Background

The world's top energy consumers must act quickly to control soaring oil prices before they trigger a global recession. According to experts, the situation regarding energy prices is becoming extremely challenging, if left un addressed, it may well cause a recession in the global economy.

Oil prices made their biggest single-day surge recently, soaring US$11 to US$138.54 on the New York Mercantile Exchange, an 8 per cent increase. On the same day, the United States announced a rise in unemployment. The burst higher, which also came on rising Middle East tensions, also raised the prospect of accelerating inflation by adding to already strained transportation costs. That gloomy outlook sent stocks tumbling, taking the Dow Jones industrials nearly 400 points.

The Indian Government has raised the domestic retail selling price of petrol, diesel, and domestic liquefied petroleum gas on June 4,2008, taking into account Indian basket prices at $113 a barrel. The global crude prices were holding above $123 a barrel inNew York Mercantile Exchange electronic trading on June 4. Apart from the price hike, the Government had also announced duty cuts, oil bonds, and higher upstream contribution to compensate the oil marketing companies, which were suffering heavy revenue losses for selling petroleum products below the cost price.

The Government of India announced an increase of Rs 5 per liter in petrol, Rs 3 per liter diesel prices and that of LPG by Rs 50 per cylinder.Government explained that the price hike had become necessary to curb the losses of oil marketing companies. Many states have already slashed sales tax on petrol and diesel and VAT on cooking gas to cushion the impact of the hike on consumers.

Impact on the Indian Economy

The revenue loss for the fiscal was estimated at Rs 2,45,000 crore. Had it not been for the increase, the three-state run oil firms BPCL, HPCL and IOC would have lost over Rs 245,000 crore in revenues this fiscal and would have run out of cash to import crude. States ruled by Left parties observed a shutdown, including two days in West Bengal, to protest the price increase.

India has somehow weathered the previous oil shocks, but the current one poses the worst threat yet to its economy. Oil price may soon move past $150 per barrel and as per some expert predictions, it will climb close to $400 per barrel by 2015. TheGovernment will need to do a lot of outside the box thinking to solve the catastrophe in the making.

The mind-boggling losses of Rs 245,000 crore of the oil companies have to be made up if they are not to go bust. Raising the prices of petrol and diesel notionally is neither here nor there, and only puts off the evil day. Tentative tinkering will only mean the double jeopardy of the crisis continuing unabated and postpone the fires of inflation.

Persistently high oil prices will soon start putting plenty of pressure on the major economic systems of the world. The government has artificially maintained prices at a certain level and this has meant saddling the country’s oil companies with mounting losses. This cannot possibly continue. Quite apart from the short-term impact of high prices, there are crucial questions that need to be answered about the management of India’s economic future given our growing dependence on crude oil imports.

The final price that we pay for petroleum products is based on the import parity price of petrol and includes freight costs, customs, excise and various state government levies as well as the education cess.

Even after the hike, we are partially insulated from the increase in prices in the international market. That’s the burden the oil companies have to bear after thegovernment pays a part of the subsidy. If they don’t get the prices they seek, they will chalk up losses, since their input costs are going up with the rise in global prices.

But what will happen if the entire price rise is passed on? Household budgets will be affected. The immediate impact will be on fuel bills. Cooking will get more expensive with LPG cylinders costing more. So will commuting to work, sending children to school and traveling for holidays.

The increased transport costs will have a ripple effect as transporters pass on the hike to consumers. That will immediately push up the costs of agricultural products. Those prices may go up for another reason: diesel generator sets are increasingly used to pump water in fields. So expect the cost of fruits and vegetables and other non-processed food products to go up soon after.

Reasons for the Rising Prices

Increasing consumption in the United States, which accounts for 5 per cent of the world’s population but consumes 25 per cent of the oil produced globally. Meanwhile, oil is being pumped out at close to full capacity around the world. The global demand for oil grew at its fastest in three decades in 2005. A large proportion of this demand has come from India and China, whose economies have been growing at breakneck pace.

Add the politics of oil to this situation. Iran, the world’s second-largest producer of oil after Saudi Arabia, has been a source of worry because of the controversy surrounding its nuclear programme. Venezuela and, more recently, Bolivia are recasting their oil policies and this is stressing out western governments, multinational oil companies and oil traders. The fallout? Even higher prices.

Over the years a lot of the black gold has flown out of oil fields of the Middle East countries, but the oil reserves of these big exporters report has not shown any proportional fall.

As a result, some oil analysts have begun questioning the amount of reserves Saudi Arabia and others actually have, and this has made oil traders jittery and pushedoil prices northwards. Oil trading, and the speculation that drives it, has been making the situation worse.

Since the past few years, the US financial sector has begun to turn its attention from currency and stock markets to commodity markets. According to The Economist, about $260 billion has been invested into the commodity market -- up nearly 20 times from what it was in 2003.

Coinciding with a weak dollar and this speculative interest of the US financial sector, prices of commodities have soared globally. And most of these investments are bets placed by hedge and pension funds, always on the lookout for risky but high-yielding investments. What is indeed interesting to note here is that unlike margin requirements for stocks which are as high as 50 per cent in many markets, the margin requirements for commodities is a mere 5-7 per cent.

As oil is internationally traded in New York and London and denominated in US dollar only. Naturally, it has been opined by experts that since the advent of oil futures,oil prices are no longer controlled by OPEC ( Organization of Petroleum Exporting Countries). Rather, it is now done by Wall Street. This shift in the determination of international oil prices from the hands of producers to the hands of speculators is crucial to understanding the oil price rise.

In June 2006, when the oil price in the futures markets was about $60 a barrel, a Senate Committee in the US probed the role of market speculation in oil and gas prices. The report points out that large purchase of crude oil futures contracts by speculators has, in effect, created additional demand for oil and in the process driven up the future prices of oil.

What is interesting to note is that the US strategic oil reserves were at approximately 350 million barrels for a decade till 2006. However, for the past year and a half these reserves have doubled to more than 700 million barrels. Naturally, this build-up of strategic oil reserves by the US (of 350 million barrels) is adding enormous pressure on the oil demand and consequently its prices.

The global crude oil price rise is complex, equation (read economics and politics) theories of demand and supply. It is speculation, geopolitics and much more. And unless this truth is understood and the link broken, oil prices cannot be controlled.

Indian Oil Scene

India is dependent on imported crude for more than 70 percent of its requirement. In terms of refining capacity the country is self-sufficient and expect for LPG. No import is required for other products. However, because of the dependence on imported oil, the economy is vulnerable to any volatility in international oil prices. Consequent to deregulation of the oil sector form April 2002. Product prices were expected to be aligned to international prices on import parity basis and hence the prices were to increase or decrease with the fluctuations in international prices, however with the steep increase in oil prices, oil companies were finding it difficult to pass on the same to the customers.

Consumption growth

(MMT)	FY01	FY02	FY03	FY04
Diesel	38	36.5	36.6	37.3
(%) change		-3.9	0.3	1.9
Petrol	6.6	7	7.6	7.9
(%) change		6.1	8.6	3.9
LPG	7	7.7	8.4	9.3
(%) Change		10.0	9.1	10.7

Till the year 1998, the Indian Petroleum sector was controlled by the Administered Pricing Mechanism (APM), which provided the players with assured returns on capital employed. The APM necessitated that the prices of crude oil/products were fixed in a manner so as to assure returns (based on net worth/capital employed) to the exploration and production (E&P) companies, refiners and marketing companies.

The deregulation of the domestic petroleum industry, which was initiated in April 1998, broadly involved the following;

• Providing adjusted import parity prices to refineries
• Decontrol of all products with the exception of MS, HSD, LPG, SKO and ATF. ATF was subsequently freed from marketing controls with effect from April 1, 2001.
• Partial rationalization of the duty structure on petroleum products.
• Providing crude realizations indexed to international prices to the exploration companies.
• Introduction of the New Exploration Licensing Policy (NELP) in the upstream sector with the intention of inducing capital flows into the sector. The complete decontrol of the sector was proposed from April 2002.DECONTRODECONTROL STORY FINALLY UNFOLD

In the Union Budget of FY2002 presented on February 28, 2002, the government finally announced deregulation of the petroleum sector. Key announcement included: -

• Administered Price Mechanism (APM) in the petroleum sector to be dismantled as on April 1, 2002
• The pricing of petroleum products to be market determined
• Issue of oil bonds to the oil companies concerned to liquidate the Oil Pool Account
• Private companies to be permitted in distribution subject to specified guidelines.
• A Petroleum Regulatory Board to be set up to oversee the sector.
• Subsidy on domestic LPG and PDS Kerosene to be provided in the Budget. 

With the administered price mechanism (APM) dismantled post March 2002, the marketing channel is open to private and foreign players. This has seen the competition increasing in the marketing front and the government owned players (On the marketing front there are four major companies HPCL, BPCL, IOC and IBP) are aggressively trying to increase their market share by providing value added services to the consumers.

The dismantling of the administered pricing mechanism means that oil companies are free to take independent decisions based on import parity and market forces in pricing of petroleum products rather than being governed by the dictates of the Government. The public sector oil companies have also to face a competitive marketing environment now.

As the oil industry moves into decontrolled era the oil companies will be free to set their prices linked to fluctuations in global crude prices. Before setting prices the oil companies will calculate the net overall impact of the free market on their margins. This will determine whether prices will move up, down or remain static. Due to freight costs, the prices in the hinterlands may be higher than in coastal areas, though the Government is trying to narrow any difference by using the market leader, Indian Oil Corporation, to determine the market prices. However, the rules of the game are expected to change dramatically when private sector oil companies enter the retail marketing. The pace of competition will pick up with the privatisation of HPCL and BPCL. Then retail prices could differ by 1-2 per

cent from company to company.

Once the initial dust of deregulation settles down and the oil companies figure out the market mechanism, consumers can expect fluctuations in the prices of petroleum products. Once private firms step in and set up their own marketing infrastructure and retail outlets, competition could even spur undercutting, which could only benefit the consumer. Domestic prices of petroleum products would be a reflection of increase or decrease in global prices plus freight and local taxes. Retail prices of petrol and diesel will vary from one place to another. Essentially, this would mean that coastal areas would have lower prices compared to inland locations, which would be saddled with additional freight.

Impact of Deregulation

During the first year of transition to a free-market economy for the oil sector, it has been a truly remarkable one. The scale and pace of changes witnessed by the industry since April 1, 2002, have been far greater than in the five preceding years put together.

Of course, some of the so-called changes, such as the freedom to marketing companies to set retail product prices, have been cosmetic - the Government still pulls the strings from behind the scenes. There is still the major issue of subsidies on liquefied petroleum gas (LPG) and kerosene, which the Government needs to address. With the upward spiral in global oil prices in recent months, the refining and marketing (R&M) companies are forced to bear a part of the subsidy, as the Government has refused permission to revise the retail prices of these two products. The freeing of product prices has seen the earnings of these companies jump within the first few years of dergulation.

The opening up of the industry has come as a boon air to domestic oil companies, which were so far stifled by controls and regulations. But the freedom is at a price - that of increased volatility in prices and profits, heightened competition and a jostling for space in the domestic market.

Exposure to global prices is a double-edged sword. The earnings of domestic oil companies will be exposed to the volatility in global oil prices during the days of control, the OPA evened out such peaks and troughs. The bigger challenge though is the level of competition unleashed by the deregulation. ’S IN STORE FOR THE FUTURE---

Theoretically, with the full decontrol of the petroleum sector, prices at the retail end should vary frequently in accordance with international trends. However, as petroleum products are for mass consumption, socio-political reasons may prevent frequent changes in the prices of the hitherto controlled products - viz. Motor spirit, Diesel, Kerosene and LPG. The prices of these products are not expected to vary on an hourly or daily basis. What is expected is that the oil companies would review the prices at frequent intervals (typically on a monthly basis) and takes the decision to revise prices accordingly. Further, customers are also unlikely to be exposed to extreme price shocks. What is likely is that if oil prices go very high, the government may intervene by imposing excise duty cuts, which is what being done by the government during the recent hike on June 4.

According to some economists, subsidies always end up being at the cost of those who most need help from the state. According to them cooking gas subsidies, for instance, don’t affect people living below the poverty line, and about 95 per cent of rural India. Economists have suggested other options - like a two-tier pricing system - for those who can and can’t afford increased rates. Economists believe there may never be a dramatic crash, but there will come a time when the country’s fiscal deficit, which is directly affected by the subsidy regime, becomes unbearable. Something will have to give, if not now then later.

High and volatile oil prices not only trigger inflationary expectations but are also regarded as a harbinger of economic slowdown. The impact of high oil prices varies across economies depending on the degree to which they are net importers and the oil intensity of the economy. The impact is generally more severe for oil importing developing countries.

Important Concepts: Oil Group References

The well-known classifications (also called references or benchmarks) are the OPEC Reference Basket, West Texas Intermediate (WTI) and Brent Crude.

OPEC

The Organization of the Petroleum Exporting Countries (OPEC) is a group of thirteen states made up of Iran, Iraq, Kuwait, Qatar, Saudi Arabia, the United Arab Emirates, Libya, Algeria, Nigeria, Angola, Venezuela, Ecuador, and Indonesia. OPEC nations account for substantial portion of the world's oil reserves The organization has maintained its headquarters in Vienna since 1965, hosting regular meetings between the oil ministers of its member states.

According to its statute, the principal goal is the determination of the best means for safeguarding their interests, individually and collectively; devising ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations; giving due regard at all times to the interests of the producing nations and to the necessity of securing a steady income to the producing countries; an efficient, economic and regular supply of petroleum to consuming nations, and a fair return on their capital to those investing in the petroleum industry.

OPEC's influence on the market has been negatively criticized. Several members of OPEC alarmed the world and triggered high inflation across both the developing and developed world when they used oil embargoes in the 1973 oil crisis. OPEC's ability to control the price of oil has diminished somewhat since then, due to the subsequent discovery and development of large oil reserves in the Gulf of Mexico and the North Sea, the opening up of Russia, and market modernization. OPEC nations still account for two-thirds of the world's oil reserves, and, as of March 2008, 35.6% of the world's oil production, affording them considerable control over the global market. The next largest group of producers, members of the OECD and the Post-Soviet states produced only 23.8% and 14.8%, respectively, of the world's total oil production.

OPEC decisions have had considerable influence on international oil prices. For example, in the 1973 energy crisis OPEC refused to ship oil to western countries that had supported Israel in the Yom Kippur War or October War, which they fought against Egypt and Syria. This refusal caused a fourfold increase in the price of oil, which lasted five months, starting on October 17, 1973, and ending on March 18, 1974. OPEC nations then agreed, on January 7, 1975, to raise crude oil prices by 10%. At that time, OPEC nations - including many who had recently nationalized their oil industries - joined the call for a new international economic order to be initiated by coalitions of primary producers.

Since currently worldwide oil sales are denominated in U.S. dollars, changes in the value of the dollar against other world currencies affect OPEC's decisions on how much oil to produce. For example, when the dollar falls relative to the other currencies, OPEC-member states receive smaller revenues in other currencies for their oil, causing substantial cuts in their purchasing power. After the introduction of the euro, pre-invasion Iraq decided it wanted to be paid for its oil in euros instead of US dollars causing OPEC to consider changing its oil exchange currency to euros, although after Iraq's invasion, the interim government reversed this policy, and the subsequent Iraq governments stuck to the US dollar. Member states Iran and Venezuela have undergone similar shifts from the dollar to the Euro.

Supply - demand trends

Demand	2001	2002	2003	10-2004	20-2004	30-2004
(In million barrels per day)
OECD	47.9	48	48.7	50.1	48.1	49.1
Russia & other former Soviet Union countries.	3.7	3.5	3.6	3.5	3.7	3.8
China	4.7	5	5.5	6.2	6.5	6.2
Latin America	4.9	4.8	4.7	4.7	4.8	5.0
Middle East	5.2	5.4	5.6	5.8	5.8	6.0
India	2.1	2.2	2.4	2.5	2.5	2.5
Other Asia	5.5	5.7	5.7	6.0	6.1	6.0
Others	3.3	3.3	3.5	3.6	3.6	3.4
Total	77.3	77.9	79.7	82.4	81.1	82.0
Supply
OECD	21.8	21.8	21.6	21.7	21.5	20.9
Russia & other former Soviet Union countries	8.6	9.4	10.3	10.8	11.1	11.4
China	3.3	3.4	3.4	3.4	3.5	3.5
OPEC	30.4	28.8	30.7	32.2	32.4	33.7
Others	31.2	14.5	13.7	14.3	12.6	12.5
Total	77.3	77.9	79.7	82.4	81.1	82

West Texas Intermediate (WTI)

Also known as Texas Light Sweet, is a type of crude oil used as a benchmark in oil pricing and the underlying commodity of New York Mercantile Exchange's oil futures contracts.This oil type is often referenced in North American news reports about oil prices, alongside North Sea Brent Crude. WTI is a light crude, lighter than Brent Crude. It contains about 0.24% sulfur, rating it a sweet crude, again sweeter than Brent. Its properties and production site make it ideal for being refined in the United States, mostly in the Midwest and Gulf Coast regions.Typical price difference per barrel is about $1 more than Brent, and $2 more than OPEC Basket. [edit] 2007

Brent Crude is the biggest of the many major classifications of oil consisting of Brent Crude, Brent Sweet Light Crude, Oseberg and Forties. Brent Crude is sourced from the North Sea. The Brent Crude oil marker is also known as Brent Blend, London Brent and Brent petroleum. It is used to price two thirds of the world´s internationally traded crude oil supplies. The name "Brent" comes from the naming policy of Shell UK Exploration and Production, operating on behalf of Exxon and Shell, which originally named all of its fields after birds (in this case the Brent Goose).

APM (Administered Pricing Mechanism)

A self-balancing system, the APM consisted of a number of oil pool accounts through which products like diesel (HSD), kerosene (SKO), and liquefied petroleum gas (LPG) were cross subsidized through higher realizations from other products such as Motor Spirit (MS) and Aviation Turbine Fuel (ATF).

A cost-plus system, the APM was worked out on the basis of the normative cost, plus a return on net worth/capital employed. A burgeoning oil pool deficit due to the inability of the Government to pass on the increased costs of crude oil through higher product prices and the need for attracting fresh investments both in the upstream and the downstream sector resulted in the initiation of a process of deregulation.

The APM was created after the Government nationalized the international oil majors - Caltex, Esso and Burmah Shell in the early 1970s. With the APM, the Government had also established a complex system of Oil Pool accounts, which was administered by the Oil Coordination Committee (OCC).

Prior to April 1, 2002 - when the new regime set in - domestic prices of some of the petroleum products were partially `insulated' (protected) from volatile international crude oil prices (from which these products are derived) and certain products like kerosene and LPG were subsidised. The oil companies were told how much to sell and at what price.

Dismantling of the APM has also led to the winding up of the Oil Pool account. The Oil Pool account had a deficit of Rs. 13,000 crore, which was outstanding dues to the oil companies as on 31.3.2002. The account was being liquidated by issuance of Government bonds to the concerned oil companies. The OCC has been reduced to Petroleum Planning and Analysis Cell under the Petroleum Ministry to oversee the functioning of the oil companies.

The Cell will also deal with issues arising out of deregulation of prices till the proposed Petroleum Regulatory Board is constituted.

Although oil companies are now free to set their prices for petroleum products, migration from a regime of price controls to the free market will take some time. In Administered Pricing, under the cost plus formula, prices of all petroleum products are fixed on the basis cost of procuring and refining crude oil. Cross subsidization among petroleum products was in existence under the administered pricing mechanism. The prices of petrol and diesel subsidized the prices of liquefied petroleum gas (LPG) and kerosene. The APM ensured a 12 per cent post-tax return to the oil companies. This is lower than those prices determined by the free market.

But the Government will continue to provide a flat rate subsidy for kerosene supplied through the Public Distribution System and for cooking gas cylinder. Besides, freight subsidies for supply of PDS kerosene and LPG in the far-flung areas of the country would also be provided by the Government. This subsidy would be phased out within a period of three to five years.

Prof. M. Guruprasad

Aicar Business School