The fear of a substantial hike in oil prices is unfounded

The Iraq war has raised questions about the impact on oil prices and growth. India’s main concerns are: Is the Iraq war likely to raise oil prices to those seen in the Seventies? And, can a prolonged war substantially weaken India’s current account?

While these fears based on our previous experience are perfectly natural and there are no simple answers, we can argue that such outcomes will be unlikely.

Pessimists today claim that oil prices could go up from $ 35 a barrel to $ 50 a barrel owing to this war. This scenario is innately much easier for India to handle, as compared with the oil price of $ 40 per barrel in 1979, which is $ 100 when measured in 2003 USD prices.

In 2003-04, at last year’s prices India is expected to import $18 billion of oil, on a base of total imports of $ 60 billion. If we assume that oil prices rise to $ 50 a barrel and stay at that level for a year, an extreme scenario, this is a 43 per cent increase in the price of oil.

Assuming this leads to a 35 per cent increase in oil imports by value, it would raise POL imports to $ 24 billion, an increase of $ 6 billion per year. This is an increase which can easily be absorbed by India today, where we have current account revenues of totally $ 90 billion a year, obtained by selling $ 50 billion of goods and $ 40 billion of services.

So there are two big differences between today and 1979. Pessimistic projections involve a price of oil which would prove to be half of that seen in 1979 (in real terms). And, India’s ability to pay for this has been transformed owing to India’s success in exports.

How likely is it that oil prices will rise to $ 50 a barrel and stay that high for a year? The recent rise in oil prices has been unnerving. However, a big part of the explanation for this lies in the disruption of oil supplies in Venezuela, the fifth largest producer of oil in the world.

One of the striking differences in today’s situation is the increase in importance of non Persian Gulf sources of oil in the world.

Middle eastern nations today account for only 30 per cent of the world output of oil. New technology, privatisation and changes in international political relations have resulted in Russia and Central Asia becoming major producers and exporters of oil.

Russian output of oil has increased by 25 per cent in the last 3 years and today it is the second largest exporter of oil, exceeded only by Saudi Arabia. In Central Asia, Khazakhstan and Azerbaijan are witnessing increasing output.

A new pipeline that would transport their oil to the rest of the world is being currently built from Baku through Georgia, through Turkey, to the Mediterranean port of Ceyhan. This huge pipeline would transport a million barrels of oil a day, which would then be exported by super tankers to the rest of the world.

Second, it is important to understand that the price of oil is not determined freely in the market. Rather, the supply of oil is controlled to manipulate the price. If so desired, OPEC countries can keep the price of oil from rising despite the stopping of supplies from Iraq.

Saudi Arabia, for example, always has excess capacity to produce oil and prevent prices from rising. A price of $ 50 a barrel is based on the assumption that all Iraqi production capacity is destroyed and, as a consequence, world oil output falls by about 4 per cent in the year.

Nobel laureate Gary Becker argues that though this could push prices up to $ 50, the price hike is likely to be temporary. Moreover, it may actually be below this level because most of the war premium has already been factored in.

Why would OPEC, an aspiring monopolist, prevent the price of oil from rising too high? OPEC has, in the past, tried to maintain the price of oil from rising too much, not for the simplistic reason often given that Saudi and Kuwaiti regimes support the US government and they keep the price of oil low in the interests of the US which is the biggest importer of oil. The reason is slightly more complex and long sighted.

To keep the world dependent on oil and preserve their share of the market, Middle eastern countries do not have an incentive to have long periods of high oil prices. As Sheik Yamani of Saudi Arabia said, “If we force Western countries to invest heavily in finding alternative sources of energy, they will.

This will take them no more than seven to 10 years and will result in their reduced dependence on oil as a source of energy to a point which will jeopardise Saudi Arabia’s interests.”

OPEC likes to keep oil prices low because high prices of oil encourage the development of fuel saving techniques which reduces the world’s dependence on oil. Fuel efficient automobiles are developed and become more popular; electricity generation and heating shifts away from oil and gas.

High oil prices also encourage the use and development of alternate sources of energy such as natural gas. In India, we have seen the use of natural gas increase sharply in the last few years. At a time when our oil production was stagnant, net production of natural gas rose from 17 billion cubic metres in 1994-95 to 28 billion cubic metres in 2001-02.

OPEC worries that higher prices make it profitable for other countries of the world, where it is more expensive to extract oil, to produce oil. A key facet here is that ‘reserves’ of oil are not fixed as in laid down by nature. The ‘reserves’ that exist at any point in time are, instead, a function of the price of oil. High oil prices are automatically associated with higher reserves.

In addition, recent developments in technology have made exploration and production far cheaper and economically feasible.

This has led to an increase in the world’s proven oil reserves in many parts of the world outside the Persian Gulf, such as China and Canada.

In India too, private participation in oil exploration has resulted in finding new reserves. While at low prices some of these may not be profitable sources of supply, if prices rise, they could be potential sources of supply. India is likely to see improvements in technology in exploration and production, owing to the increased privatisation of the oil sector.

In today’s world therefore it is far less likely for oil prices to rise as sharply as they did in the oil price hikes of the seventies and even if they do, it would in all probability be a very short-term phenomenon followed by increase in supplies that would regulate prices. In this scenario, the dooms day mentality of the world being hit by an oil price hike seems unrealistic.

ila@icrier.res.in

(The author is at ICRIER. These are her personal views.)