part of Opec. Russia pumps 11 million bpd. It could step in to export more, especially if prices do rise. The US is also a big non-Opec producer (production varies between 8.5 million bpd and 9.6 million bpd), though it’s focused on domestic demand. The shale gas revolution has put a ceiling on price. At over $55-60 a barrel, most shale operations are profitable and fresh supply enters, albeit with three-four month lags.
Putting it all together, if the Opec cuts happen, total global supply will reduce by about 1.25 per cent. That could, according to analysts, push up crude oil prices by 20-25 per cent. Brent prices were trending at $44-45 a barrel before Opec met. Prices have since crossed $51. Gas prices move in line and have also risen. Coal prices have also risen.
Another potential issue is supply disruption due to messy geopolitics. Syria-Iraq is in turmoil and Libya in bad shape. Nigeria is fighting a war against Boko Haram. Venezuela is near economic collapse. Supply disruptions could, therefore, arise in any of these regions. As noted above, even one per cent tighter supply could mean a big price spike.
High crude oil prices have negative implications for India. The 2016-17 Budget assumed the Indian crude oil basket would be priced at less than $50 a barrel for the financial year. The basket is a weighted average of Oman, Dubai and Brent grades, and costs a little less than Brent. The basket averaged about $46 for 2015-16 and $43-44 for April-August 2016. In September, the basket was at $44. It moved to $49 in early October.
Domestic gas prices have been fixed for October 2016-March 2017, using a formula that combines multiple historical foreign gas rates. The gas price has been cut by 18 per cent to $2.5 a million British thermal units (mBtu), down from $3.06 from the April-September period. This could be awkward if gas prices do move up.
Low energy prices have been beneficial for India in multiple ways. The pricing of most petro-based fuels has been freed. The subsidy on gas and kerosene has been cut. Public sector undertakings (PSUs) in the marketing-refining space have made profits. The central government has imposed excise duties, boosting revenue collections, rather than pass on price cuts. Rising crude prices would require passing on increases to consumers or cutting excise rates or forcing PSUs to accept losses, or directly raise the subsidy burden.
There is a good chance the Opec agreement will not hold and global over-supply will continue. If it does, that’s fine for India. But, threats of supply disruption do remain, and, sooner or later, prices will rise again. If that happens, India’s import dependence would hurt.
