The age of ‘high' oil

The predicament in Europe has thus far diverted attention from another crisis that has been brewing for some time now: a spike in global oil prices. The price of oil has risen by close to 20 per cent since the beginning of this year, raising the prospect of it touching the peak levels it had reached in July 2008.

Brent Crude was selling at $128 a barrel at the beginning of March, as compared with its less-than-$110-a-barrel price at the end of December (Chart 1). This spike occurred on top of the continuous increase in prices recorded since December 2008, when oil prices touched a low influenced by the global crisis. Prior to that, the free-on-board (FOB) price of Brent crude had collapsed from more than $140 per barrel in July 2008 to less than $35 a barrel by the end of that year.

But though the recession has persisted even after that, the price trend has reversed itself to reach its current high levels even by historical standards. In fact, if Europe was not experiencing the stagnation it is struggling to address, oil prices could possibly have been at another record high.

Surprising rise

From a purely demand-supply point of view, the rise is indeed surprising. The US, the world's largest importer (Chart 2), has seen its import levels drop significantly. One reason is that the combination of a recession and higher oil prices has restrained oil demand. According to official sources, the demand for oil in the US was down by 2 per cent last year. In addition, domestic supply has improved, partly because of increased domestic production and partly because of the availability of alternative fuels such as ethanol.

As a result, the share of imports in US oil consumption was down to 45 per cent from 60 per cent in 2005. Aggregate US imports of crude oil are placed at 8.91 million barrels a day in 2011, which was the lowest it has reached after 1999. All this should have worked to moderate international oil prices.

It could be argued that the fallout of these trends in the US has been partially countered by the increase in Asian demand. China and India are the second and fourth largest net importers of oil. But in their case too, growth, though higher than in Europe, the US and Japan, has slowed after the crisis. So demand from those sources too would have been lower than would have otherwise been the case.

Iran-West standoff

If prices have risen sharply despite these trends, it is principally because of the uncertainty resulting from political developments in the region. Ever since the outbreak of diverse oppositional movements in West Asia and North Africa, uncertainty with regard to supplies has been on the rise. The political disruption in Libya, in particular, was seen as having had an adverse effect on supplies.

But the factor that seems to have provided a fillip to the price rise was the standoff between Iran and the West, ostensibly over the former's nuclear programme. Iran, which is the third largest net exporter of oil (Chart 3), is already subject to US sanctions that are targeted at limiting its oil exports.

In fact, in recent times, the US has intensified its efforts to discourage global consumption of Iranian oil. To add, Europe announced that it would also impose an embargo on oil imports from Iran starting from July this year, and Iran responded by threatening to immediately cut supplies to six European countries.

Asia and Iranian oil

The price spike, however, was not because of any immediate shift in the supply-demand balance and shortfall in oil availability resulting from these factors. To start with, the announced European embargo and Iran's response to it have yet to be implemented. Secondly, the US has not been able to persuade all countries to stop oil imports from Iran, which would have effectively cut off its supplies to world markets. A typical case here is India. India imports around 3,00,000 barrels of oil a day from Iran, which amounts to a significant share of its oil consumption. Yet India seemed to be succumbing to pressure from the US, first with respect to a transnational pipeline project involving Iran and subsequently with regard to foreign currency payments arrangements for Iranian oil.

But finally, India has worked out a rupee payment deal, which secures its supplies from Iran as well as opens up opportunities for trade reminiscent of India's relationship with the erstwhile Soviet Union.

Besides India's action, Iran's supplies to the world market are likely to remain untouched because of the importance of Asia in its total exports. China, India, Japan and South Korea account for more than 60 per cent of world imports of Iranian oil. So long as these countries protect their own energy security by not cutting off their relationship with Iran, a chunk of supplies involved in the global trade in oil would not get cut off.

Finally, as in the past, Saudi Arabia has helped cool oil markets with its spare capacity and its willingness to ramp up production to cover any unmet demand. Saudi Arabia had made an important contribution to reining in oil prices during the Venezuelan oil strike in 2003, the invasion of Iraq in 2003 and the Libyan crisis last year, and promises to continue to do so.

Speculative investments

If despite all these factors that keep the supply-demand balance in control, prices have risen, it is because of the speculation engaged in by global finance by exploiting the prevailing political uncertainty.

It is known that energy markets have attracted substantial financial investor interest since 2004, especially after the decline in stock markets and in the value of the dollar.

Investors in search of new investment targets have moved into speculative investments in commodities in general, and oil in particular. Hedge funds and other investors have been buying into the commodity, fuelling the price increase even further.

The problem is that this consequence of speculation is not just a short-term price spike. If speculation feeds on political uncertainty, then we could be looking at a long-term problem in oil markets. As noted earlier (Chart 1), looking back, it emerges that nominal oil prices were rising gradually from 2003 till the middle of 2006 and sharply from early 2007 till the middle of 2008, after which we have witnessed the dip and revival since 2008. That is, the last decade, when political turmoil intensified in the West Asian region, has been a period of an almost continuous increase in oil prices, irrespective of the state of global demand.

This is by no means a normal inflationary trend, since even the real, consumer price inflation-adjusted price of oil has been at high levels in recent years. Consider, for example, the price of oil imported into the US, measured in inflation-adjusted terms or in “2012 dollars” (Chart 4).

The chart shows that the real price of oil has been on the rise since 1999 and especially since September 2001, when the US responded aggressively to the twin towers attack. What is more, the peak 2008 price in 2012 dollars was above the high prices recorded in the 1970s, which was when the world experienced the effects of the formation of OPEC, the Iranian revolution and the Iran-Iraq war. In sum, ever since “9/11”, oil prices have not just been on the rise but seem to have found a higher average level when compared with trends since the formation of the OPEC cartel.

It has been known for sometime that this long-term trend was not really the result of fundamental demand-supply imbalances but driven by financial speculators exploiting political uncertainty. On April 29, 2006, The New York Times had reported that: “In the latest round of furious buying, hedge funds and other investors have helped propel crude oil prices from around $50 a barrel at the end of 2005 to a record of $75.17 on the New York Mercantile Exchange.”

According to that report, oil contracts held mostly by hedge funds had risen to twice the amount held five years ago. To this had to be added trades outside official exchanges, such as over-the-counter trades conducted by oil companies, commercial oil brokers or funds held by investment banks.

OPEC assertion

And price increases had also attracted new investors, such as pension funds and mutual funds seeking to diversify their holdings. In fact, in November 2007, when Royal Dutch Shell, Europe's biggest oil company, presented its third quarter results, the Chief Financial Officer, Mr Peter Voser, argued that: “The price (of oil) seems to be driven by some speculation and also has a political premium in it rather than actually some of the fundamental drivers.” These trends have only intensified since.

Not surprisingly, in 2008, the Organisation of Petroleum Exporting Countries (OPEC), which is normally held responsible for all oil price increases, had asserted that oil has crossed the $100-a-barrel mark, not because of a shortage of supply but because of financial speculation.

OPEC's contribution was indirect and unintended if at all. As A.F. Alhajji, Energy Economist and Associate Professor at Ohio Northern University had argued in the Financial Times , even when some OPEC countries are to blame it is because: “As oil prices have increased, so have their (OPEC countries') revenues. Some of these revenues found their way into funds that speculate in oil futures.” In his view, it was in this way, ironically, that “petrodollars” have helped drive oil prices to record levels.

In sum, a combination of political uncertainty, partly generated and sustained by US and European foreign policy, and the operations of global finance, has taken the world into a higher oil price regime.

Such uncertainty and the accompanying speculation hold out the threat of an age of “high oil”. We seem to have forgotten that. But recent developments are once again bringing that truth to the forefront.

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