WHAT THE SAUDIS (AND OTHER OPEC PRODUCERS) NEED TO DO ABOUT THE FALLING CRUDE OIL PRICE?
Crude Oil, a commodity that literally fuels the everyday life of every person on this planet. From the motor transportation fuels, to the heating and cooking fuels as well as petrochemicals, all are borne out of this commodity that has been the lifeblood of the planet for over a century.
The global demand for crude oil has hovered in the range of 94 to 96 million barrels per day and the supply has also been in the similar range. While there has been fluctuation in the supply and demand matrix, this has been fractional when considered as a percentage of the overall demand and supply.
We have nevertheless witnessed the price of crude oil fall drastically in the last 24 months from USD 100 per barrel to below USD 30 per barrel. It is mind boggling that the commodity which was just two years ago being predicted to be headed to USD 150 per barrel levels, has now tanked to USD 30 per barrel without anyone cocking an eyebrow and without their being any structural demand or supply shift.
While it is a good thing to happen for net oil importer countries such as India, yet it needs to be acknowledged that the price of the commodity falling so drastically without a change in the underlying economics, will have more negative than positive effects for all the stake holders in the medium to long term.
For the oil producers the fall in crude oil price spells a massive cut back in the revenues thereby unsettling the national budgets. Countries such as Saudi, Iran, Russia and Nigeria which are major oil producers, peg their budget break even at crude oil prices which are much higher than present levels. The spending by such countries on domestic infrastructure as well as further oil exploration and development has been factored into the national budgets at much higher crude oil prices than they are seeing at this point of time. Nevertheless the Saudis, as a lead nation of the OPEC group, desisted from supply cuts as a tool to bolster crude oil price for fear of losing market share to the other oil producing countries. This has in turn set off a spiralling down trend in the crude oil prices and we have seen the prices fall from USD 70 per barrel to USD 30 per barrel in the last 12 months itself.
For the oil importers such as India, the crude oil price being below a particular level starts to hurt as it sucks out the investment capital available from foreign investors on the one hand, as well as depleting the spending power of oil rich countries thereby hurting our exports. More so the drying up of the foreign funds inflow into the country and the flight of capital at the back of redemptions by the oil rich investors, in turn hurts the currency and negates the effect of the crude oil price fall. Thus beyond a level the fall in crude oil price does not benefit oil importers either.
While there has been a school of thought that the lower crude oil prices would push out the new exploration and development activities in deep offshore acreages owing to non-viability, and the fact that frontier resources such as shale gas would also be marginalized with crude oil prices prevailing below their break-even production costs and thereby the supply side would check itself and gradually the prices would stabilize and head north, this theory does not seem to be playing out soon enough for the oil producers as crude continues to slide month after month.
To add to the woes of the oil producers you see further supply side disruptions emerging with Iran coming back into the market with the easing of sanctions as well as US dismantling the decades old ban on oil exports thereby becoming a contributor to the global oil and gas supply pool.
In the face of such complex dynamics of the international economies, the question arises what should major oil producers such as Saudi, Russia and West African countries do. Should they sit idly by and watch the capitulation of the markets which affects their very survival? Or should they begin to look outside of crude oil for sources of national income?
In my view the answer may be a simplistic one which may have gotten obfuscated in the complexity of market analyses and daily price movements.
To address the issue one may need to go back to the basics.
The fundamental determinants of prices are demand and supply. While there has been fluctuation in demand supply, this has been marginal and in my view definitely not significant enough to merit such a major downgrading of crude oil prices as we have seen in the recent months. There certainly hasn’t been a correction in demand figures by 10-20% or supply boost by 10-20%. On the contrary organizations such as IAEA still forecast the global energy demand rising by almost 1/3rd by 2040. Yet the prices continue to slide? What’s amiss?
In my view what is amiss is the very reference point of the price itself. The crude oil price we talk about is referred in terms of the benchmark price of crude in the form or WTI and Brent marker crudes.
WTI and Brent are quoted in US and European markets and their levels are determined not by the demand supply levels of physical crude oil traded but by the demand supply quotes of paper/future traders on a daily basis. It is a well-known fact that most of the trades on these markets are settled without physical delivery of crude and thus are purely speculative in nature. Thus in theory persons with deep financial pockets, or even nations with financial wherewithal and political or economic motives, could go short on the commodity and bring down the prices substantially without their being any real change in the demand supply realities of the commodity in the physical world.
In my view, this is where the problem lies and is being ignored by the major oil producers. Set in their ways of working they continue to peg their national resource production to prices determined by these ‘paper markets’ which are neither in their control nor of their making.
The producers of oil need to de-recognize benchmark crude indices!!!! They need to de-link their prices from these artificial and manipulated price levels of WTI and Brent.
Rather than pricing every barrel of crude based on WTI or Brent and only determining for themselves the premium or discount that their country’s crude carries to WTI or Brent, they need to determine and announce the per barrel price itself.
The OPEC Cartel thus needs to change its role from determining the quantity to be produced, to determining the fair price to be charged by the producers.
Considering the fact that the OPEC nations control more than 40% of the global production, they certainly have the pricing power and basis to determine what levels the commodity being produced by them ought to be sold at. As per basic economics it is for the producers and the consumers to negotiate and agree on the prices based on demand and supply and not for third parties to determine the price on an exchange based on pure paper/speculative transactions.
Once the OPEC nations collectively start setting the per barrel flat price of crude, it would then be for each producer to separately price their specific crude premium or discount to the flat price determined by OPEC based on the characteristics of their crude grade and the demand supply dynamics thereof.
In this manner the pricing of a commodity as important and strategic as crude oil would be free from the vices and malpractices of financial speculators and in the medium to long term the prices would stabilize as per the real physical demand supply scenario. It would eliminate speculative volatility in crude oil prices and bring stability to the macro economic scenario.
The above practice would thus be in the long term interest of not only the crude producers but also all other countries in general. It is time to unshackle real economies and business from the speculative markets which have already wrecked many sectors such as housing and brought economies to their knees.
©Anshuman Khanna
Published on 16th January 2016