The Hindu Business Line : Firm crude prices in summer worrisome

Crude oil is trading close to $35 to a barrel for spot delivery and does not show any sign of coming off. Can crude oil prices move higher and create a drag on the global economy?

How dependent is the global economy on the energy prices? We would take a look at these issues.

At the onset let us look at the crude oil market. There are essentially four grades of crude oil that are traded. Interestingly, these crude oils are priced differently. These four major crude oil types are Brent, West Texas Intermediate, Dubai and Tapis.

Though there are some other grades, they are traded as a spread to these major global grades. The four major grades' prices differ based on their locations i.e., proximity to the area of product demand and quality which is classified as light or heavy depending upon oil's specific gravity and sweet or sour based on its sulphur content. Brent is the crude drawn mainly from North Sea, West Texas Intermediate in Americas, Dubai crude in West Asia and Tapis in the Indian Ocean.

The crude prices are mainly traded at The New York Mercantile Exchange (NYMEX) and The London International Petroleum Exchange (IPE). Most of the trading in the crude is on the floating price sources i.e., futures. NYMEX is the most liquid oil exchange in the world and NYMEX West Texas Intermediate Future average daily trade volume is around 60 million barrels.

The IPE Brent crude futures average daily trade volume is around 30 million barrels. The major participants in the crude oil market are the producers, which can be classified as OPEC and non-OPEC producers.

The main demand for crude comes from refiners, airlines, shipping companies, utilities - electricity & gas, petrochemical companies, transport and mining companies.

Entities which play a role in making markets are trading companies, banks and brokers, investment and hedge funds. One of the most important players is the Government, like the American one, which controls and decides on the strategic reserves of crude oil. Their policies of using or building reserves play a dynamic role in determining the crude oil prices.

The world has seen two oil shocks in the 1970s and 1980s. These were the periods when the oil prices surged and dragged the global economy down.

However, there is a marked difference in the impact of crude oil to the global economy. The energy consumption per unit of GDP has drastically moved lower over the last three decades.

If one takes the energy consumption per unit of GDP figure of 1970 as the base, the same current figure is almost half for developed countries such as the US, Germany and the UK. This is due to more efficient processes of energy production and transmission.

In some developing countries like China the same figure has dropped to an amazing one third. The reason for such energy efficiency is that China has moved away from coal over the last 20 years to other fuel such as oil which is more energy-efficient.

There is greater emphasis on less energy-intensive industries like toys and microwaves in manufacturing production. The private sector in China which accounts for increasing share of production tends to be more efficient than the State-owned enterprises. The data indicates that the global economy is less susceptible to the oil price surges than it used to be decades ago. During the previous oil shocks there were wage increases due to the oil prices-induced pick-up in headline inflation. It is unlikely that there would be any wage response to firm oil prices now.

According to Thomson Financial Data-stream, the Brent crude prices are on dollar terms a good 18.5 per cent higher than the average of second half of 2003 and around 12 per cent higher in euro and yen terms and just 6.3 per cent in sterling terms.

In the case of West Texas Intermediate crude, the similar figure in dollar terms is around 22 per cent higher and around 15 per cent in euro and yen terms. The weaker dollar has played a part in these figures.

In the first quarter, the exchange rates have been relatively stable. In case the crude prices remain where they are for the rest of the year we would see around 17-18 per cent increase in dollar terms in 2004 from the average of last year.

Simulations show that the impact of higher crude prices is comparatively fairly limited on GDP and inflation. Even though the impact on global economy would be limited, nonetheless it would be negative for the US consumer spending in the second half of this year once the fiscal policy stimulus wears off and job growth is not consistent.

This might force the Federal Reserve to hold moving on the rate well into next year. The high crude prices would also impact the developing economies such as China and India by adding to the inflationary pressures. Crude oil prices would remain firm as OPEC has stuck to the production cut of one million barrels per day from the start of April.

The US gasoline inventories are down and there are concerns that violence in West Asia can cause disruption. OPEC in its report released last week has increased its crude oil demand forecast for 2004 by 2.3 lakh barrels per day to 26.17 million barrels per day. OPEC's expectation of the world demand is at a four-year high.

This stance would lessen the chances of traditional crude price drop at the onset of summer.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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