Oiling the economy

Indian Express, 26 November 2007

As the price of crude oil inches towards $100 a barrel, a Group of Ministers will debate whether India should raise domestic petroleum prices. While Planning Commission Deputy Chairman Montek Singh Ahluwalia has indicated that petroleum product prices in India need to rise, Petroleum minister Murli Deora informed parliament that "the government, under the instruction from the UPA chairperson, is not proposing any fuel price increase".

Mounting losses of public sector oil enterprises, that incidentally have been almost the only industry in which the public sector has been making profits, the rising off-budget subsidy in the form of oil bonds, and the impact of low petroleum product prices on private oil refining companies like Reliance who have been forced to shift entirely to exports, are among the most powerful reasons why the price of petroleum products in India should be raised. However, that is not the entire story.

One of the most important arguments in favour of an oil price hike in India, as also China, is that these two countries now account for the bulk of the growth in world oil demand. Over the last two years, 70 percent of the additional world demand for oil came from India and China. If domestic oil prices in India and China do not go up, it is unlikely that this demand for oil will reduce. And, if their demand for oil is not going to go down, there is no incentive for oil producers to want lower prices.

In the past, decisions by OPEC, especially Saudi Arabia, to reduce prices have come because of the concern that as in the years after the oil price shocks of the 1970s, expensive oil encouraged moving away from petroleum through energy saving devices, fuel efficient vehicles and alternative sources of energy. And, so to keep the world dependent on oil, OPEC did not allow the price to rise too much. If, however, India and China do not raise domestic oil prices, these economies will continue to use petroleum intensive transport and diesel for electricity generators. To the extent that Indian consumers do not feel high prices and respond through altered behaviour, OPEC has no incentive to reduce oil prices.

Today, however, there is another question: can OPEC reduce oil prices by pumping out additional oil if it so desired? On November 23 there was a small decline in crude oil prices when news arrived that OPEC will boost production by 720,000 barrels a day, instead of by 500,000 barrels per day, as agreed by OPEC in September. However, it increasingly seems that OPEC does not have much spare capacity and cannot really push up production enough to reduce the price of oil significantly.

There is uncertainty about the demand for oil in the coming years due to factors such as a likely slowdown in the world economy. As a consequence, OPEC countries, which have the bulk of the proven oil reserves are unwilling to make the large investments required to increase output. The experience in the eighties, wherein a sharp oil price hike resulted in a shift away from oil intensive technology, was a painful one for OPEC. Large investments resulted in capacity creation that had to be later kept idle to limit production, as the price of oil fell sharply.

As long as expectations about demand remain high while expectations of supply remain weak, it is unlikely that the price of oil on financial markets will drop.

In another twist to this tale, it is argued that actually the price of oil has not really risen so much. It is the dollar that has declined. If the price of a barrel of oil is measured in euros the increase is not so sharp. Sixteen months ago, in July 2006, the price of the Indian basket of crude, for example, was 58 euros per barrel. Now it is 62 euros. The apparent rise in the price of oil, when expressed in dollars, merely reflects the decline of the dollar. Unlike India or China, European governments do not trade in the currency market, so the global decline of the dollar has gone with a sharp strengthening of the Euro.

From the various projections being made about demand and supply, it seems unlikely that the rise in the dollar price of crude is temporary. Most analysts expect the dollar price of crude to go up even futher. In the above scenario, what is the best policy choice for India? Over the last one year, the rupee price of the Indian basket of crude oil has increased by from Rs 2,622 to Rs 5,537 per barrel. The government must increase domestic oil price accordingly. China has already raised domestic oil prices by 10 percent this month; it is time for India to do similarly.

The best way to address the issue in the future is to go the European way, avoiding administered pricing on either the exchange rate market or the crude oil market. By preventing petroleum product prices from rising, we reduce the incentive for households and firms to find alternatives. By preventing the rupee from appreciating, the Indian government is making the rupee price of oil imports more expensive. If the dollar price of oil rises due to the decline of the dollar, a stronger rupee will help keep crude cheap for Indian importers. It will reduce losses of public sector oil companies.

A policy framework of removing government-induced distortions on both currency and domestic product prices can keep down the domestic price of petrol more effectively than the present policy combination.

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