The Third Oil Shock?

Today’s newspapers reported on the capping of production by IOC, something which BPCL has already done. The article claims that IOC is currently losing Rs300 Crore (~$75 million) a day on account of under-recoveries (basically it sells the oils below the cost price for it to get it to the consumer). The tale does not end there, the company will not be left with any cash to pay for crude oil imports by September-end if the fuel prices are not raised or duties not cut. “If the government does not act, we might see queues and shortages,” CMD for IOC was quoted, indicating a ‘major crisis’ was in the offing.

Those are grave words. There indeed seems to be a problem in the offing with crude oil not only scaling $130/ bbl (barrel = ~159 Liters.) but managing to stay above that level for some time now. For a commodity that was trading at sub $30/ bbl till 2004 it is a significant rise. In fact, oil has crossed its historic inflation-adjusted high of $101.70, reached April 1980.

The only other instances in the recent history have been what are termed: “the oil shocks”. The two (three if you take into account the blip in1860s as well, though the global economy was far less dependent on oil at that time and therefore can not really be termed as a “shock”) instances of such “shocks” have been in the years 1973 and 1980, both precipitated by geopolitical changes: the Yom Kippur War and the Iranian revolution respectively, resulting in a supply shortfall. This third shock is being driven by demand for oil by energy users like China, India, and the United States.

What is also driving the prices up are two factors on the supply side:
a) Unreliable supply from the non-OPEC countries: Russia, the largest non-OPEC supplier has not been increasing the supply and does not seem likely to in the near future. One of the key reasons being the lack of opportunity for foreign investment in a sector, which badly needs investments. Other non-OPEC producers like Mexico, have also seen slipping production, whereas the supplies from Nigeria are perennially under doubt due to internal strife
b) Reluctance of OPEC countries to increase output: OPEC countries have been expanding production but that is not sufficient to meet the growing demand. The publicly stated reason is that the prices are high on weak dollar rather than supply issues. What might be the real reason, is that limited reserves mean that the OPEC countries are also trying to get the maximum return for their stocks

That means in the foreseeable future the price/bbl will remain in $100+ band. What make it worse in the Indian case are the government’s policies, which are not only postponing trouble and but also accentuating the level of the measures that would have to be taken to resolve the gap.

The current government policy to partially (at best) link the supply to global prices means that the oil companies are quickly loosing the operating capability as highlighted earlier in the article by the IOC Chief.

This policy has also led to issuance of oil bonds worth $2.3 billion in Jan, 2008 alone. In normal scenario if it was a direct subsidy it would have gone through the budget and would have constituted a part of the budgeted deficit. But by issuing bonds the government has been successful to keep such measures “off balance sheet”. Not so long ago, a large energy company went bankrupt and its top executives are serving time for keeping liabilities off balance sheet. I am not suggesting that the same is the case with the governments, but then there is the thought, as always, who polices the police.

In addition, subsidies on Kerosene and LPG have meant that the industry has been innovating to make diesel the fuel of choice to lower the TCO (Total cost of ownership), do a quick survey of your friends and you would immediately find out, why so many people chose the diesel model of the car they just bought. As Mr. Behuria (CMD, IOC) said “Diesel demand is growing at 20-22 per cent, a rate that will necessitate IOC to import two million tonnes, but the company plans not to shell out international prices and would rather restrict supplies,”

But will the government take action to take corrective actions, especially with pricing/ subsidies when elections are close? The answer seems to be clear from the recent comments coming out of Delhi: FM has refused to lower the import and excise duties and also seems to be reluctant to introduce an oil-cess.

With CPI (M), a key coalition partner hammering away at the government on the inflation issue, government knows that the loan waivers it has offered the farmers will not come handy if it completely antagonizes the middle class

However, by postponing the obvious and essential the government is only going to accentuate the magnitude of the final remedy. What the government can hope is that it can hold the status quo, till the elections, so that either it will have a 5 year term to resolve the quagmire it has created or it can sit in the opposition and rattle arms against the incumbent government on the growing menace of inflation.

Whatever the course of action, the economy is on for some testing times. So, fill up your tanks, and get ready for a rough ride!