International oil prices remained well below $50 per barrel in the 1980s and 1990s. The figure shows this for Brent. But they became excessively volatile since the mid-2000s — Brent ranged from $132 in mid-2008 to $30 in January 2016, with sharp swings between. A lower peak at $81 in October 2018, as well as a crash to $18 with Covid-19 both did not last long.
This volatility was one reason for slow global growth in the 2010s. Spillovers from losers to gainers reduce net gains.
For example, while commodity exporting nations were in dire straits after the 2014 oil price crash, India’s gains from were less than expected, since the slowdown in global export growth moderated gains.
As a produced commodity, the price of oil depends on the supply-demand balance, inventories, oil production capacity and costs. If inventories are low, supply or demand shocks can lead to large short-term price fluctuations. Over time, the price rise reduces demand and raises supply.
As administered price mechanisms were given up in the physical market, deep and liquid futures markets, which aggregate diverse views, were developed to aid price discovery. These were expected to make the oil market more forward-looking. As a financial asset, the price of oil depends on the structure of markets, expectations of oil fundamentals and of news impacting them. In the 1990s investors began taking positions in commodity futures as part of a diversified portfolio.
As the figure shows average price levels, as well as their volatility, rose sharply after 2000, indicating sustained deviations from fundamentals. This followed the US Commodity Futures Modernization Act passed in 2000, which lightened position limits, among other deregulations. ‘Swap dealers’, who facilitate over-the-counter investment in exchange-traded funds tracking commodity indexes, were granted exemptions from position limits. Following this, open interest in oil derivatives more than tripled and the number of traders doubled over 2004-08. Large-scale index-based investment took place as pension funds diversified their portfolios after the dotcom crash.
Deregulation aggravated pro-cyclical waves of optimism or pessimism. Even oil producers consider oil futures to be too volatile. They prefer a price band around $60, which sustains steady production. G20 should take up uniform prudential regulation of futures markets. Position limits could be re-imposed.
The size of cycles did reduce after 2015 because the entry of shale oil made the supply response easier and faster. As the market share of OPEC reduced so did their pricing power. But cycles remained larger than they were pre-2000.
The sharp plunge due to the unprecedented Covid-19 shock, however, bankrupted many over-leveraged shale oil producers. This made it easier for the OPEC to regroup and regain market power with agreement on production cuts.
As oil prices rise above $70, however, shale oil is highly profitable again. Restructuring had lowered costs and lessons about more disciplined expansion learnt. It is dangerous for OPEC to allow oil prices to rise. Countries are tempted to break the cartel. Green substitutes also get a boost. Their recent meeting again shows difficulty in reaching agreement. Consumer countries, such as China, will use large oil stocks built when prices crashed, reducing demand. If a deal is reached on sanctions, Iran’s large oil stocks may be released in the market. When prices peaked in October 2018 at $81, in the next month they had fallen to $64. History may repeat itself this year.
It is unclear whether in general recovery will stoke excess demand and inflation, or supply chains will recover and secular stagnation reappear. Markets seem to be verging to the view that inflation will be temporary. US bond yields have softened.
The domestic tangle
Indian fuel taxes were raised sharply during the 2020 slump in oil prices, as a way to recoup the sharp blow to tax revenues from the lockdown. But they have not been reversed although both tax revenues and international oil prices have recovered.
Unfortunately, the Centre and States both compete for the space, each is afraid a retreat would allow the other to muscle in. State taxes are imposed on value added and automatically rise with prices. Including energy in GST offers a solution to this impasse.
Centre-State shares could be settled on the lines of GST principles, on those set by the 15th Finance Commission (FC) based on relative spending responsibilities. Even taxation at a maximum luxury slab of 28 per cent of GST would result in double digit reduction in fuel prices per litre. It would also reduce cascading, cost-push inflation, as well as improve export competitiveness and household consumption demand.
The graph shows international fuel prices both rise and fall. Indian prices used to keep rising when they were administered. Even after they became market determined, taxes tend to rise more when international prices fall but fall less when prices rise. As a result Indian fuel prices rise more than international.
The persistence thus imparted to domestic oil prices undermines flexible inflation targeting. Monetary policy can look through volatile commodity price shocks, since well anchored inflation expectations limit pass through.
But if policy makes the price rise permanent, inflation expectations cannot be anchored after a shock. The upward ratchet sustains inflation. Second round rise in wages and long-term bond rates follow. If policy rates are forced to rise, so will borrowing costs for central and state governments.
In the days when petrol prices were administered, noisy political battles made it difficult to raise domestic prices when international prices rose. Now oil marketing companies smoothly change prices with international. Political contestation has, however, moved to taxes imposed.
This discretion allows arbitrary price and resource distortion to continue and imposes huge indirect economic costs. Removing it will allow focus on more worthwhile issues. But will governments be willing? Incessant public jostling for more hides the fact that States have not lost with GST; 14 per cent compensation was generous and decided on then prevailing rates of nominal income growth, but continued even as growth plunged. Now partly as loopholes are closed and the economy recovers, there is a rise in revenues to share.
Incentive reforms with 15th Finance Commission, open new revenue sources for States. A rise in user charges and property tax can be tied to better services.
Relations between the Centre and States have been fraught partly because the Constitution gave the Centre more powers in order to keep the nation together. Cooperative federalism works if functions are split according to what is best performed at different levels.
It is clear there is an advantage to centralising certain functions — vaccine purchase, borrowing, some types of taxation, ensuring homogeneity of public services, while the services have to be delivered locally.
States want GST compensation to continue beyond the agreed date — it could be more modest and tied to bringing energy into GST. Revenue neutrality will come from the resulting greater efficiency and growth, supplemented by an additional carbon tax, which would also encourage green alternatives and reduce India’s oil bill. Domestic add- ons would then not aggravate international oil shocks.
The writer is Emeritus Professor, IGIDR. Views are personal